Financial Cycles – Early Warning Indicators of Banking Crises?

IMF Working Papers, April 29, 2021

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Research question: Can the upturns and downturns in financial variables serve as early warning indicators of banking crises?
Sample: data from 59 advanced and emerging economies.
Main conclusion: Financial overheating can be detected in real time, and aggregating signals from financial variables can flag crises many years before occurrence.
Additional finding: The length of financial cycles is of medium-term frequency, which challenges the longer frequency often used for estimating countercyclical capital buffers.

Leading indicators by market type:
- Advanced markets: equity prices and output gap are the best leading indicators.
- Emerging markets: equity prices, property prices, and credit gap are the best leading indicators.
Aggregation of indicators:
- Combining information from multiple financial variables flags financial crises many years before the crisis.
Financial cycle periodicity:
- Financial cycles are of medium-term frequency, calling into question the longer frequency widely used in the estimation of countercyclical capital buffers.

Early detection: Real-time monitoring of equity prices, output gap, property prices, and credit gap can provide early warning signals of financial overheating.
Macroprudential frameworks:
- The medium-term frequency of financial cycles suggests reassessing the frequency assumptions used for countercyclical capital buffer calibration.
Cross-market emphasis:
- Different sets of indicators matter in advanced versus emerging markets; surveillance frameworks should be tailored accordingly.

Scope: 59 advanced and emerging economies.
Approach: Identification of leading financial indicators and assessment of aggregated signals for early warning capability.
Frequency conclusion: Estimation and analysis indicate financial cycles operate at medium-term frequency.