Economic commentary: A new early warning indicator of financial fragility in Sweden
Economic Commentaries, News In this economic commentary, the authors propose a new early warning indicator of financial fragility and apply it to the Swedish financial sector. The early warning indicator (EWI) is designed to give a numerical assessment of the build-up of systemic fragility in the credit sector of the economy.
It has three desirable features of an early warning indicator: a high degree of timing, stability and interpretability. The authors explain the crucial choice in the method to filter the trending variables for building a reliable EWI. Out-of-sample evaluations show that the new EWI would have performed well prior to the 1990 and 2008 crises. Currently, the indicator predicts an increased probability of persistent reductions in new loans and aggregate credit volumes, which historically have coincided with persistently lower GDP growth.
Following the financial crisis of 2008, policy and academic economists found that the macroeconomic models they were relying on could not meaningfully address questions related to financial crises. Likewise, the models employed by regulators to stress test individual credit institutions had not provided reliable warnings of risks that were systemic in retrospect. Economists have since tried to construct financial stress indicators and early warning indicators to bridge this gap. So far, the attempts at providing numerical indicators are still provisional, and there is room for improved modeling. This commentary is an attempt to provide an alternative early warning indicator.
By Paolo Giordani and Erik Spector, who work in the Financial Stability Department, and Xin Zhang, who works in the Monetary Policy Department.