Optimal Weights Stress Banking Indexes

Optimal Weights and Stress Banking Indexes*
Stefano Puddu†
HEC-Université de Lausanne
Abstract
The goal of this paper is to construct synthetic indexes measuring the stress level of the
US banking system. In order to achieve this result different techniques have been used.
Specifically, we present two different classes of indexes based on a signaling approach
and on Zero Inflated Poisson estimations. We compare our results with indexes based on
the variance-equal approach and on the factor analysis. The main differences in results
are above all in term of the level of stress detected by the indexes. Furthermore, the
indexes show the same shapes. Moreover, we examine how the indexes reproduce
economic and financial events for the period analyzed. It turns out that the indexes based
on the methodologies we proposed are able to replicate these main events. Finally, the
indexes show satisfactory results also in terms of coefficient stability and forecasting
properties.
Keywords: Stress-banking indexes, Signaling approach, Limited dependent variable
methods
JEL: C16, C25, G21, G33, G34
*
The author is grateful to Pascal St. Amour, Florian Pelgrin, Pierre Monnin and Luigi Infante for their comments, and the participants
at the Research Days 2008 seminars at HEC-Lausanne .
†
HEC Lausanne Switzerland, e-mail: stefano.puddu@unil.ch
1-Introduction
The interest of the monetary and regulatory authorities in understanding the conditions of the banking
sector increased in the last years because of several factors. In particular, the implementation of the
Basel II Accords on banking laws and regulations about obligatory reserves increased the authorities'
interest in the consequences of the tightness of the credit conditions at both banking and economic
level. It is crucial to study the quality of the banking sector in order to better understand the reaction of
the banking system to changes in regulatory measures; to target the regulatory measures and to
prevent banking troubles.
In order to analyze the quality of the banking sector, several contributions focus on the role played by
individual indicators. The "single indicator" approach is easy to implement and it gives an immediate
idea of the framework analyzed. However, it presents important drawbacks. Specifically, the selected
variable could not be the best indicator available, reporting partial or incomplete conditions of the
1
banking system . Moreover, this method does not take into account possible "contagion" effects. In
other words, all the crossing effects between indicators are difficult to be analyzed. More in general,
with the "single indicator" approach it is hard to have an overall point of view of the phenomenon
analyzed. It is for these reasons that, instead of focusing only on one variable, it seems more
appropriate to aggregate in a synthetic index a set of indicators that can capture different features of
the framework analyzed.
The aim of this paper is to develop a stress index in order to have a synthetic notion of the quality of
the banking sector. This goal is achieved collecting and combining the information coming from
several indicators. This achievement is associated to several problems. In particular, the definition of a
crisis period and the choice of the best approach to generate the optimal weights are the two key
elements for constructing a synthetic index. There is not consensus in how to define a crisis.
Depending on the perspective chosen, differences in results can arise. There are several ways to
chose optimal weights. In our knowledge, the most common methods are the factor analysis and the
variance-equal approach. However, these methods have some limitations. On the one hand, the factor
analysis cannot be used if the variables included in the index do not move together. This means that,
the factor analysis is useless when not all the variables are affected by the same shock. On the other
hand, the fundamental assumption of the variance-equal approach that all the variables included in the
index are equally important and thus they have the same weight is too weak.
1
Marcucci and Quagliariello (2008) show that loan losses reserves (LLRTL) are accumulated by the banks over time, implying
that LLRTL do not increase drastically during a crisis. It turns out that choosing this variable as a unique indicator for measuring
the quality level of the banking system can lead to a partial vision of the overall banking system soundness.
Moreover, "the single indicator approach" is not recommended in case of adverse selection or moral hazard problems
characterizing the banking system. In a banking context characterized by heterogeneous agents (bad and good types) and high
competition among banks, if the indicator for the banking quality is represented only by the amount of credits loaned by the
banks, a high level of credits amount could be interpreted as a low level of stress. However, because of strong banking
competition, banks could be tempted to decrease credit requirements in order to enlarge their clients. If this is the case not only
good type have the access to the credit market, but also bad type could have an access. This implies that the quality of the
borrowers decreases. Therefore, the quality of the banking sector gets worse also, even if the amount of loaned credits is
increasing. Using as a single indicator the amount of the credits, the quality of the borrowers is totally missed.
1
Alternatively, in this paper, we propose two different approaches. The first one is an improvement of
2
the signaling method proposed by Kaminksy (1998) , while the second approach is based on
econometrical estimations. In both cases, a key role is played by the number of failures in the banking
system. Our claim is that there exists a relationship between the number of bank failures and the
banking sector stress. Specifically, the higher the number of banking failures, the larger is the level of
stress characterizing the banking sector.
In the signaling approach, the number of banks failures is used in order to define crisis and tranquil
periods. Each indicator during these two periods can correctly signal the presence of a crisis or of a
tranquil period, depending on the case. Moreover, it can happen also that the indicator detects a crisis
or a tranquil period even if this is not the case. Based on these mistakes, for each indicator it is
possible to generate a measure of noise. The weights are then ascribed considering the level of noise
of each indicator. The larger the noise generated by a particular indicator, the lower is its weight.
In the econometric approach, the number of banks failures is regressed against a set of explanatory
variables. We provide the outcomes obtained using different econometric techniques. The most
suggestive results are those obtained using the Zero Inflated Poisson approach. Based on the
relationship between the number of banking failures and the level of the banking stress, the estimated
coefficients of the explanatory variables are used in order to build a set of optimal weights.
Specifically, the system of weights are based on the magnitude and the statistically significance of the
marginal impact of the explanatory variables on the dependent variable. For a given indicator, the
higher its impact on the number of banking failures, the larger is its weights.
The contribution of this paper lies in the fact that it helps to exceed the limitations and the issues
concerning the factor analysis and the variance-equal approach.
Interesting conclusions arise comparing our results with an index obtained using the factor analysis
and with a variance-equal weights index proposed among others by Hanschel and Monnin (2004). It
turns out that the index obtained using the factor analysis approach (FA) and the variance-equal
method (VE) lead to results similar to those obtained using the modified signaling approach (MSA) and
the Zero Inflated (ZIP) econometric techniques. The main differences among indexes refer to the
reported stress level and to the ability of the indexes of detecting economic and financial events.
The rest of the paper is organized as follows: in the next section, we analyze the methodologies used
in the literature for building a single index. In section 3 the methods proposed in this paper and their
results are analyzed. In section 4, we compare the results obtained. In section 5 the results about the
stability of the weights and the forecasting properties of the indexes are reported. Finally, in the
conclusions the main results of this paper are summarized.
2
Goldstein, Kaminsky and Reinhart C. provide a superb analysis of the signaling approach in "Assessing Financial
Vulnerability: An Early Warning System for Emerging Markets" (2000).
2
2-Theoretical and empirical contributions
In this section, we analyze the methodologies applied for building single indexes. Furthermore, we
discuss the main results obtained implementing macro and micro approaches.
2.1-Metodologies used in the construction of single indexes
Several approaches can be used in order to build synthetic indexes. The easiest method is the
variance-equal weights method. It generates an index giving the same weight to all the variables. In
order to work with a homogenous scale, the indicators used for generating the index are standardized
assuming normality. The main caveat of this approach is that all the variables involved have the same
weight. This implies that all of them have the same importance, even if this is not always true. This is
the approach followed, among others by Hanschel and Monnin (2004). Their index, based on Suisse
data, identifies three periods where the stress level is above the average. These periods correspond to
economic downturns. Their index is able to fit the main economic events of the Suisse economy.
If the indicators belong to different markets, the credit weights approach can be applied. This method
is based on the idea that the weight to assign to each variable must be proportional to the size of the
market to which it belongs. We have to exclude this approach from our analysis because our
indicators belong to the same market.
Moreover, if there is a unique source of shock, that is if all the variables move together, then it is
possible to apply the factor analysis approach. In a multiple variables setup, rotating the scatter plots
of the observations, it is possible to extract weighted linear combinations between them. The highest
weight is assigned to the indicator that better explains the total variance. Illing and Liu (2003) have
used previous methods for developing an index of financial stress for the Canadian financial system.
They compare the results obtained in this way with previous contributions. They find that their indexes
fit financial and economic events better than existing indexes referring to the Canadian economy.
In this paper, we provide the results obtained using two alternative approaches. The first one is based
on the signaling method used by Kaminsky (1998) for analyzing currency and banking crises, while the
other approach exploits the results coming from the econometric analysis.
2.1.1-Signaling Approach
The signaling method is based on the ability of a particular indicator in detecting a crisis period and
distinguishing it from a tranquil period. In the traditional signaling approach, the variable xi is detecting
a crisis if it is above or below a threshold level x i . Once an indicator signals a crisis in a particular
period there are two possibilities. On the one hand, the crisis takes place in that period or in a t-length
window; on the other hand, the crisis does not occur. The noise of a particular indicator is a measure
of its precision, and it is obtained combining the mistakes of the indicator not detecting a crisis or a
tranquil period when this is the case. More precisely, the noise is defined as the ratio between the
probability of missing crisis (Error of type I) over one minus the probability of false alarm (Error of type
3
II). The threshold level for the variable xi is endogenous, and it is chosen such that the noise is
minimized. For the same level of noise, a specific indicator has more explanatory power if a crisis
occurs inside the predefined window. Using a macro-signaling approach, Kaminsky (1998) finds that
asset price corrections, indicators capturing over-borrowing behaviors and economic growth variables
have a significant impact in predicting banking problems.
2.1.2-Qualitative response Approach
This method is based on econometric estimations in order to compute the effects of a vector of
explanatory variables on a dependent variable, as bank failures or bank crisis. In the majority of the
cases, the dependent variable has a discrete outcome. Moreover, in this setup the dependent variable
is assumed to be drawn from a continuous probability function. Contingent on the features of the
dependent variable, the probability function can assume several specifications leading to different
results. Finally, regression results are used to analyze the importance of each independent regressor
in explaining the dependent variable.
González-Hermosillo (1999) focuses on the impact of banking sector fragility on the probability of
individual bank failure. Using a micro-approach, González-Hermosillo finds that the main determinants
of bank failures are liquidity, market and credit risks. For the US economy, she focuses on three
episodes of banking distresses: South West (1986-1992), North East (1991-1992) and California
(1992-1993) crises. In the three cases, specific features qualify failed banks with respect to the non-
failed banks. In particular, the former showed higher ratio of commercial and industrial loans (energy
loans are included) to total assets. Moreover, the failed banks were characterized by a higher
exposure, in terms of loans, in the commercial and real estate market. They had a lower net interest
margin (that implies high interest on deposits and low interest on loans), a higher ratio of loans to
assets, higher non performing loans to total assets, lower equity capital ratio and finally a low liquidity
ratio.
Tab.1: Values before the crisis

Variables North East South West California
C&I loans Higher Higher
C&R_estate loans Higher Higher
Loans to Asset Higher Higher Higher
Liquidity Lower Lower Lower
Non-perf. loans On average Higher On average
Equity/Capital Lower Lower
Net interest Margin Lower
Source: González-Hermosillo (1999).
In a macro-qualitative approach Hutchinson and McDill (1999) show that a key role in explaining
banking sector problems is played by interest rate, terms of trade/real exchange rate and inflation.
4
Their results confirm the findings of Demirgüç-Kunt and Detragiache (1998, 1999). Finally,
Eichengreen and Arteta (2000) find that also institutions are important in explaining banking crises.
Tab.2: Effects on banking crises

Positive Effect Negative Effect
Domestic credit growth
Output growth M2/base money
Terms of trade/real M2 multiplier
exchange rate Domestic credit/GDP
Liberalization
Interest rate
Source Bell and Pain (2000)
3-Indexes
The aim of this paper is to build synthetic indexes able to take into account the level of the stress in
the banking system. In order to achieve this goal we combine the information produced by the
signaling approach and the econometric estimations. We show different indexes based on these two
methods, and we compare our results with those obtained using the factor analysis method and the
variance equal approach.
3.1-Dataset
Our dataset is based on quarterly US-level data and covers the period from 1984 to 2007, for an
overall of 95 observations. The dataset includes six variables: the return on assets (ROA), the net loan
losses over average total loans (LSTL), the non-performing loans over total loans (NPTL), the loan
loss reserve over total loans (LLRTL), the net interest margin (NIM), and finally the number of the
commercial banks failed (FAILS).
ROA refers to the profitability of banks, NIM is a proxy for bank profits, while all the other variables,
LSTL, NPTL and LLRTL summarize the fragility of the banking system.
The dataset comprises the aggregate commercial banking sector and it has been generated collecting
information from the Federal Reserve of St. Louis and from the Federal Deposit Insurance Corporation
(FDIC). All the variables but the FAILS have been normalized to standard normal distribution with zero
mean and unit standard deviation. In the table below, we report the main features of the variables
included in our dataset.
5
Tab.3: Dataset summary, quarterly based
Variable Obs Mean St. Dev. Skewness Kurtosis Min Max
FAILS 95 15.73 21.62 1.55 5.17 0 99
ROA 95 1.04 .349 -1.31 4.92 -4.04 1.05
LSTL 95 .78 .2944 .919 3.16 -1.47 2.83
NPTL 95 1.97 1.088 .41 1.49 -1.17 1.77
LLRTL 95 1.94 .5 .177 1.81 -1.56 1.61
NIM 95 4.02 .31 -.074 2.99 -2.19 2.86
3.2-Mechanism linking the indicators, the banking failures and the

banking stress level
Our claim is that a large number of banking failures is a signal for a high level of stress in the banking
system. There exists a positive and monotonic relationship between the unobservable level of banking
stress and the number of the banking failures. This implies that studying the impact of the indicators
on the number of banking failures it is possible to infer the relationship between the indicators and the
level of stress in the banking sector.
Return on assets, ROA, measures the profitability of the bank. Low level of ROA should be a signal for
a low level of profitability in the banking sector. This means that the lower the ROA, the larger is the
banking stress level. Net loan losses over average total loans, LSLT, are a proxy of the fragility of the
bank. Higher values of LSLT are associated with higher banking fragility. Also non-performing loans
over total loans, NPTL, are an indicator of the fragility of the bank. More specifically, it is a measure of
the quality of the bank loans. Higher NPTL leads to lower quality of loans. Loan Loss Reserve over
Total Loans, LLRTL, is a proxy of the quality level deterioration in the banking sector: banking stress is
3
increasing in LLRTL . Finally, the net interest margin, NIM, has an ambiguous impact on banking
stress4. First, NIM is an indicator for banks profits. Therefore, higher NIM should imply a higher level of
profits and then lower level of stress in the banking sector. Second, NIM can be also a measure of the
competition in the banking sector: low level of NIM could imply a tough competition among banks.
More competition may force banks to decrease lending standards and then banking stress should
increase. These two arguments imply that higher level of NIM leads to a lower banking stress level.
However, there exists at least one argument that breaks this logic. The net interest margin could be
also affected by capital requirement measures enforced by the monetary authorities. Measures that
are more stringent decrease NIM, but at the same time, they make the banking system safer and more
robust against future banking crises. In this case, lower NIM not necessarily implies a higher level of
stress in the banking sector. In order to deal with this ambiguity, we take into account indexes with the
net interest margin associated with a positive and a negative weight. In the table below, we report the
definition of the previous variables and their expected sign according to the economic theory.
3
However, provisions are a biased signal of crisis because during stress periods banks’ capacity and incentive to raise
provisions might be reduced.
4
Ho and Saunders (1981), Allen (1988), Zarruk and Madura (1992), Wong (1996), Saunders and Schumacher (2000), Maudos
and Fernandez de Guevara (2007).
6
Tab.4: Variables description and expected sign
Variables* Definition Expected sign
It is equal to a fiscal year's

ROA earnings divided by its Negative
Return on Assets
total assets, expressed as
a percentage.
Net Loan Losses LSTL Defaulted loans Positive

over Average Total
Loans
Banks usually classify as

Non-performing NPTL non-performing assets any Positive
Loans over Total
Loans commercial loans, which
are more than 90 days
overdue.
Loan Loss Reserve LLRTL Reserves for those assets

over Total Loans at Banks whose ALLL** Positive
exceeds their Non-
performing Loans
Net Interest Margin NIM The dollar difference

between interest income Negative/Positive
and interest expenses
Number of bank FAILS Number of commercial

failures banks failed.
*All the variables refer to US Commercial Banks. All variables are expressed in ratios.**ALLL
stays for allowance for loan and lease losses.
3.3-Identification of a benchmark for the definition of a crisis period
In order to analyze the quality of an indicator it is crucial to define some benchmarks. In this way, it is
possible to distinguish between tranquil and stress periods, and then check the indicators properties.
Several criteria can be used to define a crisis period. It is important to underline the fact that there is
no consensus on the determinants of a systemic crisis. Illing and Liu (2003) define the stress period as
that force exerted on economic agents by uncertainty and changing expectations of loss in financial
markets and institutions. Kaminsky and Reinhart (1999) focus on closures, mergers or takeovers due
to bank runs, as indicators of bank crisis, and consequently of a stress period. Demirgüç-Kunt and
7
Detragiache (1998, 1999), claim that the banking system is experiencing a crisis if at least one of the
following criterion is satisfied:
1. the ratio of non-performing assets to total assets is larger than the 10%;
2. the cost of the rescue operation is larger or equal than 2% of the GDP;
3. large number of bank runs or government emergency measures as a consequence of a crisis;
4. large-scale nationalization as a consequence of banking sector problems.
For the US economy, following the Kaminsky's approach, we focus on banking failures. Our claim is
that there is a link between the not directly observable banking stress level and the number of banking
failures. The higher the number of banking fails the more important is the level of stress in the banking
sector. As anticipated in a previous section, the number of banking failures is used as a determinant
for defining a crisis period in the signaling approach and as a dependent variable in the quantitative
approach.
In graph 1a and graph 1b, we report the number of bank failures on a yearly and quarterly basis
respectively. The period with the highest number of failures is included between 1984, with 79 yearly
failures, and 1993 with 42 yearly hits. The number of the bank failures reaches the peak in 1988 with
280 annual failures. Since 1994, the number of annually fails as drastically decreased to at most 11
failures per year. Analyzing the data from a quarterly point of view, the peak of failures, 99 hits, is
reached the in second quarter of 1988. The minimum value, zero failures, is observed 25 times and it
turns out to be the mode of the series.
Graph 1a: Yearly basis failures Graph 1b: Quarterly basis failures
100
300
80
FAILS,QUARTERLY
200
60
FAILS
40
100
20
42
10
0
0
1985 1990 1995 2000 2005 0 20 40 60 80 100

TIME TIME
In order to take into account the dimension of a banking crisis we focus on two elements. On the one
hand, we consider the fraction of the banks that experienced a failure over the total number of banks.
On the other hand, we focus on the fraction of the assets of the failed banks. Moreover, we generate a
measure of the dimension of the crisis given by
# Bf
CM = # B
A
1− f
A
8
where #Bf is the number of failed banks in a given period, #B is the overall number of banks in the
same period, Af is the value of the assets involved in the failures and finally A is the overall value of
the banks assets. CM, the crisis measure, is increasing in both elements. Moreover, it is bounded
between zero and one.
In the graph below, we compare the CM indicator with the time series of the absolute number of bank
failures, FAILS.
Graph 2: CM and FAILS time series
.008
100
80
.006
60
FAILS
.004
CM
40
.002
20
0
0
1985q1 1990q1 1995q1 2000q1 2005q1
TIME
CM FAILS
CM is an indicator that takes into account both the relative value and the relative number of the banks
involved in the crisis. However, working with a bounded dependent variable does not allow us to take
5
into account, appropriately , the zeros in the dependent variable distribution. We can solve this
possible issue using the results from previous graph. Even if the two variables are expressed in
different scales, the two series move in the same direction, showing the same patterns. This suggests
that the results based on the signaling and the regression analysis, using the two series, will be
qualitatively the same.
3.4-Modified "Signaling" approach
The first attempt to build a banking stress index is based on the signaling approach, Kaminsky (1998).
The number of banking failures is used in order to distinguish between crisis and tranquil periods. For
each point in time, we observe the position of each of indicator, and in particular, we analyze the
placement of the indicators with respect to predefined threshold levels. The threshold levels are
5
This is true for several econometric techniques as the Poisson, Negative Binomial and Zero inflated methods.
9
defined based on the crisis and the tranquil periods. In this way, it is possible to measure the ability of
the indicators of detecting crisis periods. We focus on the mistakes produced by the indicators when
they do not detect a crisis, or they give a false alarm. The first type of mistake is defined as error of
type I, and it can be measured as the probability of not detecting a crisis given that there is a crisis,
( )
P no alarm crisis . The second type of fault is the error of type II, and it is valuated as the probability of
( )
detecting a crisis during a tranquil period, P alarm no crisis . These two errors can be combined
together in order to generate a measure of the indicator precision. Specifically, we define the noise of
an indicator x i as the ratio between the probability of missing a crisis (Error of type I) over one minus
the probability of false alarm (Error of type II):
P (no alarm crisis )

ni =
1 − P (alarm no crisis )
The determination of the noise is crucial in defining the weight to ascribe to a particular indicator.
Specifically, the lower is the noise generated by an indicator, the higher is its weight. This means that
we ascribe weights such that the more precise indicator receives the larger weight.
The weights obtained are then used to generate a banking stress index. It is defined in the following
way
STRESS = w1ROA + w 2 LSTL + w 3NPTL + w 4 LLRTL + w 5NIM
where the weights are a function of the banking failures and of the criterion chosen. Specifically
w i = f (FAILS,Criterion )
Our approach presents some differences with respect to the Kaminsky (1998) methodology. First, we
use the benchmark number of banking failures, in order to define crisis periods. Kaminsky, on the
contrary, defines a priori the crises. Moreover, we define specific cut-off points based on the definition
of a crisis period. This implies that they are exogenously determined. Contrarily, for each indicator,
Kaminsky defines a several cut-off points and then it is chosen the threshold level such that the noise
is minimized. Second, we combine the information referring to the indicators noise in order to collapse
it in a single index. Kaminsky instead proceeds using an individual-variable analysis: once computed
the noise her analysis claims only how well the indicators predict the crisis.
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3.4.1-Defining the crisis zone, computing the threshold level
The first issue we have to deal with is the definition of the threshold levels. Based on the information
provided in section 3.3, it is possible to define three criteria in order to characterize a crisis period.
These criteria are founded on the number of banking failures. The first criterion (F0) is such that all the
quarters with a number of failures greater than zero are included in a crisis period. This is the least
conservative among the criteria: just the fact that there is a bank failure is considered a signal for a
crisis. According to the second and the third identification methods (F10) and (F40), there is a crisis in
a particular year if there are at least 10 and 40 banking failures respectively, in that year. In both
cases, all the quarters of a crisis year are included in the crisis period independently on the quarter
specific failure frequency.
Tab.5: Criteria and quarters involved

I II III
CRITERIA Fails>0 Fails>10 Fails>40
BASE Quarterly Yearly Yearly
QUARTERS of CRISIS 70 48 40
During the crisis and the tranquil periods, the average value of each variable is computed. In this way,
6
it is possible to observe how much each variable deviates from its overall period mean . In table 6 we
report the main results.
Tab.6: Average values during the crisis periods

ROA -.255** -.67*** -.94***
LSTL .234** .60*** .704***
NPTL .33*** .85*** 1.1***
LLRTL .244** .508*** .54***
NIM .249** .445*** .327***

*=10%, **=5%, ***=1%. Null hypothesis: the parameter equals zero.
6
As mentioned before, all the indicators have been normalized so that they have zero mean and unit standard deviation.
11
Tab.6.1: Average values during the tranquil periods
ROA .714*** .691*** .685***
LSTL -.655*** -.613*** -.512***
NPTL -.924*** -.87*** -.806***
LLRTL -.683*** -.519*** -.39***
NIM -.698*** -.455*** -.237**

*=10%, **=5%, ***=1%. Null hypothesis: the parameter equals zero.
In the majority of the cases, the departure from the overall period mean is more important as the
minimum number of banking failures used for defining a crisis increases. All indicators show the
expected results, and they are coherent with the results of González-Hermosillo, with the only
exception of the net interest margin (NIM). As explained before, from a theoretical point of view NIM
has an ambiguous impact on banking failures. From the information provided in the tables above,
during the crisis, net interest margin shows a positive mean, NIM is above the overall period mean.
Moreover, previous results imply that positive values of NIM are associated with higher level of
banking stress. This fact suggests that the positive effect of NIM on banking stress is dominating its
negative effect. The fragility bank variables, net loan losses (LSTL), non-performing loans (NPTL) and
loan losses reserve (LLRTL) are above the overall period average during the crisis. Finally, the return
on assets (ROA) shows the expected sign with average values during the crisis below the overall
period mean. These results are robust to small change of the criteria conditions.
The indicators' average values during the crisis and the tranquil periods are used in order to compute
the threshold levels. Based on results reported in table 6 and table 6.1, for each indicator we construct
confidence intervals at 99%, 95% and 90% around the corresponding average values. For a given
criterion, the bound at 99% is minimizing the error of type I and amplifying error of type II. Vice versa,
using a bound at 90%, it is as if the error of type I is minimized and the error of type II is maximized.
Bounds at 95% have an intermediate effect.
In the table below, we report the main results for different confidence intervals and for different criteria.
For the crisis periods, in case of variables with positive (negative) average crisis values, we report only
the lower (upper) confidence interval bound. The opposite is true for the tranquil periods.
12
Tab.7: bounds, for the Crisis periods
Fails>0 Fails>10 Fails>40

99% 95% 90% 99% 95% 90% 99% 95% 90%
ROA .0676 -.01 -.05003 -.304 -.394 -.44 -.568 -.663 -.709
LSTL -.0827 -.00658 .03271 .224 .314 .36 .287 .393 .44
NPTL .03308 .009 .141 .60 .66 .694 .941 .984 1.005
LLRTL -.06507 .009 .047 .105 .202 .252 .041 .168 .23
NIM -.009 .053 .085 .16 .23 .263 .044 .116 .151
Tab. 7.1: bounds for the No-Crisis period

99% 95% 90% 99% 95% 90% 99% 95% 90%
ROA .61 .63 .65 .61 .63 .64 .60 .62 .63
LSTL -.38 -.45 -.48 -.43 -.48 -.50 -.279 -.337 -.366
NPTL -.83 -.85 -.86 -.81 -.82 -.83 -.72 -.743 -.75
LLRTL -.37 -.45 -.49 -.31 -.36 -.39 -.17 -.227 -.25
NIM -.13 -.27 -.34 -.07 -.17 -.21 .17 .069 .018
It is possible to define crisis and tranquil zone combining previous results and using the support of the
graph 4. For an indicator with positive crisis mean, on the one hand the crisis zone is defined as the
region, above the lower bound of the confidence interval constructed around the crisis mean. On the
other hand, the no crisis zone is determined as the region below the upper bound of the confidence
interval constructed around the no crisis mean. Indicators with negative crisis mean, the other way
around holds. A variable working correctly must lies in the crisis zone during the crisis and in the no
crisis zone otherwise.
The size of the crisis/no-crisis zone is a function of the intolerance of the monetary authorities to a
crisis. The larger the crisis zone, the higher is the intolerance to a crisis period. In other words, the
monetary authorities give more importance to error of type I, when the crisis zone is large. The choice
of the bounds, that affects the size of the zones, can depend on the relative importance that banking
authorities assign to the two types of errors.
13
Using the bounds reported above it is possible to analyze the position of each variable in each point in
time, during the crisis and the tranquil periods. In this way, for each indicator, taking into account how
many times it generates an error of type I or an error of type II, the corresponding noise is computed.
Graph 4: Error of Type I and Error of Type II
Average values
x under the two
regimes
CRISIS ZONE Bounds
t
CRISIS PERIOD NO CRISIS PERIOD
TRANQUIL ZONE ERROR TYPE II
ERROR TYPE I
3.4.2-Generating the vector of the weights
The probabilities computed in this way are then used for generating a system of weights. As specified
above, the noise is a combination of the two errors and it is equal to
P (no alarm crisis )

ni =
1 − P (alarm no crisis )
The higher the ni , the lower is the weight to assign to the variable x i . Specifically, we define mi as
the inverse of ni and M as the sum of the individual inverse noises mi :
mi = (n i )
−1
M=
∑
i =1
mi
14
Finally, we compute the individual weight w i as the ratio between the individual mi and the M
mi
wi =
M
7
The weights, computed using this method, are reported in the table below .
Tab. 8: Weights using two bounds

99% 99% 99%
ROA .166 .223 .295
LSTL .176 .161 .151
NPTL .181 .298 .175
LLRTL .198 .181 .218
NIM .277 .134 .159
Using criterion F0, the less restrictive among the criteria, the most important variable is the net interest
margin with a weight equals 27.7%. The rest of the variables show weights included between 16.6%
for ROA and 19.8% for LLRLT. A more constraining criterion, F10, leads to important changes: in this
case, the key indicator is the NPTL with a weight around 30%. An important role is played also by
ROA, with a weight equals to 22.3%. The other variables show a relative weight included between
16.1% for the LSLT and 18.1% for the LLRTL. Finally, in the case of the more conservative criterion,
F40, the most important indicator is the ROA with a weight equals 29.5%. LLRTL with a weight around
22% is the second most important variable. The other three variables lie in an interval of 2 percentage
points between 15.1% for the LSTL and 17.5% for the NPTL.
Depending on the criterion chosen (F0, F10 AND F40) three different variables have a dominant role:
NIM, NPTL and ROA respectively. Moreover, NIM when it is not the leading variable, plays a marginal
role. This is not the case for NPTL and ROA with weights larger than 15%. Finally, LSTL and LLRTL
show constant results. The former indicator shows weights included from 15.1% to 17.6% and the
latter has weights around 20%.
7
For simplicity, for each criterion we report the results referring only to bounds at 99%.
15
3.4.3-Drawbacks related to the signaling approach
Even if the signaling method is intuitive and easy to compute, it has at least two important drawbacks
that can affect the results obtained. The first problem is that the signaling approach is unable to
measure the magnitude of the errors. An indicator with positive mean during the crisis periods, is
producing an error of type I if it lies just below or far away from its threshold level. Between these two
errors, there exists a relevant difference in terms of size. However, this information is not taken into
account by the signaling method.
The second issue is about the fact that the signaling approach is based on a partial equilibrium
analysis. This means that all the crossing effects are missed. Specifically, not all the "contagion
effects" are taken into account. Each indicator affects the banking stress in two different ways. On the
one hand, the indicator has a direct impact on the stress level. On the other hand, it can also have an
indirect impact, depending on its capacity in affecting the position of the other variables in the same
period. It follows that if variable x i has more "contagion" properties than variable x j , then it would
have more relative importance. Unfortunately, working with the signaling approach, these effects are
missed.
3.5-Modified Qualitative approach
In this section, we propose a technique alternative to the signaling approach in order to generate a
vector of optimal weights to ascribe to a set of indicators. Specifically, the number of banking failures
is regressed against a set of explanatory variables, and then the regression results are used for
generating weights to assign to the indicators in order to squeeze their information in a single index.
As explained above, there exists a positive and monotonic relationship between the number of
banking failures (observable) and the level of the stress in the banking system (unobservable). It is
plausible to conclude that if an indicator affects the number of banking failures in a particular direction,
the same is true for the relationship linking the level of banking stress and the indicator. It is for this
reason that the regression results based on the number of banking failures are used in order to infer a
relationship linking the indicators to the level of the banking stress. In order to achieve this goal
several econometric methodologies have been used. The regression outcomes are used in order to
generate a banking stress index. The weights are ascribed such that the most relevant variable
obtains the largest weight. In order to measure variables relevance we proceed in two directions. On
the one hand, the marginal effects of each variable on the dependent variable corrected by their
precision are taking into account. On the other hand, we focus, when it is possible, on the IRR, the
Incidence Rate Ratio considering again the precision of the estimation to generate an optimal vector of
weights.
In the following sections, we propose results related to different econometric methodologies. The main
issue for selecting the best methodology is about how the methodologies exploit the information
embedded in the dependent variable. Moreover, we explain possible advantages and caveats
16
associated to the methodologies implemented. Finally, we focus only on those regression results that
refers to the best methodologies in terms of exploiting the information of our dataset, and that are
coherent with the economic theory and are statistically significant.
3.5.1-Linear, Logit Transform, Logit and Ordered Logit models
In the linear and logit transform estimations, CM has been used as a dependent variable. As
anticipated before, CM takes into account the amount of banks involved in the crisis and their value in
terms of assets. More precisely, CM is defined as follows:
# Bf
(
)
CM = # B
A
(1 − f )
A
CM is a bounded variable and takes values included between 0 and 1. Let us assume to estimate a
regression where the CM is regressed against a set of explanatory variables as the return on assets,
the loan losses, the non-performing loans, the loan losses reserves and the net interest margin.
Specifically we have that
CMt = X it β + ε t
Linear regression has been used to estimate the previous specification. In this case, linear regressions
leads to the same problems that arise when the linear regression is used in order to estimate
regressions with binary dependent variables. For this reason, a logit transform procedure is needed.
Let us define y t ≡ CM t . Moreover, let us assume that the relationship between the dependent variable
and the explanatory indicators can be described by
1
yt =
1 + exp(Xβ )
Performing the logit transformation, we obtain
 y 
yˆ t = ln t  = Xβ
 1 − yt 
In this way, the dependent variable y t defined between zero and one is mapped to the all-real line.
Thanks to previous transformation, it is possible to estimate
yˆ t = X it β + ε t
17
Although this method allows us to solve an important problem, it generates another important issue.
The crucial point is that the transformed dependent variable ŷ is missed if the original dependent
variable assumes values equal to one or to zero. These cases are extreme situations when all banks
8
fail or none among them has failed. We can interpret the zero failures case in two alternative ways.
The null observations can be sampling zeros: the banking system, in a particular period, has some
positive probability of sounding good. In this case, generalized linear models can be applied. However,
the null observations can be also considered as structural zeros: in some period, the banking system
shows zero failures because of a robust structure. If this is the case, it could be better to estimate the
model using techniques based on switching regimes. In order to apply previous methods, an integer
dependent variable is needed. In section 3.3 we already showed that, from a qualitative point of view,
working with the CM leads to results that are similar to those obtained working with FAILS. It is for this
reason that for the rest of the estimations FAILS is used as a dependent variable.
We can exploit the information provided by the dependent variable in several different ways. The first
attempt consists in concentrating all the information in a binary dependent variable. Specifically, we
construct a binary variable, BIN, that takes value zero when FAILS is equal to zero and one otherwise.
This implies that all the information about a positive number of failure is squeezed in only one
outcome. It is obvious that, in this way, an important amount of information is lost. Specifically, using a
logit model, the following specification has been estimated:
BIN = X it β + ε t
where the vector X includes as explanatory variables the return on assets, the loan losses, the non-
performing loans, the loan losses reserves and the net interest margin. Previous specification leads to
unsatisfactory results with only the non-performing loans showing a statistical significant estimated
coefficient and reporting the expected sign.
A way to improve the previous specification is to disentangle the information concentrated in the non-
zero part of the dependent variable BIN. In order to achieve this result, we split the original dependent
th th th
variable, FAILS, in four different groups using the 25 , 50 and 75 centiles as threshold levels. The
corresponding values are zero, three and twenty-nine respectively. The new dependent variable
generated, CENTILE, takes the following values:
= 1 if FAILS = 0
= 2 if 0 < FAILS ≤ 3

CENTILE = 
= 3 if 3 < FAILS ≤ 29
= 4 if FAILS > 29
8
We refer only to the zero case, but the same it is true for original values assuming value equals to one.
18
In this way, it is possible to increase the information available. However, there are still several
problems: half of the observations of the dependent variables belong to the outcomes included
between zero and three. Using a ordered logit model, the following specification has been estimated:
CENTILE = X it β + ε t
where the vector X includes the same explanatory variables as before. Unfortunately, also working in
this way the results are not satisfactory. Also in this case, the only variable showing interesting results
is the non-performing loans: this variable is the only to be statistically significant at 1% and to exhibit
the expected sign.
These results can be explained by two main reasons. First, not all the information about the dependent
variable is taken into account. For this reason, it is better consider all possible outcomes associated to
the dependent variable. Second, the non-positive component of the dependent variable should be
treated in a particular way, because it reflects a structural feature of the banking system, and it
represents, with 25 hits, the mode of the failure series.
3.5.2-Poisson, Negative Binomial and Zero Inflated Poisson regressions
Observing the frequency of the distribution of the quarterly based banking failures, FAILS, the crucial
role played by the zeros in the distribution is clear. 25 out of 95 quarters show zero failures.
Graph 4: Failure frequency

25
20
FREQUENCY
10 5
0 15
0 10 20 30 40 50 60 70 80 90 100
FAILURES
In this case, a more appropriate distribution to assume for the dependent variable is for instance the
Poisson distribution. One of the main assumptions of Poisson distribution is that the model mean and
variance are equal. If this is not the case, then the observations are over-dispersed with respect to the
Poisson model. The variance exceeding the mean of the model is a signal of several zero
characterizing the distribution. In our specific case, the expected value equals 15.73 and the standard
deviation is equal to 21.62, as reported in table 3.
The negative binomial distribution represents a possible solution to this problem, and it can be used as
an alternative to the Poisson distribution. In both cases, we estimate the following regression
19
y t = F (X it ) + ε t
with y t defined as the number of bank failures (FAILS). Moreover, the dependent variable is assumed
to follow a Poisson and a Negative Binomial process respectively. The X vector contains the following
explanatory variables: the return on assets (ROA), net loan losses (LSTL), non-performing loans
(NPTL), loan losses reserves (LLRTL), and net interest margin (NIM). However, previous
specifications do not take into account the large number of zeros in the dependent variable
distribution. It is for this reason that it is better to use a model that can distinguish between zeros and
non-zero failures.
Based on these considerations, previous regression has been re-estimated using a zero-inflated
approach, based on Poisson and Negative Binomial dependent variable distribution hypothesis. The
main feature of the zero inflated approach is that it permits to take into account the zeros in the
distribution of the dependent variable. It consists in a two-regime estimation. A first specification is
needed to define the elements characterizing the zero part of the dependent variable, while a second
specification is required in order to define the variables affecting the no-zero part of the dependent
variable. More precisely, we estimate the following regression:
G(Z it ) + ε t if y t = 0

yt = 
F (X ) + η if y > 0
 it t t
where the dependent variable is the number of bank failures FAILS, Z is a vector of variables as the
return on assets, ROA, and net interest margin, NIM, indicators of the profitability and of the profits of
the bank system. Finally, X is the vector with the variable describing bank fragility as the net loan
losses (LSTL), non-performing loans (NPTL) and loan losses reserves (LLRTL). All the explanatory
variables are lagged by one period (corresponding to one quarter), in order to avoid endogeneity and
reverse causality problems.
In the following table we report the regression results based on the LINEAR, logit transformed
(TRANS), PROBIT and OPROBIT estimations, and on the POISSON, Negative Binomial (NEGBIN),
Zero Inflated Poisson (ZIP), Zero Inflated Negative Binomial (ZINB) estimates.
20
+
Tab 9: Regressions results, dependent variable FAILS
LINEAR TRANS POISSON NEGBIN LOGIT OLOGIT
ROA -.000361* -.222* -.0343 -.241 -.1284 -.6108

(.000214) (.121) (.141) (.188) (1.88) (.555)
LSTL -.000371* -.0647 -.272* -.136 -.144 -.642
(.000209) (.114) (.141) (.134) (.88) (.423)
NPTL .00111*** 1.155*** 1.419*** 1.713*** 5.17* 3.67***
(.000310) (.161) (.209) (.229) (3.10) (.78)
LLRTL .000572** -.0151 .117 -.0899 -.52 -.09
(.000263) (.120) (.158) (.118) (1.74) (.396)
NIM -.000476** -.0711 -.150 .150 .461 .201
(.000185) (.123) (.181) (.132) (.711) (.321)
Const .00125*** -7.534*** 1.939*** 1.514*** 4.33*
(.0000941) (.0728) (.115) (.0911) (2.22)
Lnalpha -.931***
(.161)
Vuong test
Obs, y=0
Obs y>0
Tot Obs 94 69 94 94 94 94
R2 .716 .83 0.43 0.46
*=10%, **=5%, ***=1%. In parenthesis robust standard error are reported.
+In the Linear and Trans estimations CM has been used as a dependent variable. In
the Logit for the Ologit estimations BIN and CENTILE respectively have been used as
a dependent variable.
Table 9 shows the results referring to the LINEAR, TRANS, POISSON, NEGATIVE BINOMIAL, LOGIT
and OLOGIT regressions. In the majority of the estimations non-performing loans, NPTL, is always
statistically significant at 1%. Moreover, it also shows the expected sign: the larger NPTL the higher
the probability of failure. Significant results for all the variables are obtained only in the LINEAR
regression case. However, we already discussed the problems arising from the use this approach. The
estimations confirm theoretical problems. Specifically, fitted values are out of bounds, taking values
lower than zero or larger than one. Moreover, the Poisson and the Negative Binomial estimations as
well as the Logit and Ordered Logit estimations turn out to be unsatisfactory in terms of results.
Looking at the results obtained using econometric methods that take into account the zeros in the
dependent variable more interesting results are achieved.
21
ZIP_1 ZIP_2 ZINB
Fails=0 Fails>0 Fails=0 Fails>0 Fails=0 Fails>0
ROA 2.084*** 2.853*** 3.235
(0.474) (.667) (23.09)
LSTL -.275*** -.267*** -.198*
(.0979) (.0898) (.117)
NPTL 1.286*** 1.188*** 1.864***
(.122) (0.110) (.169)
LLRTL .0742 0.189* -.0583
(.0891) (0.0998) (.0932)
NIM -.685** -0.334** -3.283
(.332) (0.137) (5.316)
Const -2.033*** 2.156*** -2.335*** 2.268*** 1.638*** -7.3
(.134) (.325) (0.440) (0.126) (.145) (29.19)
Lnalpha -1.007**
(0.450)
Vuong test OK** OK*
Obs, y=0 25 25 25
Obs y>0 69 69 69
Tot Obs 94 94 94
In the table above, the results associated to the Zero inflated Poisson process and the Zero inflated
Negative Binomial are reported. ZINB regression produces not statistically significant results, while ZIP
estimations generate results that are more satisfactory. In ZIP_1 specification, we include in the
inflated part both ROA and NIM, while the ZIP_2 specification NIM is dropped from the inflated part
and it is added in the non-inflated part. In this way, we can control for the ambiguous role played by
NIM on the level of banking stress.
The Voung test confirms that is better to work with a ZIP model than with the classical Poisson model.
Analyzing the inflated part of the estimation, it comes out that ROA in both specifications is statistically
significant and with the expected sign. The larger is the ROA, the higher the probability of having zero
failures. The results referring to NIM are ambiguous. On the one hand, if it is included in the zero
inflated part, its coefficient is statistically significant and with negative sign: higher NIM implies lower
probability of zero failures. On the other hand, if it is included in the non-zero part, its coefficient is
again statistically significant and with negative sign. In this case, higher NIM implies lower probability
of having a positive number of failures. The results obtained in the two specifications are contradictory.
Looking at the not-inflated part of the specifications, the key-role played by NPTL is clear. It is
statistically significant and with the expected positive sign. A higher level of non-performing loans
positively affects the probability of having a non-zero number of failures. The loan losses reserve,
LLRTL, appears to be not statistical significant in the ZIP_1 specification, while it is statistically
significant at 10% in the ZIP_2 specification reporting the expected sign. Higher LLRTL implies high
22
probability of failures. Finally, puzzling results are associated with the net loan losses, LSTL. It shows
statistically significant results but with the wrong sign.
In order to check for the robustness of the results related with the ZIP estimations, we run the same
regression using four period lagged (corresponding to four quarters) explanatory variables. The results
do not change, and they are reported in the following table.

ZIP_1 ZIP_2
Fails=0 Fails>0 Fails=0 Fails>0
ROA 1.981*** 2.51***
(.394) (.58)
LSTL -.374*** -.347***
(.113) (.0923)
NPTL 1.466*** 1.33***
(.144) (.114)
LLRTL -.0521 .101
(.0937) (.08)
NIM -.469 -.522***
(.315) (.14)
Const 2.040*** -1.811*** -2.07*** 2.18***
(.151) (.349) (.47) (.12)
Vuong test OK** OK*
Obs, y=0 25 25
Obs y>0 66 66
Tot Obs 91 91
The Vuong test, also in this case, confirms that it is better to estimate the model using a zero inflated
approach instead of the classical Poisson regression. Moreover, the ROA is statistically significant. In
addition, NIM is no more significant in the inflated regression of the ZIP_1 specification, while it is
statistically significant with the negative sign in the ZIP_2 estimation. In addition NPTL shows robust
results, while LSTL is still statistically significant, but with the wrong expected sign. The results also
confirm the marginal role played by LLRTL.
23
3.5.3-Generating the optimal weights vector
As anticipated before we focus only on those regression results that refers to methodologies that
exploit in the best possible way the information of our dataset, that are coherent with the economic
theory and are statistically significant. This is the case for the ZIP_1 and ZIP_2 regressions.
The main reason of using regression results based on banks failures (observable) in order to build a
banking stress (unobservable) index is that there is a link between these two variables. The higher the
number of banking failures, the higher is the level of the banking stress. This relationship is strong for
a high number of banking failures, while it is weaker for low failure frequencies. If a variable x i has a
positive effect on bank failures, then the same positive effect characterizes the relationship between
the variable x i and the level of the banking stress. Moreover, we assume that this relationship is
proportional to the effect that x i has on the number of banking failures. Only asymptotically, the two
effects are the same.

The stress measure is defined as
STRESS = ω1ROA + ω 2 LSTL + ω3NPTL + ω 4 LLRTL + ω5NIM
where the weights are a function of the estimated coefficients coming from the regression results and
the corresponding standard errors. Specifically
(
ωi = f βî , βˆ≠ i , se( βî ), se( βˆ≠ i ) )
The ZIP estimations are based on a Poisson regression, for the no-inflated part, and on a Probit
regression for the inflated part. This implies that the estimated coefficients cannot be interpreted
directly as marginal effects of the explanatory variables on the dependent variable. In order to figure
out the vector of weights we proceed in two different directions. On the one hand, we compute the
marginal effects of the explanatory variables on the dependent variable, using for the parameterization
9
the average values of the explanatory variables during the crisis and the tranquil periods . On the
other hand, for each explanatory variable the IRRs have been computed, and then they have been
used to generate the vector of weights. These two methods lead to fixed weights. Alternatively, the
first method can be used in order to generate a vector of flexible weights. Specifically, the weights
have been computed from the marginal effects of the explanatory variables on the dependent variable,
using for the parameterization the values of the variables in each point in time. In this way, it is
possible to generate a vector of flexible weights.
9
In order to define a crisis, criterion III has been used.
24
3.5.3.1-Fixed weights based on Incidence Rate Ratios, IRRs
The estimated coefficient of particular explanatory variable i , obtained by a Poisson regression, can
be interpreted as the difference of the log of expected number of failures, µ , evaluated at i = z + 1 and
i = z , keeping all the other variables constant. Specifically we have:
β i = log(µi = z +1 ) − log(µi = z )
Using logarithm properties, previous expression can be written also as
 µi = z +1 
β i = log 
 µi = z 
Applying the exponential to both sides, we obtain
µ
exp(β i ) = i = z +1
µi = z
The Incidence Rate Ratio, IRR, is defined as the exponential on the estimated coefficient
IRRi ≡ exp(β i )
and it represents the ratio of the expected number of failures evaluated at i = z + 1 and i = z , keeping
all the other variables constant. In other words, it represents in expected relative terms, how much the
dependent variable changes for a unit change of the explanatory variable i , keeping the rest constant.
For the Probit part, in order to have values that can be comparable with the IRR of the Poisson part,
the estimated coefficient has been rescaled. More details are provided in the Appendix.
The system of weights based IRR takes into account the magnitude of the Incidence Rate Ratio, but
also its precision. The precision of the IRR is a function of the precision of the estimated coefficient.
Let us define τ i the ratio between the IRR relative to the variable i and one plus the correspondent
standard error
τi =
( )
IRR βî
( ( ))
1 + se IRR βî
with τ i converging to the IRR as the standard error goes to zero.
Then we define Γ the sum of the absolute value τ i :
25
I
Γ=
∑ i =1
τi
Finally, we compute the individual weight ωi as the ratio between the individual τ i and Γ
τi
ωi =
Γ
The vector of weights generated in this way is reported in table 12.
3.5.3.2-Fixed weights based on estimated marginal coefficients
An alternative way to proceed consists in generating a vector of weights from the effect of marginal
changes of the explanatory variables on the dependent variable. This method leads to results that are
similar to those obtained using Incidence Ratio Rates.
The marginal effects are computed using for the parameterization of the explanatory variables their
values during the crisis and the tranquil periods.
In order to generate a vector of weights, based on previous estimations, we take into account the
impact of the explanatory variable on the dependent variable correcting it by its standard error. This
measure has the property to increase when the estimated marginal impact goes up or the
corresponding standard error goes down. Given an explanatory variable i we define χi the ratio
between the estimated marginal effect ϕ̂ , and its standard error:
ϕî
χi =
1 + se(ϕî )
with χi converging to the true value of the marginal effect, ϕ , as the standard error goes to zero.
The different χi are used to build a vector of weights: the variable with the higher χi receives a
higher weight relative to the weights ascribed to the other variables. Specifically, let us define Λ the
sum of the absolute value χi :
Λ=
∑ i =1
χi
Finally, we compute the individual weight ωi as the ratio between the individual χi and Λ
χi
ωi =
Λ
The vector of weights generated in this way is reported in table 12.
26
3.5.3.3-Flexible weights based on estimated marginal coefficients
The marginal change method permits to generate also a system of flexible weights. The logic behind
this approach is the same used before. The system of weights is based on the effect of marginal
changes of the explanatory variables on the dependent variable. The key point here is that the
parameterization changes each period, and it is based on the values of the variables for each point in
time.
10
The method used to computed the weights is the same as before. The vector of average weights
obtained in this way is reported in table 12.
Table 12 vector of weights using different approaches

IRRs Fixed Marginal Flexible Marginal
Effects Effects (average)
ZIP_1 ZIP_2 ZIP_1 ZIP_2 FLX_1 FLX_2
ROA .213 .19 .163 .133 .167 .157
LSTL .136 .132 .183 .172 .20 .188
NPTL .511 .48 .475 .45 .416 .372
LLRTL .04 .09 .056 .109 .064 .124
NIM .10 .108 .121 .135 .153 .157
Analyzing the results in table 12, the main crucial feature is the role played by NPTL independently of
the method used. It has a weights included between 37.2% and 51.1%. The second important result is
about ROA and LSTL. Their weights take values included between 13.3% and 21.3% for ROA and
between 13.2% and 20% for LSTL. In all the specifications, it turns out that ROA and LSTL have an
essential role and they are only less important than NPTL. Moreover, there is consensus among the
results for the marginal role played by LLRTL and NIM. In terms of variability of the weights,
depending on the method used, NPTL shows the highest variance while NIM turns out to have the
most stable weight.
Comparing the results of table 12 with those relative to the signaling approach, reported in table 8,
there exist several differences. In particular, the vectors of weights based on the signaling approach
look like the vector of weights obtained using the variance-equal approach, where all the variables
have the same weights. The results based on the regression analysis are more heterogeneous, in
terms of weights, than those that are based on the signaling approach.
10
Using average values it is possible to compare the results obtained using the three different methods.
27
4-Generation of the index: which sign for the indicators?
Once the vector of weights has been computed, the last issue is represented by the sign to give to the
different indicators when they must be summed up. In order to deal with this problem we proceed in
several ways. Method A ascribes to the variables the sign based on the economic theory. Method B
takes into account the sign of the average values of the indicators during the period crisis, defined
using criterion F40. Finally, method C1 and C2 use the sign of the estimated coefficients obtained
using the ZIP1 and ZIP2 specifications. In the table below, we report previous information.
Tab 13: Signs methods for adding up the indicators

Variables* A B* C1 C2
Return on Assets ROA Negative Negative Negative Negative
Net Loan Losses over LSTL Positive Positive Negative Negative

Average Total Loans
Non-performing Loans NPTL Positive Positive Positive Positive
over Total Loans
Loan Loss Reserve LLRTL Positive Positive Positive Positive
over Total Loans
Net Interest Margin NIM Negative Positive Positive Negative
* For all the three criteria, F0, F10 and F40, the same signs are applied.
Indexes are built taking into account two dimensions: on the one hand, a criterion for defining the
vector of weights is needed. On the other hand, a criterion for combining all the variables is required.
We focus on F40 index (there is a crisis period if there are at least 40 failures per year) based on the
signaling approach; we also discuss the properties of the indexes based on IRRs, those based on
fixed marginal effects (FXME), and finally we report as well the indexes based on flexible marginal
effects (FLME). We compare the indexes mentioned above to the index obtained using the variance-
equal approach, VE (all the variables receive the same weight) and to the index obtained using factor
11
analysis, PCA (Principal Component Analysis) .
The information coming from the index is easy to interpret. The indexes are built by the combination of
indicators that have zero mean and unit standard error. This implies that values of the indexes larger
than zero are equivalent to banking stress periods higher than on average, while negative values are
associated with a banking situation better than on average.
11
The comparison with the PCA is possible only when sign method B is used.
28
Several economic and financial events have been taken into account, in order to check the quality of
the indexes. In particular, an index performs correctly if it is able to detect the events of interest.
Specifically, we focus on the regional US economic downturns (1986-92 in South-West States, 1991-
92 in North-East regions, and 1992-93 in California,), and on some event characterizing the US stock
market (October 1987 crash, October 1997 mini-crash, March 2001 dot-com bubble crash). Moreover,
we also focus on the two recessions that hit the US economy, between July 1990 and March 1991,
and from March to November 2001. Finally, we analyze the behavior of the indexes in the last two
years 2006 and 2007, just before the sub-prime crisis showed up.
The black vertical lines refer to the crash and min-crash of the October 1987 and 1997, the zone
delimited by the orange lines takes into account the regional crises of the South-West, North-East and
California for an overall period included between 1986 and 1993. The segment bounded by the
cranberry-dot lines refers to the recessions periods. Moreover, the third cranberry-dot line from the left
hand side coincides with the peak of the dot-com bubble in March 2001.
From a general point of view, it can be claimed that the regional crisis are well captured by our
indexes. In the majority of the cases, the indexes lead the 1987 stock exchange crash, and they lag
that of 1997. Moreover, during the recession periods the indexes show an increasing path. The same
is true for the period after the peak reached by the dot-com bubble. Moreover, on the one hand, the
index closer to the index based on the variance-equal approach is that built using the signaling
approach (F40 index). On the other hand, the other indexes diverge from the variance-equal one
above all in terms of magnitude. In particular, from 1984 to 1995, the VE index reports, on average,
less stress than that reported by the other indexes, after 1995 this relationship is reverted.
29
4.1-Indexes based on sign Method A
Analyzing the graph 6 (a) the first evidence is that the IRR indexes have the same shape. With respect
to the variance equal index, they are more inflated in the first part of the sample and less expanded
from 1995 on. Moreover, at the begging of the period, the gap between the two indexes and the VE
index is about 0.5 standard deviation and then the difference decreases.
The FLME indexes, graph 6 (b), show some differences in terms of the reported level of banking
stress. In particular, the FLME1 shows a more inflated pattern at the beginning and at the end of the
period considered. With respect the relationship with the VE index, they show the same behavior of
the IRR indexes, even if some important difference characterizes the end of the period. In particular,
the FLME1 index demonstrates an increasing pattern reaching the zero stress line in the last period.
The FXME indexes, graph 6 (c) have the same patterns characterizing the IRR indexes. The only
difference is based on the level of the stress detected by the indexes.
Finally, the F40 index, graph 6 (d), is the closest to the VE index. Only small discrepancies
characterize the patterns of the two indexes.
Looking at how the indexes fit the main economic and financial events proposed above, in general
terms it can be claimed that all the indexes well reproduce the regional economic crisis (zone between
the orange lines). All the indexes are above the zero-stress value during that period. However, all
indexes but F40 and VE indexes, show, already before that the regional crises start, values of stress
above the average, anticipating in this way, the stress period. The recessions (bounded by the
cranberry-dot lines) are associated to increasing path of the indexes, even if in the second period they
are below the average zero line. This can be due to the fact that, during the second recession, there is
a corresponding number of bank failures relatively low. In addition, the indexes seem to lead the stock
exchange crash of the 1987, while they show an increasing path just after the second crash in 1997.
The dot-com bubble crash is well represented by an increasing path pattern of the indexes. More
specifically, from a minimum value reached about one year before the crash, the indexes show a
constant increasing trend. Finally, observing the last two years, all the indexes show an increasing
path, even if they show level of stress strictly below the average value. The most relevant result
related to the sub-prime crisis is that associated to the FLME1 with stress values around the zero
stress line.
30
2
1
0
-1 Graph 6: Indexes based on sign method A
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_A IRR2_A
VE_A
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_A FLME2_A
VE_A
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_A FXME2_A
VE_A
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_A VE_A
31
4.2-Indexes based on sign Method B
The overall view of graph 7 suggests that there are not important differences between indexes based
on Zero Inflated Poisson process specifications 1 and 2. All the different pairs, IRRs, FLMEs and
FXMEs in the majority of the cases overlap and at most they show minimal differences.
Comparing the indexes with the index based on the variance-equal approach some differences appear
above all in the first part of the period analyzed. Furthermore, the divergences are about the level of
stress reported by the indexes, with the VE index resulting, in the majority of the cases, the most
parsimonious. The largest gap is about 0.5 standard deviations. Moreover, also in this case F40 turns
out to be the index the closest to the VE index.
Analyzing the ability of the indexes in detecting the main economic and financial facts we are
interested in, all the graphs anticipate the stock market crash of 1987, but they are not able to detect
the 1997 mini-crash. The dot-com crash is well documented by the indexes: in all the cases, reported
in graph 7, they show an important increasing path just after the crash. The recessions periods are
associated to an increasing trend of the indexes. About the regional crises, on average these crises
are well reported by the majority of the indexes, even if some index shows level of stress larger than
on average both before and after the “crises window”. Finally, indexes based on sign method B are not
able to signal any element of warning about the sub-prime crisis: in all the cases, in the last part of the
time series, the stress level is below the average (banking conditions better than on average) by about
1 standard deviation.
Graph 7: Indexes based on sign method B

2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_B IRR2_B
VE_B
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_B FLME2_B
VE_B
32
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_B FXME2_B
VE_B
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_B VE_B
4.3-Indexes based on sign Method C1
As in the previous case, fixing the weight method and changing the sign criterion does not lead to
different results. From a general point of view, there exist important discrepancies both in the stress
level reported and in the shape between the indexes based on several weight methodologies and the
VE index. Only in the last part of the time series, the differences reduce. Also in this case, the system
of weights F40 generates the index the closest to the variance-equal one.
Focusing on the ability of the indexes in reproducing the economic and financial events of interest,
results associated to sign method C1 are not satisfactory. In the majority of the cases, the indexes
show a level of stress larger than on overage both before and after the regional crises characterizing
the US divisions from the middle of the 1980s to the middle of the 1990s. Indexes lead the 1987 stock
market crash, but they are not able to detect the mini-crash in 1997 and the dot-com crash.
Contrasting results are associated to the recession periods: on the one hand the recession during the
1990s is associated with an increasing path of the level of the banking stress; on the other hand, the
recession in 2001 is not detected by the indexes. Finally, unsatisfactory results are also associated to
the ability of the indexes of describing the sub-prime crisis in the last part of the time series: in all the
cases, the indexes report a level of stress lower than on average, and included between half and one
standard deviation.
33
Graph 8: Indexes based on sign method C1
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_C1 IRR2_C1
VE_C1
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_C1 FLME2_C1
VE_C1
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_C1 FXME2_C1
VE_C1
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_C1 VE_C1
34
4.4-Indexes based on sign Method C2
Results associated to sign method C2 are the most interesting. First, also in this final case, the F40
index is the closest to the index based on the variance-equal approach, even if some differences arise
in the last part of the series. With respect to the other indexes, the main differences with the VE index
refer again to the reported level of stress. Analyzing the graphs there is a particular pattern: in the first
part of the period taken into account the VE index is the more parsimonious, while from 1995 on it
turns out to be the index signaling the highest level of stress. In other words, the VE index is the index
which lies the closest to zero stress line.
In all the cases, the 1987 Dow-Jones crash is anticipated by the indexes, while that of the October
1997 is followed by an increasing in the stress level. Finally, all the indexes fail in detecting the dot-
com bubble burst. The results associated to the recession periods are again ambiguous: the recession
during the 1980s is well reported with a strong increasing trend, while the second recession is not
detected by the indexes. Indexes based on C2 sign method are those that take into account in the
best way the sub-prime crises. In general terms, all the indexes report increasing values of stress in
the last two years. In particular, the FLME1_C2 index, graph 9 (b) signals positive level of stress
starting from 2006. Finally, satisfactory results are also those related with the regional crises. Again,
during the crises period the indexes show level of stress larger than on average. However, the indexes
report level of stress larger than on average already before the crises take place.
Graph 9: Indexes based on sign method C2

2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_C2 IRR2_C2
VE_C2
1 1.5
.5
-.5 0
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_C2 FLME2_C2
VE_C2
35
1 1.5
.5
0
-.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_C2 FXME2_C2
VE_C2
1 1.5 2
.5
0
-.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_C2 VE_C2
4.5-Principal Component and Principle Factor indexes.
In this section, we compare the indexes based on method B with the index obtained using Principle
Component (PC) and Principle Factor Analyses (PF). The main idea behind these two methodologies
is that given a bunch of variables it is possible to combine them in such a way that the majority of the
total variance generated by the variables is taken into account by the combination. Then the residual
unexplained variance is used again in order to figure out another combination of the variables and so
on until when all the variance is explained by repeated combinations among the variables. The
difference between the two methods is that the PC assumes that all the variability generated by the set
of indicators must be taken into account, while the PF considers for the analysis only the variability
that is in common between the items.
In our case, it is possible to use this approach because the indicators included in our dataset belong to
the same market, and then they are affected by the same kind of shocks. The variables taken into
account are those already involved in the signaling and econometric approaches. Specifically, we
focus on ROA, LSTL, NPTL, LLRTL and NIM.
The results presented in tables 10 and 11 are very important. Comparing the indexes obtained using
the methodologies provided in this paper and the index obtained with the Principal component and
Principal Factor analysis there are not substantial differences. This means that the alternative
approaches we propose based on banking failures lead to successful results.
36
Graph 10: Indexes based on sign method B, comparison with the PF index
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_B IRR2_B
PF
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_B FLME2_B
PF
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_B FXME2_B
PF
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_B VE_B
PF
37
Graph 11: Indexes based on sign method B, comparison with the PC index
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_B IRR2_B
PC
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_B FLME2_B
PC
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_B FXME2_B
PC
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_B VE_B
PC
38
4.6-General considerations
The indexes proposed in this section correctly represent the main economic and financial events taken
into account for testing their performance. The index that mimics the best the patterns of the variance-
equal index is the F40 index, independently of the sign method used. It has been generated by the
modify signaling approach proposed in the first part of this paper. With respect the other indexes, the
VE index shows above all differences in the amount of stress signaled. In a general way, it can be
claimed that the VE index is among the indexes, that that stay the closest to the zero stress line.
Comparing the indexes obtained using the alternative methods proposed in this paper with the
indexes based on factor analysis it turns out the there are not important differences among them. The
only divergences are in terms of the level of stress reported by the indexes. This finding is crucial
because working with very different approaches we arrive to the same result.
Analyzing the performance of the indexes in taking into account the economic and financial events of
interest, it follows that the majority of the indexes well reproduce these events. Moreover, about the
US regional crises a common pattern of all the indexes is to report level of stress larger than of
average already before the crises take place. Some problem arises also in the ability of the indexes in
detecting the 1997 mini-crash, the recession that hit the US economy in 2001, and the more recent
sub-prime crisis. In any case, from a general point of view the results are more than convincing.
39
5-Weights stability and Forecasting
5.1 Weights stability
In this section the stability properties of the indexes have been tested. In order to achieve this goal the
following procedure has been used. First, a confidence interval at 95% has been constructed around
the index generated using the entire sample. Moreover, shirking the sample and using only the first 60
observations, corresponding to the first 15 years, the in-sample weights are generated. The weights
obtained in this way, are used for generating an out-of sample index, using the remaining 35
observations. If the weights are stable over time, then the forecasted index has to lie between the
confidence interval bounds constructed around the index generated using weights based on the entire
sample.
For the indexes based on flexible weights the procedure used for testing weights stability is slightly
different than that used in the fixed weights case. Specifically, the two approaches are identical with
the exception for the generation of the in-sample weights: in the former case the in-sample weights are
averages values of the flexible weights generated using the first 60 observations. For the rest, the two
approaches follow the same rules.
Finally, for the F40 index, given the crisis and tranquil periods based on the information of the overall
sample, the weights have been computed taking into account the noise referring to the first sixty
observations only.
Graphs reported in the next pages are ordered by index. The most interesting results are related to the
F40 and IRR1 indexes. In all the four cases, the weights are stable. The out-of-sample index lies
between the bounds, overlapping, in the majority of the cases, the correspondent index based on the
overall sample. On the contrary, IRR2 indexes show not satisfactory results with the out-of-sample
indexes based on sign methods A, C2 staying out of the bounds. For the sign methods B and C1, in
several cases, the out-of-sample indexes overlap with the bounds.
FXME results are ambiguous. Specifically, out-of-sample indexes based on sign method C2 do not
supply interesting results, while results based on sign method A lies at the limit. Finally, also the
results referring to the FLME are not totally convincing. Specifically, on the one hand, the worst results
are those associated to the FLME1 with out-of-sample indexes in the majority of the cases out of the
bounds. On the other hand, FLME2 results are more satisfactory, only in two cases (sign methods A
and C2) the out-of-sample indexes lies out of the bounds.
From an overall point of view, the best results are achieved by indexes based on methods F40 and
IRR1. In all the specifications, the weights turn out to be stable. The results based on the other
methods are sometimes ambiguous and they depend on the sign method implemented.
40
Graph 10: F40 Forecasting based on different sign methods
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_F40_A L_F40_A
F40_A F40out_A
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_F40_B L_F40_B
F40_B F40out_B
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_F40_C1 L_F40_C1
F40_C1 F40out_C1
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_F40_C2 L_F40_C2
F40_C2 F40out_C2
41
Graph 11: IRR1 Forecasting based on different sign methods
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR1_A L_IRR1_A
IRR1_A IRR1out_A
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR1_B L_IRR1_B
IRR1_B IRR1out_B
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR1_C1 L_IRR1_C1
IRR1_C1 IRR1out_C1
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR1_C2 L_IRR1_C2
IRR1_C2 IRR1out_C2
42
Graph 12: IRR2 Forecasting based on different sign methods
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR2_A L_IRR2_A
IRR2_A IRR2out_A
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR2_B L_IRR2_B
IRR2_B IRR2out_B
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR2_C1 L_IRR2_C1
IRR2_C1 IRR2out_C1
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_IRR2_C2 L_IRR2_C2
IRR2_C2 IRR2out_C2
43
Graph 13: FXME1 Forecasting based on different sign methods
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FXME1_A L_FXME1_A
FXME1_A FXME1out_A
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FXME1_B L_FXME1_B
FXME1_B FXME1out_B
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FXME1_C1 L_FXME1_C1
FXME1_C1 FXME1out_C1
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
44
Graph 14: FXME2 Forecasting based on different sign methods
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FXME2_A L_FXME2_A
FXME2_A FXME2out_A
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FXME2_B L_FXME2_B
FXME2_B FXME2out_B
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
1 1.5
.5
-.5 0
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
45
Graph 15: FLME1 Forecasting based on different sign methods
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FLME1_A L_FLME1_A
FLME1_A FLME1out_A
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FLME1_B L_FLME1_B
FLME1_B FLME1out_B
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FLME1_C1 L_FLME1_C1
FLME1_C1 FLME1out_C1
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FLME1_C2 L_FLME1_C2
FLME1_C2 FLME1out_C2
46
Graph 16: FLME2 Forecasting based on different sign methods
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FXME2_A L_FXME2_A
FXME2_A FXME2out_A
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
U_FXME2_B L_FXME2_B
FXME2_B FXME2out_B
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
1 1.5
.5
-.5 0
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
47
5.2 Forecasting
An interesting exercise related to the stress index concerns the possibility to forecast it. If this is
possible, monetary authorities can anticipate measures and actions in order to prevent banking
troubles. In order to deal with this issue, given the feature of our dataset, we follow the Early Warning
Systems (EWSs) models based on a macro approach. The macroeconomic variables selected for our
specification are related to the level of consumption prices, the overall economic conditions, the
banking system credit behaviour and finally the shape of the real estate market. In particular, we focus
on the inflation rate (CPI), the GDP growth rate (GDP), the business cycle component of the credit-
income ratio (CR), while for the real estate market the business cycle component of the Median Sales
Prices of New Homes Sold in United States (Hprice) has been selected.
Higher level of the consumption prices has detrimental effects on the household's wealth. Moreover,
higher level of CPI leads to an increase in the interest rate. Therefore, on the one hand, for the same
price households can borrow less. On the other hand, as a consequence of higher interest rate the
level of insolvency can increase as well. Consequently, the level of the stress in the banking system
increases as the level of the prices goes up. It is for this reason that the expected sign for the CPI is
positive.
In order to analyze the impact of the general economic conditions on the stress level in the banking
sector, the GDP growth (GDP) has been taken into account. It is expected to negatively affect the
banking index: higher GDP growth rate implies a lower level of defaults. This leads to a reduction of
the non-performing loans. It turns out that the higher the GDP growth rate the lower is the banking
stress level. Its expected sign is negative.
The credit ratio is defined as the ratio between the total amount of assets and liabilities of the US
commercial banks over the level of GDP. Usually, a growing economy shows increasing level of the
credit ratio. However, if credits grow too fast with respect to the GDP, this fact can reflects the fact that
the credit risk in the banking sector is increasing. This means that banks are decreasing their lending
standards, and riskier borrowers can have access to the credit. This implies that the banking stress
level increases as the credit ratio deviates from its long-term trend. Its expected sign is positive.
The Median Sales Prices of New Homes Sold in United States (Hprice) has been used in order to take
into account the real estate market impact on the stress index. Given the fact that an important fraction
of the households' wealth is hold in real estate, higher levels in Hprice are expected to positively affect
the householders' wealth. In other words, real estate can be interpreted as collateral. This means that
householders' borrowing capacity can increase as Hprice goes up. Hprice is expected to negatively
(stress decreases) affect the stress level in the banking system.
48
Our model is defined in the following way:
S_INDEX = α + β1CPI −1 + β 2GDP−1 + β 3CR −1 + β 4 Hprice −1 + β 5CPI − 4 + β 6GDP− 4 + β 7CR − 4 + β 8 Hprice − 4 + ε
The first and the fourth lags have been taken into account. This is because our index is quarterly
based. Our claim is that the actual level of the index is affected by the value of the regressors just one
period before and by the value of the same variables lagged by four quarters. In the table below we
report the regression results referring to the weights methods FLME1, FLME2, FXME1, FXME2, IRR1,
IRR2, F40 and VE, combined with sign methods A, B, C1 and C2.
The regression results show, in the majority of the case, that CPI is statistically significant in both lags
and it always appears with the expected sign. Results concerning the GDP growth and the Hprice
show that these variables have a long-lagged impact on the dependent variable. Specifically, on the
one hand, their fourth lags are always statistically significant and with the correct sign. On the other
hand, GDP(-1) and Hprice(-1) show unsatisfactory results: the estimated coefficients are not
statistically significant or they exhibit the wrong sign. However, running a t-test on the sum of the
estimated coefficients of the first and fourth lags for the abovementioned variables, in the majority of
the cases we reject the hypothesis that their sum is equal or greater than zero. This implies that the
overall effect of the GDP growth and of the Hprice on the banking system level is negative (higher
level of the variables implies lower level of stress).
Results about the credit ratio variable suggest that it affects the level of stress in a short-lagged way.
More specifically, in the majority of the cases, the CR first lag is statistically significant and it shows the
expected sign. On the contrary, its forth lag shows not satisfactory results: the estimated coefficient is
statistically not significant or with the wrong sign.
In order to implement the forecasting part an in-out-sample fixed window analysis has been used.
First, the fitted values of each regression are estimated using the full sample. Moreover, the sample
has been split in two parts. The coefficients are estimated using the first 60 observations, while the
rest of the sample is used for the forecasting part. Results are reported in the graphs below. In order to
check the quality of the forecasted part the RMSE has been computed. Specifically, the RMSE is
defined as the squared root of the sum of the square difference between the original dependent
variable and its out-of-sample prediction, weighted by the number of the observations. The smaller the
RMSE the better is the forecasted computed.
Comparing the graphs and the results reported in table 19, the best results are achieved by sign
method B (the signs ascribed to the variables are based on the economic theory). Keeping constant
the weights method, in the majority of the cases, the best result, in terms of RMSE, is accomplished
when the sign method B is used. Specifically, focusing on sign method B, the best results is obtained
by the FLME2 with a RMSE equals .24. Moreover, the correspondent regression results are coherent:
is CPI always significative and with the expected sign both at lag one and four, and the fourth lag of
the other relevant variables are all statistically significant and with the expected sign.
Combining these results with the evidence related to the stability of the weights we could conclude that
FLME2_B is the best stress index. Its in-sample analysis, it is able to take into account the main
relevant economic and financial facts. Specifically, it signals a level of stress higher than on average
49
during the US regional crises, it shows a noticeable increasing path during the recession periods and
finally, it is also able to detect the financial crashes of the 1987, the dot-com bubble burst, and the last
sub-prime crisis. Given the fact that the out-of-sample index overlaps the in-sample index the same
considerations hold also for it, for the recession during the in 2001, the burst of the dot-com bubble
and the sub-prime crisis.
The VE_B index shows the worst result with a RMSE equals to .36. The difference with the RMSE
associated to the FLME2_B is about .10. Moreover, looking at the estimation results, those referring to
the VE_B are not satisfactory or puzzling. It is for these reasons that the FLME2_B better performs
that the VE_B. Finally, the F40_B IRR1_ and IRR2_B indexes even if they report significant values, in
terms of forecasting they turn out to be less performing than the FLME2_B index.
Tab 14: RMSE for different forecast

A B C1 C2
FXME1 .61 .29 .38 .41
FXME2 .57 .26 .39 .36
FLME1 .79 .29 .52 .55
FLME2 .58 .24 .46 .35
IRR1 .59 .32 .35 .45
IRR2 .54 .28 .34 .40
F40 .44 .33 .52 .27
VE .55 .36 .62 .29
50
Tab. 15: Regressions results, dependent variable different type of indexes
FXME1_A FXME1_B FXME1_C1 FXME1_C2 FXME2_A FXME2_B FXME2_C1 FXME2_C2
CPI(-1) .390*** .418*** .293*** .265*** .391*** .422*** .305*** .273***

(.0722) (.0601) (.0550) (.0528) (.0685) (.0601) (.0567) (.0488)
GDP(-1) .0206 .0240 .0993*** .0958*** .0222 .0261 .0968*** .0930***

(.0245) (.0214) (.0181) (.0180) (.0232) (.0218) (.0191) (.0167)
CR(-1) 21.94*** 9.452* 12.22* 24.70*** 21.23*** 7.381 9.978 23.83***

(7.142) (5.652) (6.365) (6.236) (6.686) (5.444) (6.294) (5.755)
Hprice(-1) .208 .185 .0830 .106 .297 .272 .176 .201

(.384) (.444) (.341) (.236) (.372) (.462) (.364) (.216)
CPI(-4) .349*** .474*** .284*** .158*** .330*** .469*** .290*** .151***

(.0606) (.0565) (.0439) (.0397) (.0580) (.0572) (.0458) (.0365)
GDP(-4) -.0825*** -.140*** -.0727*** -.0151 -.0972*** -.161*** -.0978*** -.0338**

(.0213) (.0211) (.0164) (.0149) (.0204) (.0214) (.0170) (.0139)
CR(-4) .799 -6.184 -8.014* -1.032 .0379 -7.708 -9.428* -1.682

(8.244) (6.096) (4.477) (4.852) (7.941) (5.909) (4.747) (4.712)
Hprice(-4) -1.047*** -1.522*** -1.408*** -.933*** -.995*** -1.522*** -1.415*** -.888***

(.393) (.333) (.339) (.275) (.373) (.346) (.361) (.251)
Constant -1.965*** -2.123*** -1.967*** -1.809*** -1.824*** -1.999*** -1.853*** -1.678***

(.121) (.0949) (.0908) (.0952) (.112) (.0956) (.0958) (.0875)
Obs 91 91 91 91 91 91 91 91
2
R .861 .920 .860 .822 .863 .917 .852 .832
51
Tab 16: Regressions results, dependent variable different type of indexes
FLME1_A FLME1_B FLME1_C1 FLME1_C2 FLME2_A FLME2_B FLME2_C1 FLME2_C2
CPI(-1) 0.389*** 0.453*** 0.288*** 0.223*** 0.414*** 0.445*** 0.289*** 0.258***

(0.0889) (0.0693) (0.0724) (0.0676) (0.0730) (0.0616) (0.0672) (0.0490)
GDP(-1) 0.00227 0.00741 0.120*** 0.115*** 0.00631 0.0160 0.119*** 0.110***

(0.0289) (0.0228) (0.0254) (0.0221) (0.0234) (0.0223) (0.0240) (0.0164)
CR(-1) 23.48*** 2.474 8.629 29.64*** 20.10*** 0.00933 5.921 26.01***

(8.370) (6.124) (7.455) (7.467) (6.544) (5.321) (6.713) (5.511)
Hprice(-1) 0.267 0.309 0.0722 0.0304 0.385 0.377 0.158 0.166

(0.444) (0.513) (0.443) (0.373) (0.383) (0.448) (0.371) (0.212)
CPI(-4) 0.295*** 0.480*** 0.254*** 0.0691 0.286*** 0.452*** 0.228*** 0.0625*

(0.0756) (0.0653) (0.0617) (0.0518) (0.0617) (0.0585) (0.0548) (0.0347)
GDP(-4) -0.0696*** -0.163*** -0.0753*** 0.0179 -0.103*** -0.193*** -0.108*** -0.0189

(0.0229) (0.0227) (0.0202) (0.0189) (0.0198) (0.0210) (0.0194) (0.0144)
CR(-4) 4.766 -10.42* -11.05* 4.140 1.419 -11.70** -11.67** 1.443

(9.435) (6.175) (5.669) (6.056) (7.971) (5.733) (5.487) (4.747)
Hprice(-4) -0.470 -1.679*** -1.642*** -0.433 -0.659* -1.321*** -1.245*** -0.584**

(0.503) (0.374) (0.457) (0.372) (0.390) (0.333) (0.395) (0.247)
Constant -1.708*** -1.980*** -1.962*** -1.691*** -1.662*** -1.760*** -1.701*** -1.603***

(0.145) (0.104) (0.111) (0.118) (0.116) (0.107) (0.115) (0.0889)
Obs 91 91 91 91 91 91 91 91
2
R 0.797 0.912 0.777 0.687 0.854 0.917 0.771 0.790
52
Tab. 17: Regressions results, dependent variable different type of indexes
IRR1_A IRR1_B IRR1_C1 IRR1_C2 IRR2_A IRR2_B IRR2_C1 IRR2_C2
CPI(-1) 0.410*** 0.434*** 0.341*** 0.317*** 0.407*** 0.432*** 0.342*** 0.317***

(0.0710) (0.0603) (0.0543) (0.0568) (0.0676) (0.0589) (0.0539) (0.0532)
GDP(-1) 0.0375 0.0403* 0.0962*** 0.0933*** 0.0369 0.0400* 0.0942*** 0.0911***

(0.0243) (0.0213) (0.0184) (0.0196) (0.0230) (0.0209) (0.0183) (0.0183)
CR(-1) 23.98*** 13.72** 15.77** 26.04*** 23.07*** 11.99** 13.98** 25.06***

(7.403) (6.246) (6.686) (6.920) (6.968) (5.925) (6.465) (6.483)
Hprice(-1) 0.179 0.160 0.0845 0.103 0.247 0.226 0.152 0.173

(0.365) (0.416) (0.330) (0.251) (0.353) (0.422) (0.339) (0.234)
CPI(-4) 0.363*** 0.466*** 0.324*** 0.221*** 0.345*** 0.456*** 0.319*** 0.208***

(0.0590) (0.0550) (0.0436) (0.0430) (0.0566) (0.0545) (0.0437) (0.0401)
GDP(-4) -0.0770*** -0.124*** -0.0744*** -0.0270 -0.0879*** -0.139*** -0.0905*** -0.0393**

(0.0209) (0.0206) (0.0169) (0.0162) (0.0200) (0.0204) (0.0168) (0.0152)
CR(-4) -0.0846 -5.822 -7.181 -1.443 -0.651 -6.848 -8.166* -1.969

(7.874) (6.079) (4.496) (5.347) (7.573) (5.832) (4.498) (5.110)
Hprice(-4) -1.209*** -1.600*** -1.515*** -1.125*** -1.154*** -1.576*** -1.494*** -1.072***

(0.381) (0.331) (0.325) (0.301) (0.361) (0.330) (0.330) (0.279)
Constant -2.205*** -2.335*** -2.219*** -2.090*** -2.066*** -2.206*** -2.094*** -1.954***

(0.122) (0.0983) (0.0923) (0.104) (0.114) (0.0950) (0.0915) (0.0963)
Obs 91 91 91 91 91 91 91 91
2
R 0.874 0.920 0.889 0.851 0.876 0.920 0.886 0.856
53
Tab 18: Regressions results, dependent variable different type of indexes
F40_A F40_B F40_C1 F40_C2 VE_A VE_B VE_C1 VE_C2

CPI(-1) 0.421*** 0.458*** 0.355*** 0.317*** 0.378*** 0.424*** 0.288*** 0.241***
(0.0736) (0.0724) (0.0723) (0.0584) (0.0746) (0.0716) (0.0748) (0.0523)
GDP(-1) 0.0343 0.0388 0.101*** 0.0965*** 0.0129 0.0186 0.101*** 0.0950***

(0.0226) (0.0240) (0.0243) (0.0191) (0.0231) (0.0247) (0.0253) (0.0174)
CR(-1) 25.20*** 8.800 11.08 27.49*** 23.02*** 2.496 5.512 26.04***

(7.134) (6.855) (8.468) (7.292) (6.743) (6.038) (8.174) (6.224)
Hprice(-1) 0.561* 0.531 0.446 0.476** 0.510 0.472 0.361 0.398*

(0.335) (0.477) (0.415) (0.214) (0.373) (0.522) (0.451) (0.227)
CPI(-4) 0.227*** 0.392*** 0.234*** 0.0696 0.216*** 0.422*** 0.214*** 0.00844

(0.0624) (0.0670) (0.0584) (0.0438) (0.0634) (0.0680) (0.0602) (0.0393)
GDP(-4) -0.111*** -0.187*** -0.131*** -0.0554*** -0.102*** -0.197*** -0.124*** -0.0288**

(0.0189) (0.0226) (0.0208) (0.0149) (0.0194) (0.0233) (0.0210) (0.0136)
CR(-4) -2.628 -11.80** -13.31** -4.140 -0.150 -11.63* -13.62** -2.148

(6.803) (5.661) (5.987) (4.521) (7.629) (5.856) (6.634) (4.351)
Hprice(-4) -0.947*** -1.571*** -1.477*** -0.853*** -0.712* -1.493*** -1.369*** -0.588**

(0.349) (0.398) (0.449) (0.275) (0.382) (0.412) (0.485) (0.251)
Constant -1.568*** -1.774*** -1.646*** -1.439*** -1.327*** -1.586*** -1.416*** -1.157***

(0.113) (0.116) (0.127) (0.101) (0.113) (0.115) (0.132) (0.0903)
Obs 91 91 91 91 91 91 91 91
2
R 0.841 0.887 0.776 0.768 0.810 0.885 0.699 0.694
54
Graph 17: FXME1 Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_B in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_C1 in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME1_C2 in-sample
out-of-sample
55
Graph 18: FXME2 Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME2_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME2_B in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME2_C1 in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FXME2_C2 in-sample
out-of-sample
56
Graph 19: FLME1 Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_B in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_C1 in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME1_C2 in-sample
out-of-sample
57
Graph 20: FLME2 Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME2_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME2_B in-sample
out-of-sample
1
.5
0
-1 -.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME2_C1 in-sample
out-of-sample
1
.5
-1 -.5 0
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
FLME2_C2 in-sample
out-of-sample
58
Graph 21: IRR1 Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_B in-sample
out-of-sample
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_C1 in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR1_C2 in-sample
out-of-sample
59
Graph 22: IRR2 Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR2_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR2_B in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR2_C1 in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
IRR2_C2 in-sample
out-of-sample
60
Graph 23: F40 Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_B in-sample
out-of-sample
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_C1 in-sample
out-of-sample
2
1
0
-1
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
F40_C2 in-sample
out-of-sample
61
Graph 24: VE Indexes based on different sign methods
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
VE_A in-sample
out-of-sample
2
1
0
-1
-2
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
VE_B in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
VE_C1 in-sample
out-of-sample
-1 -.5 0 .5 1 1.5
1985q1 1990q1 1995q1 2000q1 2005q1

TIME
VE_C2 in-sample
out-of-sample
62
6-Conclusions
In the literature, two main methods are used in order to build synthetic indexes. On the one hand, the
factor analysis (FA) approach is used when all the set of indicators are affected by shock of the same
nature, that is when the variables move together. On the other hand, when this is not the case, the
variance-equal (VE) approach can be used. This second method has the implicit and strong
assumption to assign to each variable the same weight.
We present two alternative methods, based on the signaling approach and the Zero inflated
regressions, in order to construct indexes summarizing the stress level of the banking system.
The indexes are obtained combining two methods: on the one hand a method is needed in order to
find the optimal weights; on the other hand, a method to establish the sign to ascribe to the different
variables is necessary. Each index is the combination of these two methods
Looking at the weight methods, we focus on the signaling approach and the Zero inflated regressions.
The system of weights obtained using the signaling approach shows the important role played by two
variables: the Return on assets (ROA) and the non-performing loans over total assets (NPTL). The
vector of weights based on the Zero inflated regressions confirms this result. In particular, it is clear
the key role played by NPTL. The two approaches also agree in assign a secondary role to the rest of
the variables included in our dataset. Specifically, loan losses, loan losses reserve and net interest
margin play a marginal role in the determination of the index. Focusing on the sign method we
selected three main criteria. These criteria are based on the economic intuition, the signaling approach
results and the econometric regression outputs.
Our results differ with respect to those based on FA and VE methods in terms of magnitude, but they
coincide in terms of shape. This means, on the one hand that our indexes report level of stress higher
or lower, depending on the cases, than that reported by the indexes based on FA and VE methods; on
the other hand the two class of indexes have the same shape. The index obtained using the signaling
approach is closer to the VE and FA indexes. The performance of the indexes has been measured
looking at the ability of the indexes in reproducing various economic and financial events. In particular,
we focus on the regional economic crises that hit several States during the eighties and nineties, the
recession periods characterizing the US economy and the most relevant financial events happened in
the period analyzed as the 1987 Dow-Jones crash, the 1997 mini-crash and the dot-com bubble.
This study shows two alternative methods that can be used in order to generate synthetic indexes. Our
application focuses on the stress level of the banking system. The signaling approach and the Zero
inflated regression methods represent two valid alternatives to the classical variance-equal approach
and the factor analysis method. Improvements are represented by an individual bank level analysis
based on more sophisticated econometric methods.
63
Appendix
Let us assume to have to estimate the following Probit model:
y = xβ + e
with
 = 1 if y * > 0

y=
= 0 if y * = 0

In this case, the probability that y = 0 given a set of values of the explanatory variables, P ( y = 0 x ) is
given by the following formula:
P ( y = 0 x ) ≡ 1 − G( xβ )
where G( xβ ) is the cdf of the error term e . Let us assume that the only explanatory variable is the
ROA and a constant. Moreover, let us define by ρ the ratio between the P ( y = 0 x ) computed at
ROA=1 and the same probability at ROA=0. Specifically, we have:
P ( y = 0 ROA = 1)
ρ≡
P ( y = 0 ROA = 0)
The ratio ρ is a function of the parameterization and of the estimated coefficient βˆROA and α̂ . That
( )
is ρ = f ROA, βˆROA ,αˆ . If the ratio ρ is equal to 0.33, this means that increasing by one unit the
explanatory variable, keeping the rest constant, the probability of having y = o increases by .33%. In
our analysis the ratio ρ has been used to compare the results in the no-inflated part to the IRR results
that refer to the inflated part of the regression.

The correspondent τ i , for the explanatory variables included in the Probit part of the Zero inflated
process, is equal to the ρ i , relative to the variable i , over one plus its standard error
τi =
( )
ρ βî
( ( ))
1 + se ρ βî
64
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66

Optimal Weights Stress Banking Indexes

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Optimal Weights and Stress Banking Indexes*

Specifically, we present two different classes of indexes based on a signaling approach

Keywords: Stress-banking indexes, Signaling approach, Limited dependent variable

JEL: C16, C25, G21, G33, G34

2.1-Metodologies used in the construction of single indexes

2.1.2-Qualitative response Approach

Tab.1: Values before the crisis

C&R_estate loans Higher Higher

Loans to Asset Higher Higher Higher

Liquidity Lower Lower Lower

Non-perf. loans On average Higher On average

Equity/Capital Lower Lower

Net interest Margin Lower

Source: González-Hermosillo (1999).

Tab.2: Effects on banking crises

3.2-Mechanism linking the indicators, the banking failures and the

It is equal to a fiscal year's

Net Loan Losses LSTL Defaulted loans Positive

Banks usually classify as

Loan Loss Reserve LLRTL Reserves for those assets

Net Interest Margin NIM The dollar difference

Number of bank FAILS Number of commercial

3.3-Identification of a benchmark for the definition of a crisis period

1985 1990 1995 2000 2005 0 20 40 60 80 100

3.4-Modified "Signaling" approach

the probability of false alarm (Error of type II):

P (no alarm crisis )

STRESS = w1ROA + w 2 LSTL + w 3NPTL + w 4 LLRTL + w 5NIM

Tab.5: Criteria and quarters involved

Tab.6: Average values during the crisis periods

ROA -.255** -.67*** -.94***

LSTL .234** .60*** .704***

NPTL .33*** .85*** 1.1***

LLRTL .244** .508*** .54***

NIM .249** .445*** .327***

ROA .714*** .691*** .685***

LSTL -.655*** -.613*** -.512***

NPTL -.924*** -.87*** -.806***

LLRTL -.683*** -.519*** -.39***

NIM -.698*** -.455*** -.237**

Fails>0 Fails>10 Fails>40

Tab. 7.1: bounds for the No-Crisis period

Fails>0 Fails>10 Fails>40

Graph 4: Error of Type I and Error of Type II

TRANQUIL ZONE ERROR TYPE II

3.4.2-Generating the vector of the weights

P (no alarm crisis )

the inverse of ni and M as the sum of the individual inverse noises mi :

Tab. 8: Weights using two bounds

LSTL .176 .161 .151

NPTL .181 .298 .175

LLRTL .198 .181 .218

NIM .277 .134 .159

3.5-Modified Qualitative approach

3.5.1-Linear, Logit Transform, Logit and Ordered Logit models

and the explanatory indicators can be described by

Performing the logit transformation, we obtain

Thanks to previous transformation, it is possible to estimate

3.5.2-Poisson, Negative Binomial and Zero Inflated Poisson regressions

Graph 4: Failure frequency

ROA -.000361* -.222* -.0343 -.241 -.1284 -.6108

*=10%, **=5%, ***=1%. In parenthesis robust standard error are reported.

Tab 11: Regressions results, dependent variable FAILS

ROA -.255 -.67* -.94***

LSTL .234 .60* .704***

NPTL .33* .85* 1.1***

LLRTL .244 .508* .54***

NIM .249 .445* .327***

ROA .714* .691* .685***

LSTL -.655* -.613* -.512***

NPTL -.924* -.87* -.806***

LLRTL -.683* -.519* -.39***

NIM -.698* -.455* -.237**

=10%, =5%, =1%. In parenthesis robust standard error are reported.

=10%, =5%, =1%. In parenthesis robust standard error are reported.