Adjusting the countercyclical capital buffer with early warning indicators of banking crises: forming a composite indicator for prediction

Abstract

In this thesis, I study the use of early warning indicators (EWIs) in predicting banking crises. After the financial crisis of 2007-2008, policymakers realized the importance of financial market regulation, which led to the introduction of macroprudential policy tools. The purpose of these tools is to mitigate financial imbalances and to enhance the resilience of the financial system. The countercyclical capital buffer is a central tool that can be used to curb the financial cycle's tendency to overheat and to promote lending in a downturn.

Early warning indicators are used to monitor the phase of the financial cycle so that the countercyclical capital buffer can be adjusted at the right times. The Finnish early warning framework consists of 13 individual indicators that monitor various sectors of the financial markets. These sectors include, for example, credit growth, property prices, and the external balance. In the empirical section of this paper, I construct a composite indicator from the individual EWIs included in the Finnish early warning framework. Composite indicators combine information of standalone EWIs and may perform better and have a more consistent predictive power compared to standalone EWIs.

The composite indicator I construct has good predictive power in both in-sample and out-of-sample estimations and fulfils the requirements of a good indicator as defined in the literature. This means predicting correctly at least 2/3 of future crises with a low noise-to-signal ratio. Most relative weight is assigned to debt service-to-income ratio, house price growth, and current account-to-GDP development indicators. These are also determined as some of the best-performing standalone EWIs in the previous literature.

Finally, I use the new indicator I have constructed to estimate the current state of the financial cycle. The estimation shows that there is currently a low risk of a banking crisis occurring in the next 1-5 years. The indicator values are well below the signalling threshold and the indicator has a downward trend. Standalone EWIs suggest a similar current development.