Improving early warning indicators for

banking crises – satisfying policy

requirements
Mathias Drehmann and Mikael Juselius
Bank for International Settlements

“Understanding Macroprudential Regulation”

Norges Bank, Oslo, 29–30 November 2012

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CGFS report No 48

Operationalizing the selection and

application of macroprudential
instruments

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Operationalising macroprudential policies

 Report focusses on 3 high-level criteria that are key in

determining instrument selection and application in practice
 The ability to determine the appropriate timing for the
activation or deactivation of the instrument
 The effectiveness of the MPI in achieving the stated objective
 The efficiency of the instrument in terms of a cost-benefit
assessment

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Report ends with 9 questions and answers

1. To what extent are vulnerabilities building up or crystallising?

2. How (un)certain is the risk assessment?
3. Is there a robust link between changes in the instrument and the
stated policy objective?
4. How are expectations affected?
5. What is the scope for leakages and arbitrage?
6. How quickly and easily can an instrument be implemented?
7. What are the costs of applying a macroprudential instrument?
8. How uncertain are the effects of the policy instrument?
9. What is the optimal mix of tools to address a given
vulnerability?

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Report analysis three groups of macroprudential
instruments
 Capital-based tools (countercyclical capital buffers, sectoral
capital requirements and dynamic provisions)
 Liquidity-based tools (countercyclical liquidity requirements)
 Asset-side tools (loan-to- value (LTV) and debt-to-income (DTI)
ratio caps)
 For all tools report proposes ‘transmission maps’

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 Transmission map for capital based tools

Options to address
shortfall Loan market
Leakages
 Voluntary to non-
Increase capital requirements or

buffers banks
↑ lending
spreads

Impact on the credit cycle

 dividend and Reprice  credit
provisions

bonuses loans demand

Undertake SEOs1

Asset
 assets,  credit supply prices

Arbitrage especially with

away high RWA

Expectation channel

↑ Loss Tighter risk

Absorbency management

Increase resilience
Improving early warning indicators for
banking crises – satisfying policy
requirements

7
Introduction

 CGFS (2012): Policymakers need to be able to determine the

appropriate timing for the activation or deactivation of the
instrument
 In this paper we want to find reliable early warning indicators
(EWIs) for systemic banking crises
 What policy requirements do EWIs need to satisfy?
 Need to be evaluated with preference free methodology
 Need to have right timing
 Need to be stable
 Need to be robust
 Need to be understood by policymakers

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Implementing the framework

 We assess a broad range of indicators

 We find
 Credit-to-GDP gap best indicator for predicting crises 2-5 years
in advance
 Debt service ratios highly successful indicator for predicting
crises 1-2 years in advance

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 How to evaluate the goodness of an EWI?

 To fully evaluate quality of a signal would need to know preferences

of policymakers, which are unknown (eg CGFS (2012))
 What are costs of acting on wrong signals (false positives)?
 What are the benefits of acting on correct signals (true
positives)?

→ Need to evaluate signalling quality independent of preferences

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 The ROC curve

 Policymakers receive noisy signal S

 S higher → higher risk of a crisis
 At which threshold you policymakers act?

Informative signal Uninformative signal Fully informative signal

W2
1
W1 1 1
W2

True True True

positive positive positive
rate rate rate

W1

1
1 False positive rate 1
False positive rate False positive rate

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Area under ROC curve as measure of signalling quality

 Area under the ROC curve (AUROC) provides summary measure

of the classification
1
ability (eg Jorda and Taylor, 2011):

 AUROC  ROC( FP )dFP
0
 AUROC=0.5 → uninformative indicator
 AUROC=1 → fully informative indicator
 AUROC ideal measure if preferences are not known
 Benefits
 Can be estimated non-paramterically
 Has convenient statistical properties

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Timing of ideal EWIs

 Ideal EWI needs to signal crisis early enough

 Likely to be 1-2 year lead-lag relationship (e.g. countercyclical
capital buffers)
 Policymakers tend to observe trends before reacting (e.g.
Bernanke, 2004)
 Ideal EWI signal crises not too early
 Introducing buffers too early may undermine effectiveness
(e.g. Caruana, 2010)
 We look at individual quarters within a 5 year horizon

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EWIs need to be stable and robust

 Policymakers adjust policy stance gradually

 Optimal for MP (Bernanke, 2004, Orphanides, 2003)
 Indictor should issue consistent signals
 Consistency of signal tied to persistency of underlying series
(eg Park and Phillips (2000))
 High degree of persistency problematic for statistical inference
 Non-parametric approach

 EWIs need to be robust to different samples and specifications

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Interpretability of EWI

 Evidence that practitioners value sensibility of forecasts more

than accuracy (Huss, 1987) adjust forecasts if the lack justifiable
explanations (Onka-Atay et al (2009)
 Purely statistical approaches are not suitable for policy
purposes and communication
 Our indicators reflect
 excessive leverage and asset price booms (Kindleberger, 2000,
and Minsky, 1982)
 non-core deposits (Hahm et al, 2012)
 the business cycle

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Analysing potential EWIs
 We construct and test a range of potential early warning
indicators building on Drehmann et al (2011)
 We select indicator variables from...
 Credit measures: Credit-to-GDP gap and real credit growth
 Asset prices: Real property and equity price gaps and real
property and equity price growth
 None-core bank liabilities (Hahm, Shin, and Shin (2012)):
 GDP growth
 History of financial crises
 ...and add one new measure:
 Debt service ratio (DSR) (Drehmann and Juselius (2012)):
interest payments and repayments on debt divided by income

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 Analysing potential EWIs (II)

 We analyse quarterly time-series data from 27 countries.

 The sample starts in 1980 for most countries and series, and at
the earliest available date for the rest
 Use balanced sample
 We follow the dating of systemic banking crises in Laeven and
Valencia (2012)
 We ignore crises which are driven by cross-boarder exposures
 We adjust dating for some crisis after discussions with CBs

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Persistency
 Several of the variables display dynamics which are hard to
distinguish from I(2) process
 Indicators which have performed well in the past are more
persistent

→ Benefits of a non-parametric approach

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 Behaviour around systemic crises
DSR Credit-to-GDP gap Property pr. gap Equity pr. gap GDP growth

100
15

40

10
40
10

20

5
50
20
5

0
0
0

-20

-5
0

-50
-20

-40

-10
-5

-20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12

Non-core deposit ratio Credit growth Prop. price gr. Equity price gr. history
60

40

100

2
20
40

1.5
50
20
10
20

1
0
0

0
0

.5
-50
-10
-20

-20

0
-20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12 -20 -16 -12 -8 -4 0 4 8 12

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 ROC curves for 2 year forecast horizon

DSR Credit-to-GDP gap Property pr. gap Equity pr. gap GDP growth
1

1
.8

.8

.8

.8

.8
.6

.6

.6

.6

.6
ROC

ROC
ROC

ROC

ROC
.4

.4

.4

.4

.4
.2

.2

.2

.2

.2
0

0
0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
FP FP FP FP FP

Non-core deposits ratio Credit growth Prop. price gr. Equity price gr. History
1

1
.8

.8

.8

.8

.8
.6

.6

.6

.6

.6
ROC

ROC
ROC

ROC

ROC
.4

.4

.4

.4

.4
.2

.2

.2

.2

.2
0

0
0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
FP FP FP FP FP

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 ROC curves over time
1

1
.9

.9
.9

.9
.9

.8

.8
.8

.8
.8

.7

.7
.7

.7
.7
AUROC

AUROC

AUROC

AUROC

AUROC
.6

.6
.6

.6
.6

.5

.5
.5

.5
.5

.4

.4
.4

.4
.4

.3

.3
.3

.3
.3

.2

.2
DSR Credit-to-GDP gap Property pr. gap Equity pr. gap GDP growth
.2

.2
.2

-20 -15 -10 -5 0 -20 -15 -10 -5 0 -20 -15 -10 -5 0 -20 -15 -10 -5 0 -20 -15 -10 -5 0
Horizon Horizon Horizon Horizon Horizon
1

1
.9
.9
.9
.9

.9
.8
.8
.8
.8

.8
.7
.7
.7
.7

.7
.6
AUROC

AUROC

AUROC

AUROC

AUROC
.6
.6
.6

.6
.5
.5
.5
.5

.5
.4
.4
.4
.4

.4
.3
.3

.2
.3
.3

.3
Non-core deposits ratio Credit growth Prop. price gr. Equity price gr. History
.2
.2
.2

.2
-20 -15 -10 -5 0 -20 -15 -10 -5 0 -20 -15 -10 -5 0 -20 -15 -10 -5 0 -20 -15 -10 -5 0
Horizon Horizon Horizon Horizon Horizon

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 Combining variables

Credit to GDP gap and Credit to GDP gap and DSR and property price
property price gap DSR gap
1

1
.9

.9

.9
.8

.8

.8
.7

.7

.7
AUROC

AUROC

AUROC
.6

.6

.6
.5

.5

.5
.4

.4

.4
.3

.3

.3
Credit/GDP gap Property gap Credit\GDP gap and prop. gap Credit/GDP gap DSR Credit\GDP gap and DSR DSR Property gap DSR and prop. gap
.2

.2

.2
-20 -15 -10 -5 0 -20 -15 -10 -5 0 -20 -15 -10 -5 0
Horizon Horizon Horizon

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Robustness checks

 Robust across samples

 Robust to different crisis dating
 Robust to balanced versus unbalanced samples
 Robust if partial ROC curves are used

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 Conclusion

 We argue that EWIs need satisfy six policy requirements:

 Need to be evaluated with preferences free methodology
 Need to have right timing
 Need to be stable
 Need to be robust
 Need to be understood by policymakers
 Appliying this approch to data from 27 countries we find that:
 The DSR and the credit-to-GDP gap dominate other EWIs
 The DRS dominates at shorter horizons and the credit-to-GDP
gap dominates at longer ones

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