Systemic Risk Diagnostics: Coincident indicators and early warning signals
by Bernd Schwaab of European Central Bank,
August 30, 2011
Abstract: We propose a dynamic factor modeling framework to assess financial system risk. We construct coincident measures ('thermometers') and a forward looking indicator ('barometer') for the likelihood of a simultaneous failure of many financial intermediaries. The indicators are based on macro-financial and credit risk factors that we extract from a large data set comprising the U.S., the EU-27 area, and the respective rest of the world. Credit risk conditions can significantly and persistently decouple from macroeconomic and financial fundamentals. Our risk indicators may serve as part of a financial sector surveillance and early-warning system for macro-prudential policy.
Keywords: financial crisis, systemic risk, credit portfolio models, frailty-correlated defaults, state space methods.