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Improving early warning indicators for banking crises – s Improving early warning indicators for banking crises – s

Improving early warning indicators for banking crises – s - PowerPoint Presentation

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Improving early warning indicators for banking crises – s - PPT Presentation

requirements Mathias Drehmann and Mikael Juselius Bank for International Settlements Understanding Macroprudential Regulation Norges Bank Oslo 2930 November 2012 2 ID: 573687

crises credit policy gap credit crises gap policy ewis 2012 indicators policymakers requirements gdp tools roc capital instrument early

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Slide1

Improving early warning indicators for banking crises – satisfying policy requirements

Mathias

Drehmann

and Mikael

Juselius

Bank for International

Settlements

“Understanding Macroprudential Regulation”

Norges

Bank, Oslo, 29–30

November

2012

Slide2

2

CGFS report No

48

Operationalizing

the selection and application of macroprudential

instruments Slide3

Operationalising macroprudential policies

Report

focusses on

3 high-level

criteria that are key in determining instrument selection and application in

practice

The ability to determine the appropriate timing for the activation or deactivation of the instrumentThe effectiveness of the MPI in achieving the stated objectiveThe efficiency of the instrument in terms of a cost-benefit assessment

3Slide4

Report ends with 9 questions and answers

To what extent are vulnerabilities building up or crystallising?

How (un)certain is the risk assessment?

Is there a robust link between changes in the instrument and the stated policy objective?

How are expectations affected?

What is the scope for leakages and arbitrage?

How quickly and easily can an instrument be implemented?What are the costs of applying a macroprudential instrument?How uncertain are the effects of the policy instrument?

What is the optimal mix of tools to address a given vulnerability?

4Slide5

Report analysis three groups of macroprudential

instruments

C

apital-based

tools (countercyclical capital buffers, sectoral capital requirements and dynamic provisions

)

Liquidity-based tools (countercyclical liquidity requirements)Asset-side tools (loan-to- value (LTV) and debt-to-income (DTI) ratio caps)For all tools report proposes ‘transmission maps’5Slide6

Increase

resilience

Impact on the credit cycle

↑ lending spreads

 dividend and bonuses

Undertake SEOs

1

credit demand

Options to address shortfall

Asset prices

Loan market

Increase

capital requirements or provisions

credit supply

Voluntary buffers

Arbitrage away

Leakages to non-banks

Expectation channel

Reprice loans

assets, especially with high RWA

Loss Absorbency

Tighter risk management

Transmission map for capital

based tools Slide7

7

Improving early warning indicators for banking crises – satisfying policy requirements Slide8

Introduction

CGFS (2012):

Policymakers

need to be able to

determine

the appropriate timing

for the activation or deactivation of the instrumentIn this paper we want to find reliable early warning indicators (EWIs) for systemic banking crisesWhat policy requirements do EWIs need to satisfy?Need to be evaluated with preference free methodology

Need to have right timing

Need to be

stable

Need

to be

robust

Need to be understood by policymakers

8Slide9

We assess a broad range of indicators

We find

Credit-to-GDP gap best indicator for predicting crises 2-5 years in advance

Debt service ratios highly successful indicator for predicting crises 1-2 years in advance

Implementing the framework

9Slide10

To fully evaluate quality of a signal would need to know preferences of policymakers, which are

unknown (

eg

CGFS (2012))

What are costs of

acting on

wrong signals (false positives)?What are the benefits of

acting on correct

signals (true positives)?

Need to evaluate signalling quality independent of preferences

10

How to evaluate the goodness of an EWI? Slide11

11

The ROC curve

Policymakers receive noisy signal S

S higher → higher risk

of a crisis

At which threshold you policymakers

act? Slide12

Area under ROC curve as measure of signalling quality

Area under the ROC curve (AUROC) provides summary measure of the classification ability

(

eg

Jorda

and Taylor, 2011): AUROC=0.5 →

uninformative

indicator

AUROC=1

fully

informative indicator

AUROC ideal measure if preferences are not known

Benefits

Can be estimated non-

paramterically Has convenient statistical properties

12Slide13

Timing of ideal EWIs

Ideal EWI needs to signal crisis early enough

Likely to be 1-2 year lead-lag relationship (e.g. countercyclical capital buffers)

Policymakers tend to observe trends before reacting (e.g. Bernanke, 2004)

Ideal EWI signal crises not too early

Introducing buffers too early may undermine effectiveness (e.g. Caruana, 2010)

We look at individual quarters within a 5 year horizon

13Slide14

EWIs need to be stable and robust

Policymakers adjust policy stance gradually

Optimal for MP (Bernanke, 2004,

Orphanides

, 2003)

Indictor should issue consistent signals

Consistency of signal tied to persistency of underlying series (

eg

Park and Phillips (2000))

High degree of persistency problematic for statistical inference

Non-parametric approach

EWIs need to be robust to different samples and specifications

14Slide15

Interpretability of EWI

Evidence that practitioners value sensibility of forecasts more than accuracy (Huss, 1987) adjust forecasts if the lack justifiable explanations (Onka-Atay et al (2009)

Purely statistical approaches are not suitable for policy purposes and communication

Our indicators reflect

excessive leverage and asset price booms (Kindleberger, 2000, and Minsky, 1982)

non-core deposits (Hahm et al, 2012)

the business cycle

15Slide16

Analysing potential EWIs

We construct and test a range of potential early warning indicators building on Drehmann et al (2011)

We select indicator variables from...

Credit measures: Credit-to-GDP gap and real credit growth

Asset prices: Real property and equity price gaps and real property and equity price growth

None-core bank liabilities (

Hahm

, Shin, and Shin (2012)):

GDP

growth

History of financial crises

...and add one new measure:

Debt service ratio (DSR) (Drehmann and Juselius (2012)): interest payments and repayments on debt divided by income

16Slide17

17

We analyse quarterly time-series data from 27 countries.

The sample starts in 1980 for most countries and series, and at the earliest available date for the rest

Use balanced sample

We follow the dating of systemic banking crises in

Laeven

and Valencia (2012)

We ignore crises which are driven by cross-boarder exposures

We adjust dating for some crisis after discussions with

CBs

Analysing potential EWIs (II)Slide18

Several of the variables display dynamics which are hard to distinguish from I(2) process

Indicators which have performed well in the past are more

persistent

Benefits of a non-parametric approach

Persistency

18Slide19

Behaviour around systemic crises

19Slide20

ROC curves for 2 year forecast horizon

20Slide21

ROC curves over time

21Slide22

Combining variables

22

Credit to GDP gap and property price gap

Credit to GDP gap and DSR

DSR and property price gapSlide23

Robustness checks

Robust across samples

Robust

to different crisis dating

Robust to balanced versus unbalanced

samples

Robust if partial ROC curves are used

23Slide24

We argue that EWIs need satisfy six policy requirements:

Need to be evaluated with preferences free methodology

Need to have right timing

Need to be stable

Need to be robust

Need to be understood by policymakers

Appliying

this approch to data from 27 countries we find that:

The DSR and the credit-to-GDP gap dominate other EWIs

The DRS dominates at shorter horizons and the credit-to-GDP gap dominates at longer ones

Conclusion

24