Banking Stress and MIP Indicators

Prediction of banking stress episodes in EU using macroeconomic
imbalance scoreboard indicators
Petr JAKUBIK Bogdan Gabriel MOINESCU

European Insurance and Occupational Pensions Authority1 National Bank of Romania3
Charles University in Prague2 Bucharest University of Economic Studies4
Abstract
This paper highlights a substantial potential for most of the macroeconomic imbalance scoreboard
indicators in signaling not only economic instability risks but also banking stress episodes within the
European Union. It subsequently emphasizes the opportunity of developing a banking stress alert satellite
for the macroeconomic imbalance procedure (MIP), which is currently employed by the European
Commission for its general economic assessments of the EU member states. To this end, the study
employs adapted indicative thresholds for selected MIP indicators based on rating techniques and well-
performing multivariate configurations. It further emphasizes their complementarity with core financial
soundness indicators compiled by the International Monetary Fund, both directly through combined
multivariate models and indirectly by integrating institutional-based models as interdimensional synthetic
indices. These mixtures not only reduce the model risk, but also contain the variability of estimated crisis
probability. Finally, in contrast with the usual decisional framework based on a singular threshold, this
paper puts forward the merits of a more granular staged approach, which involves rating scales with
several risk categories.
Keywords
banking stress episodes, macroeconomic imbalance scoreboard, financial soundness indicators, crisis
probability, early warning systems, rating scales
JEL Codes: G01, G21, G28.
There are no conflicts of interest associated with this paper, and there has been no financial support for
this work that could have influenced its outcome.
1
petr.jakubik@eiopa.europa.eu
2
jakubik@fsv.cuni.cz
3
bogdan.moinescu@bnro.ro
4
bogdan.moinescu@fin.ase.ro
1
1. Introduction
The macroeconomic stance, along with variables of banking stability and institutional quality, is a
recurrent factor, both for the academic literature and practice, in efforts to explain the causes of financial
stress episodes.
Economic growth and the real short-term interest rate, together with the current account balance relative
to GDP and the real effective exchange rate, were the macroeconomic variables most often highlighted
as leading indicators to banking crises in early research of late 1990s (Eichengreen and Rose, 1998;
Demirgüç-Kunt and Detragiache, 1998 & 2000; Kaminsky and Reinhart, 1999). At that time, analyses
focused on emerging economies, following a series of crises in Latin American and South-East Asian
countries, and the pattern seemed rather similar: economic boom fueled partially by rising indebtedness
and expanding external vulnerabilities. The record of early warning systems developed on these bases
was, nevertheless, a mixed one (Edison, 2002; Berg et al., 2004; Honohan and Laeven, 2005;
Christofides et al., 2016).5 Illustrative in this respect is the case of the onset of the international financial
crisis in 20086, which was a totally surprising event for both investors and public authorities. In fact, since
then, the EWS literature has proliferated. Klomp (2010) finds that the low level of economic growth and
high interest rates, along with the fast pace of lending, are the main determinants of banking crises. Pedro
et al. (2018) conclude that a low GDP growth rate and high level of non-deposit bank liabilities are the
prime factors of major banking stress episodes. The interbank interest rate is identified by Alonso and
Molina (2019) as the main leading indicator for financial crises, and short-term external debt also plays
an important role. In the category of external imbalances, Tolo et al. (2018) provides evidence for the
share of the current account balance in GDP as an early warning indicator of banking crises. Lo Duca
and Peltonen (2013) show that multivariate models that include a combination of local (country-specific)
and global (common) variables produce relatively high success rates in anticipating banking stress
episodes. A similar result was reported by Behn et al. (2017). However, Barrell et al. (2010) find that
capital adequacy and liquidity rates are negatively correlated with the likelihood of banking crisis and may
lead to the exclusion of traditional variables, i.e. macroeconomic indicators, from multivariate
configurations. Behn et al. (2013) show that a stronger capital position in the banking sector decreases
the likelihood of the banking crisis, while very high profitability tends to precede banking stress episodes.
On the other hand, Cihak and Schaeck (2010) consider the deterioration of profitability a good early
warning factor for systemic banking crises, and aggregate prudential indicators, such as financial
soundness indicators compiled by the International Monetary Fund, are useful in identifying vulnerable
banking systems. However, the variables that describe the quality of assets seem to provide unclear
signals, while indicators of capital buffers would not help disentangling solid banking systems from fragile
ones. Detken et al. (2014) consider and reject the banking leverage indicator as a predictive factor for
systemic banking crises. Four years later, Tolo et al. (2018), which includes also a comprehensive
inventory of early warning indicators according to the literature, find that only leverage and the ratio of
banking assets to GDP have proven to be statistically significant predictors of banking variables, but with
moderate discriminatory power. Subsequently, Filippopoulou et al. (2020) argue that banking variables
that reflect industry concentration, asset structure, financing and liquidity are more important, on average,
5
Babecky et al. (2014) consider that the lack of robust early warning systems was caused by the high heterogeneity of sample states included
in the analyzes.
6
. Comprehensive literature reviews on the determinants of banking crises before 2008 can be found in the papers Demirgüç-Kunt and
Detragiache (2005), Davis and Karim (2008) and Kauko (2014).
2
than macroeconomic variables. According to them, the only statistically significant macroeconomic
variables in all multivariate configurations of models for anticipating banking stress episodes in euro area
countries would be the share of public debt in GDP and the net international investment position. On the
other hand, Lee et al. (2020) conclude that understanding how financial vulnerabilities and
macroeconomic imbalances evolve before the onset of banking stress episodes provides a better
framework for understanding the role that the first category of factors plays in the outbreak of banking
crises. At the same time, there is some empirical evidence in favor of structural indicators of bank
financing, such as the rate of stable financing (non-financial customer deposits) and the rate of interbank
resources. While bank deposit guarantee schemes have significantly reduced the risk of traditional bank
panic, reliance on institutional financiers increases vulnerability to market liquidity shocks. Kamin and
DeMarco (2012) and Laina, Nyholm and Sarlin (2015) argue that a higher stable funding ratio has a
stabilizing effect on the financial system. Betz et al. (2013) and Hahm, Shin and Shin (2013), similarly,
show that a high share of non-core debt is a good warning of the imminence of a banking crisis. De Haan
et al. (2020) suggest that low levels of liquid assets and resources attracted from domestic non-
governmental customers, combined with high levels of external liabilities and leverage are leading
indicators of banking crises.
The Great Recession following the international financial crisis highlighted the high degree of
interconnection between the institutional sectors of the economy and, against this background, the
substantial likelihood of spreading the shocks from one to another economic segments. Regardless the
area in which the first syncope in meeting financial obligations occurs, systemic processes develop amid
the existence of substantial vulnerabilities in the households, non-financial companies, public and
financial sectors7. However, traditional macroeconomic monitoring has a limited capacity to identifying
and evaluating them early.
Macro-financial and structural developments, which are finally visible at the macroeconomic level through
the accumulation of both external imbalances and internal vulnerabilities (excessive accumulation of
public/private debt or the formation of real estate bubbles), have proved to be key factors in triggering
balance of payments or public debt crises in the European Union (European Commission, 2016).
Although some empirical correlations suggest that banking stress episodes generally occur after
excessive lending episodes, represented by substantial positive credit-to-GDP gaps.8 However, Behn et
al. (2017) note that the false alarm rate is quite substantial in these cases. Thus, the variables that
describe the evolution of lending should be accompanied by other macro-financial indicators such as the
dynamics of residential property prices and the level of capitalization of the banking system. In addition,
Anundsen, Gerdrup, and Hansen (2014) show that indicators on households’ borrowings have a higher
informational content than those aimed at lending to the non-financial companies in anticipation of crises.
Moreover, a number of previous studies (Barba and Pivetti, 2009; Obstfeld and Rogoff, 2009;
Büyükkarabacak and Valev, 2010; IMF, 2012; Jorda et al., 2013) have shown that the expansion of
households’ credit increases the likelihood of a banking crisis and the severity of the recession that
7
Not all economic shocks end up triggering banking crises. Financial systems are most often able to withstand shocks in the economy (Lee et
al. 2020).
8
Based on a comprehensive set of states and crisis episodes, Drehmann and Juselius (2014) show that credit-to-GDP gap is a robust indicator
of early warning of the accumulation of long-term financial vulnerabilities, while the debt service rate at the households’ level is the dominant
variable for the near-term horizon. Babecky et al. (2014) conclude that banking stress episodes are preceded by substantial credit growth, and
interbank interest rates are also early indicators worth monitoring. Alessi and Detken (2017), as well as Virtanen et al. (2018) support the
relevance of credit-to-GDP ratio and of debt service ratio of the households in anticipation of banking crises.
3
accompanies it. Thus, the structural assessment of private sector lending is important, the empirical
results indicating optimally, from a macroprudential perspective, the evolution in tandem of the two
components. Vermulen et al. (2015) for 28 OECD countries, and later Coudert and Idier (2016) for 10
Euro area states, highlighted the major role of long-term government bond yields, which is an expression
of the systemic impact of the public finance situation on banking sector. Beutel et al. (2019) also illustrated
the dependence of the banking system on the vulnerabilities present in other sectors of the economy,
highlighting the role of the current account balance, the dynamics of residential property prices and the
investment rate on the likelihood of banking stress, along with the credit-to-GDP ratio.
Given that the broadband connection between the real economy, the financial system and the
government sector has become a major concern in the economic policy mix, the reform of economic
governance in the EU has involved the introduction of the macroeconomic imbalances procedure and
the revision of the financial supervisory framework with a focus on crisis prevention and management.
The main tool for monitoring the economic stance in the new governance framework is a scoreboard with
14 key indicators, structured so as to capture the most relevant internal and external aspects of
macroeconomic imbalances, through a limited set of high quality statistical indicators on competitiveness,
indebtedness (including at the level of institutional sectors), labor market situation, etc. In addition,
another 25 ancillary indicators are used, which provide additional information. Imbalances are assessed
according to their severity, judged based on configurations of variables whose levels exceed the
established alert thresholds, evolution and economic policy responses, taking into account also possible
spillover effects to other member states.
Moreover, the strengthening of the macroeconomic surveillance mechanism in the European Union with
additional elements to those directly targeting the field of public finances was the objective of the
European authorities even before the events of 2008-2009 (European Commission, 2016). Within the
scope of financial supervision, the reporting system of consolidated banking data had already been
introduced since 2002, under the coordination of the Committee of European Banking Supervisors, the
forerunner of the current European Banking Authority. The role of these aggregate prudential indicators
was to allow monitoring of bank soundness, based on profitability, balance sheet structure, asset quality
and solvency (Borgioli et al, 2013; Barbic et al, 2017). A few years earlier, the International Monetary
Fund had begun compiling financial soundness indicators with the launch of the Financial Sector
Assessment Program, together with the World Bank, in order to monitor the fragility of national financial
systems. The ambitious effort to collect internationally comparable statistical data on banking soundness,
which also includes aggregate prudential indicators on capital adequacy, asset quality, profitability,
liquidity and market risk sensitivity, has benefited from a standardized framework since 2006, with the
completion of the compilation guide.
The experience of the international financial crisis and developments in prudential regulations have led
to both the revision and expansion of these data sets. In addition, new institutions created for the purpose
of macro-prudential oversight, i.e. for the prevention and mitigation of systemic risks, such as the
European Systemic Risk Board in the EU, have accelerated the efforts to both take stock of the financial
stress episodes and identify specific indicators for their early warning. A comprehensive synthesis of the
recent literature is provided by Tolo et al. (2020).
This study stands at the intersection between the consistent literature on early warning indicators of
banking crises and the incipient body of studies aiming at assessing the signal strength of MIP
4
scoreboard9 indicators for anticipating events of economic instability in the Member States of the
European Union. Although both research areas capitalize on similar methodological solutions, there are
notable differences both in terms of the content of the dependent variable and in terms of the typology10
of early warning indicators. While in the case of traditional alert systems, the target is to anticipate banking
stress episodes, in the second case the aim is to early warn on economic crisis, generally11 expressed
by a negative GDP deviation above a standard deviation (Csortos and Szalay, 2014; Domonkos et al.,
2017; Siranova and Radvanský, 2018). Some recent research (Dany-Knedlik et al., 2020; Biegun and
Karwowski, 2020) has advanced towards exploring the relevance of the 14 indicators of the MIP
scoreboard for anticipating financial stress episodes in the European Union, focusing on the particularities
of Central and Eastern European Member States. Using the nonparametric methods applied by Alessi
and Detken (2011) on signal strength assessment, Dany-Knedlik et al. (2020) conclude that the current
account balance (but without upper limit), along with the dynamics of residential real estate prices, the
flow of credit to the private sector and the pace of liabilities of the financial sector are relevant indicators
for anticipating cases of financial stress episodes. Such periods were identified according to the list of
systemic financial crises contained in the ECB/ESRB (Lo Duca et al., 2017) at the level of the 11 Member
States in the CEE region. However, out of the four selected indicators, only the current account balance
seems to have passed the test of statistical relevance for the type of financial stress considered, under
the conditions of parametric estimation using probit regression. A less satisfactory result for the Union for
the period 2008-2017 was reported by Biegun and Karwowski (2020), who tested the relevance of the
indicators in the main MIP set for anticipating events of economic instability identified both on the basis
of a self-developed multidimensional indicator and according to the inventory of financial stress episodes
from the ECB/ESRB crises database (Lo Duca et al., 2017). In the latter case, however, it is not clear
which of the types of financial stress identified separately12 in the ECB/ESRB database was used as a
dependent variable in the empirical analysis.
The contribution of the current analysis versus the research indicated above contains the evaluation of
MIP indicators, including recently introduced variables on the supplementary list, respectively banking
leverage, population indebtedness and net international investment position (excluding debt
instruments), to anticipate the events of banking stresses in all Member States of the European Union,
using as a reference the strict inventory of banking crises prepared by the ECB / ESRB. The robustness
of the results is tested on the basis of a set of control variables mainly consisting of financial soundness
indicators compiled by the IMF.13 Thus, unlike the preferred approach used in the literature to select14
early warning indicators based on empirical results reported in previous studies, the set of candidate
explanatory variables used in this article consists almost entirely the standard indicators monitored by
9
Although it is not considered a pure EWS, as it does not provide a crisis probability, it can be assimilated to the wider set of alert mechanisms
due to its purpose of early identification and periodic monitoring of sources of economic instability and its indicator-based construction with
indicative thresholds. However, the method by which the upper and/or lower limits were established for each factor involved simply identifying
the corresponding quartile in the statistical distribution (European Commission, 2016), without defining an explicit dependent variable and
applying a procedure to minimize prediction errors.
10
limitated to the MIP set in the second case
11
Alternative specifications used in the literature include the call for international financial assistance (especially from the International Monetary
Fund) or substantial increases (above a standard deviation) in government bond yields (Knedlik, 2014)
12
The main categories presented in the ECB / ESRB inventory are: i) balance of payments / foreign exchange; ii) public / sovereign debt; iii)
banking; iv) active price correction; v) transition.
13
For a comprehensive assessment of the set of macroprudential indicators used by the ESRB, see Filippopoulou et al. (2020).
14
in the absence of a generally accepted theoretical structural model (O’Brien and Wosser, 2018)
5
international institutions for purposes of anticipating banking stress episodes. Secondly, methodological
extensions to the usual approaches are applied both before running the standard nonparametric tests
(ROC curve) and after developing multivariate models. The investigation of the functional relationship
between the empirical probability of crisis and the values of the candidate variables per decile, which is
a commonly employed approach in the development of credit-scoring models (Loeffler and Posh, 2011),
allows the identification of non-monotonous impact factors (e.g. parabolic type) and setting multiple
indicative thresholds for superior signal accuracy. At the end of the diagnosis process, a rating scale is
developed with four risk classes, in general. In this manner, the complications associated with setting a
unique decisional threshold, based on the best guesses about the relative cost between the false positive
and negative ratios, are better contained. Thirdly, the proposed alert mechanism provides indicative
thresholds adapted to the early identification of banking crisis cases for MIP scoreboard variables
including for six of the indicators in the supplementary list that do not currently have benchmarks for crisis
monitoring purposes as well as multivariate configurations that largely explain the banking stress
episodes in the EU in the context of the international financial shock of 2008. There are also provided
unique combinations between sets of MIP and FSI variables in the form of synthetic indexes to limit both
the model risk and the variability of probability of banking stress resulting from the multivariate
intermediate specifications (MIP/FSI).
The rest of the study is organized as follows. The second chapter presents the methodological steps
followed in the analysis. The third chapter describes the data used and the results of the preliminary
screening of the candidate variables. It concludes with the short-list of determinants, along with their
indicative thresholds and applied transformations. The fourth chapter discusses the process of
developing and selecting multivariate configurations, which are structured on three dimensions, namely
combinations along types of indicators (macro-imbalances, financial soundness and credit related),
integrated indices and inter-sectoral models with variables from different categories. The fifth chapter
introduces possible decision rules based on rating scales. The last chapter summarizes the main
conclusions.
2. Methodology
The analytical framework employed for assessing the predictive capacity of the European Commission's
scoreboard indicators in relation with banking stress episodes includes recognized procedures in finance
for modeling binary events. To this end, we utilize techniques used by the banking industry, academia
and central banks alike to estimate the probability of default, the risk of insolvency for both non-financial
corporations and financial institutions, and the likelihood of a systemic banking crisis.
To ensure the robustness of the research, the analysis is developed in three stages. Given that the
purpose of early warning systems is to identify a limited number of variables that together help to
anticipate the emergence of financial crises, the first stage of the process aims at preselecting the
potential predictors. This involves verifying the informational content of each factor considered, using a
mix of nonparametric and parametric approaches. During this first stage, the optimal signal horizon is
also explored based on lags up to three years. The second stage includes the configuration of multivariate
models, based on the combination of the short-listed variables in the previous stage employing
alternatively forward and backward methods. Econometric estimations are performed using the logit
model for panel data. Finally, the stability of these results is tested by reestimating the models in the
presence of financial soundness indicators compiled by the International Monetary Fund (FSIs) and
6
credit-to-GDP ratio15, which is considered the main macroprudential indicator in several recent European
studies (Tolo et al., 2018; Virtanen et al., 2018; O’Brien and Wosser, 2018). Each of these stages, in turn,
involves a series of operations.
During the preselection stage, the filtering procedure has been generally run four times for each variable,
respectively for the instantaneous impact and lags up to three years.16 The univariate analysis starts from
spotting the differences between the average values of crises and non-crises samples for each factor
under consideration. Then, the analysis is deepened by observing the stress probability on deciles of
each indicator, respectively on ten bins17 with equal number of observations18. In this sense, the usual
credit-scoring technique is applied (Loeffler and Posh, 2011), respectively the calculation of the crisis
probability, for each decile, dividing the number of banking stress episodes19 by the total number of
observations in that bin (one tenth of the size of the data sample in the case of deciles). On this basis,
conclusions are drawn regarding the typology of the functional relationships of banking stress episodes
with each potential leading indicator. Candidate variables for which the values of the banking stress
probabilities per decile form a flat trend are dropped-out from the subsequent stages.20 In the case of the
remaining variables, whether the probable functional relationship is linearly-increasing or decreasing, or
nonlinear, the preliminary processing continues with the optimization of the bin structure by aggregating
the sub-intervals for which the level of banking stress probability is similar. Based on the new
segmentation, the information value statistic was calculated, and the actual values for each observation
were replaced with the corresponding probability of banking stress. Hence, the new risk values (empirical
default rates for each risk bucket) were used for replacing the initial values, as suggested by Loeffler and
Posh (2011), considering that data transformation based on default rates represents an effective
approach in dealing with outliers. At the end of the first stage, the short list of explanatory variables was
configured by ranking the tested variables, specified separately on their own lags of up to three years21,
depending on the area under ROC curve indicator (53% lower limit) and the pseudo-R-squared (2% lower
limit) resulting22 from running the logit regression23 without fixed effects using only that variable.
15
Similar to de Haan et al. (2020), who also use the credit-to-GDP ratio as a control variable in estimating the probability of a banking crisis.
16
Most papers published by the Bank for International Settlements on the subject consider forecast horizons of one to five years.
17
Sometimes even on 20 bins for exploring the functional relationship in more detail.
18
The number of ranges that we choose depends on the size of the data set and the average default rate; hence, a more granular approach,
such as the one using centiles, would not be feasible given the number of observations available (approx. 400) and the share of banking stress
episodes (approx. 25%).
19
To this end, we employed the usual floor for the defaults number in the credit-scoring literature, respectively an arbitrarily small value of 0.01.
Otherwise, the logit transformation could not have been applied in cases where the crises rate is zero.
20
In contrast to the noise-to-signal filtering methods and the area under the ROC curve indicator, repeatedly used as a standard method in
studies on early warning indicators of banking stress episodes, the prior investigation of the relationship between crisis risk and indicators
considered relevant employs the decile segmentation. It has the advantage of highlighting the informational content of the factors with non-
monotonic impact on the likelihood of banking crisis, such as the current account balance, for which we presume a quadratic functional
relationship with banking crises risk. This allows accommodating substantial deviations from the equilibrium level implying similar risks from the
perspective of banking stability. Calculating the area under the ROC curve directly on the actual current account balances would conclude that
this indicator fails to properly order the observations in the sample according to risk. Therefore, the informational content of the variable current
account balance would have been significantly underestimated and thus the indicator would not have been promoted in the next stage performing
multivariate configurations.
21
with the exception of private sector credit flow, where lag four was also used in view of the longer impact period
22
hierarchical results are generally consistent for the two statistics
23
in line with the usual approach in the field (Demirgüç-Kunt and Detragiache, 1998; Cihak and Schaeck (2010); Navajas and Thegeya, 2013);
logit regression continues to be, in fact, the main method for building early warning systems (Lo Duca and Peltonen, 2013; Tolo et al., 2018),
7
1
𝑃(𝑦 = 1|𝑀𝐼𝑃) =
1+ 𝑒 −(𝑀𝐼𝑃𝑖×𝛽𝑖 +𝑐)
In the second stage, the formation of multivariate configurations with macroeconomic imbalances
indicators is done both by the forward and backward methods. In the first case, we are sequentially
adding factors in descending order of their discriminatory power between the stress and normal
situations. In the second case, we are iteratively eliminating the variables without significant informational
input (which does not contribute to the increase of the explanatory power of the model). In both cases,
we are considering all lags for each variable to retain or eliminate it from the shortlist. In order to avoid
simultaneity problems, the instantaneous interaction has been excluded, which would allow for using a
signal interval of at least one year for developed models. The estimation of the coefficients of the
functional form was performed by running a logit regression on panel data, without fixed effects in line
with the usual approach in the relevant literature.
The likelihood of a bank stress event (P) is expressed as a function of a vector of MIP variables, selected
in the previous stage, using the logit model. The vector of parameters (𝛽) is estimated by the maximum
likelihood method.
The dependent variable is binary, taking the value 1 in case of banking crises24 and 0 otherwise. The
explanatory variables indicated by the univariate filtering were used in the second stage with the values
replaced by the probabilities of banking stress observed at the level of homogeneous bins (number to be
optimized according to those mentioned above). Transforming variables based on crisis incidence
addresses, as presented before, the data challenges associated with the presence of extreme values
while allowing for input standardization among the early warning indicators.
Finally, the robustness of MIP configurations is tested by adding relevant IMF’s financial soundness
indicators and the bank credit-to-GDP ratio (credit-to-GDP from here on), expressed both in level and
growth rate. The informational content of these control variables was tested using the preselection
procedure. Moreover, those factors with predictive power were capitalized for the development of
multivariate configurations for both sets of control variables, namely FSIs and credit-to-GDP related
ratios, using the same approaches described as for the second stage. The backtesting of the developed
models was not performed, due to data constraints as presented in the next section.
Although multivariate models allow for testing the simultaneous statistical significance of several
explanatory variables and their relative importance, so that the selection of the empirical configuration
can be based on its statistical inference performance, this approach does not directly provide an early
warning rule. Extending the usual approach both in the academic literature and in central banking
practice, which employs a single decisional threshold calibrated in terms of a unitary ratio between the
costs associated with missed crises and false alarms, this paper employs a more granular staged
approach, which involves the use of rating scales with 3-4 risk categories. In short, it advocates for the
machine learning solutions (decision trees, neural networks, etc.) recording lower results in ex-post testing, despite superior performance in
explaining the events in the estimation sample (Beutel et al., 2019; Tolo, 2020). Compared to machine learning methods, the logit model has
the advantage that it is based on a clear and direct statistical model, which explicitly takes into account the uncertainty, and is easy to interpret.
24
According to the ECB / ESRB inventory of financial crises in the European space, carried out by combining a quantitative approach based on
a financial stress index with the assessment of experts from national and European authorities
8
use of traffic light approach in guiding macroprudential policy rather than employing only one indicative
threshold calibrated based on perceived relative costs (mostly unobservable) of prediction errors.
3. Data and preliminary analysis
The data set employed in the analysis covers 15 years of information, from 2005-2019, for all 28 Member
States of the European Union, according to its official configuration at the end of 2019. Thus, we use
panel data25, with annual frequency including rather homogenous jurisdictions.26 Banking stress episodes
account for a quarter of the 420 observations available. This database is not susceptible to the selection
bias problem, given that there are nine cases without banking stress among the jurisdictions considered.
The information on the dependent variable, which takes binary values, respectively value 1 for banking
stress episodes and 0 otherwise, is extracted from the inventory of European financial crises developed
by the ECB and ESRB for macroprudential purposes (Lo Duca et al., 2017, with subsequent updates). In
this database, the periods of banking stress for each Member State of the European Union have been
identified precisely, along with other categories of major financial turmoil events (public debt crises,
currency crises, etc.), since 1970. Given that the credibility of early warning mechanisms depends on the
accuracy of identifying and dating previous financial stress episodes, the result generated by combining
the series of events identified based on the financial stress indicator method proposed by Duprey et al.
(2015) with the lists of episodes identified in the main contributions in the relevant literature (Laeven and
Valencia, 2013) has been cross-checked, based on homogeneous criteria, with expert judgement from
national and European authorities.
Both limiting the set of jurisdictions selected in the sample to the EU membership and setting the
dependent variable based on the inventory of European banking stress episodes as identified and dated
by the ECB and ESRB represent two critical ingredients for avoiding challenges induced by the structural
vulnerabilities associated with panel data sets, including heterogeneity in terms of financial stress
typology and improper timing. Hence, the data set fulfills the preconditions required for an adequate input
quality in developing a robust early warning system.
The main set of possible early warning indicators of banking stress episodes is represented by the 14
indicators of the macroeconomic imbalance procedure (MIP) used by the European Commission for
monitoring of economic developments at the Member States within the framework of the European
Semester. Along with these, six other indicators from the extended MIP set (auxiliaries) were considered,
namely economic growth, investment rate (share of gross fixed capital formation in GDP), banking
leverage (assets-to-equity multiple), as well as the share in GDP of households’ debt, net international
investment position (excluding non-defaultable instruments) and the current and capital account balance.
The values of all 20 variables on macroeconomic imbalances and their brief methodological description
were extracted from the Eurostat website. In addition to these potential explanatory variables, the long-
term interest rate indicator from the Maastricht criteria, the real short-term interest rate, as well as the
annual changes in the indebtedness indicators of the public and private sectors were also employed.
25
As pointed out by Claessens (2009), single-country studies suffer from the problem that there are only a few financial crisis periods.
26
Moreover, the empirical evidence presented in the literature (Davis et al., 2011; Babecky et al., 2014) indicates that the performance of an
early warning system to anticipate financial stress episodes improves when the sample consists of homogeneous countries (including with
similar institutional characteristics). In addition, Papadopoulos et al. (2016) show that although EWS studies using global samples benefit from
more data, the potential for predictive power would be lower for them than for research targeting homogeneous groups of countries.
9
The list of control variables comprises of the 11 core financial soundness indicators27 compiled by the
International Monetary Fund (core FSIs) and the credit-to-GDP ratio, expressed both in level and as
annual variation (in pp). The data source in the first case is the IMF database, while for the second one
is World Bank.
Thus, the whole set of determinants includes a total of 37 indicators, out of which 13 are control variables.
For each indicator only its lags from one to three years28 were generally considered (𝑉𝑡−𝑘 , where k takes
values between 1 and 3).29 The instantaneous impact was excluded, both to avoid simultaneity issues,
given that even the banking stress episodes may cause changes in the factors considered as
determinants, and for practical reasons related to its lack of usefulness in early warning activities. Incident
indicators with banking stress episodes, beyond the issue of clarifying the causal direction, have the
disadvantage that they cannot be used for forecasting purposes. However, they may be relevant for
simulation exercises, studying both the impact of scenarios relevant for prudential (micro and macro) and
resolution purposes and the adequate timing for releasing capital buffers.
The preliminary exploration of the discriminatory power employs a comparative assessment based on
mean values of macroeconomic imbalance indicators in crises versus non-crisis stance. Our results show
a promising potential for almost all variables considered. Although the maximum differences between the
average values of the crisis periods and those without banking stress episodes are notable in the case
of the contemporary impact for almost all indicators, substantial gaps are also maintained for the delayed
impact (lags 1 to 3) for the majority of them. Illustrative in this respect (Table 3.1) are the variation in the
market share of exports, the share of public debt in GDP (including annual change), the activity ratio, the
youth unemployment rate, the consolidated banking leverage, economic growth, long-term government
bond yields, real short-term interest rates, etc.
Table 3.1 – Crises versus non-crisis average values of macroeconomic imbalance indicators, over time
horizons of up to three years
Instantaneous Lag 1 Lag 2 Lag 3
Macroeconomic imbalances indicators
Non-crisis Crises Non-crisis Crises Non-crisis Crises Non-crisis Crises
Current account balance -0.8% -0.9% -0.8% -1.7% -0.9% -2.2% -1.0% -2.6%
Net international investment position -31.7% -51.4% -33.1% -49.8% -34.9% -47.0% -36.1% -46.2%
Real effective exchange rate 1.4% -0.6% 1.2% 0.0% 0.9% 0.5% 1.0% 1.0%
Nominal unit labour cost 7.4% 5.8% 6.8% 7.4% 6.6% 7.9% 6.9% 7.9%
Export market shares 8.5% -6.7% 7.8% -4.7% 6.5% -2.1% 5.1% -0.4%
General government gross debt (level) 54.7% 81.8% 55.9% 75.9% 56.8% 70.7% 57.5% 66.7%
General government gross debt (y-o-y) -0.5% 5.9% 0.0% 5.2% 0.6% 4.4% 1.4% 4.1%
Private sector debt 133% 174% 134% 172% 136% 166% 138% 161%
Private sector credit flow 8.0% 2.7% 6.6% 7.1% 6.0% 9.6% 5.4% 11.7%
House price index 3.5% -3.4% 3.0% -2.1% 1.9% 0.5% 0.9% 2.1%
Total financial sector liabilities 9.2% 2.3% 8.3% 5.0% 8.0% 7.7% 7.3% 10.4%
Activity rate 1.3% 0.4% 1.2% 0.6% 1.1% 0.7% 1.0% 0.8%
Long-term unemployment rate -0.7% 1.3% -0.5% 1.0% -0.3% 0.7% 0.0% 0.5%
27 Data available starts from 2007.

28
The number of lags considered is limited by the length of time for the available data. The use of an impact interval of more than three years
would reduce the sample size of the model estimate, affecting the robustness of the analysis, without obtaining a significant gain in the application
of possible macroprudential measures. Moreover, for those variables that, hypothetically, could provide stronger signals at intervals longer than
three years, the use of lag three should be sufficiently informative for the timely adoption of macroprudential measures.
29
Except for one indicator (private sector debt), where fourth lag was also considered.
10
Unemployment rate 8.4% 10.0% 8.8% 9.3% 9.1% 8.7% 9.4% 8.3%
Youth unemployment rate -2.3% 4.8% -1.7% 4.0% -0.9% 3.3% 0.1% 2.6%
Consolidated banking leverage 12.6 18.0 12.9 18.3 13.3 18.3 13.9 18.4
Real gross domestic product 3.0% -0.7% 2.8% 0.0% 2.5% 0.8% 2.1% 1.3%
Gross fixed capital formation 22.5% 19.7% 22.2% 20.8% 22.0% 21.6% 21.9% 22.3%
Current plus capital account -0.1% 0.5% 0.1% -0.7% 0.3% -1.5% 0.2% -2.0%
NIIP excl. non-defaultable instruments -127% -102% -123% -105% -120% -108% -111% -120%
Household debt, consolidated 50.2% 71.7% 50.5% 71.1% 50.7% 69.8% 51.4% 68.6%
Long-term government bond yields 2.9% 5.2% 3.1% 5.2% 3.3% 5.1% 3.7% 4.9%
Real short-term interest rate -0.8% 0.8% -0.7% 0.9% -0.4% 0.6% -0.2% 0.5%
Source: Eurostat, ECB/ESRB, authors’ calculations
In addition, for variables such as current account balance (including the option with capital account
added) and private sector credit flow, the signal strength becomes noticeable over the medium term. In
these cases, the highest differences between crisis and non-crisis average values are recorded for lags
2 and 3.
The in-depth assessment of the informational content of each explanatory variable assumed the
investigation of the functional relationship between the risk of banking crisis and the values of each
indicator, based on the observed probability of banking stress at decile level. Additionally, in most cases,
the analysis was detailed using a data structure with 20 bins. The procedure was run for each of the lags
1-3 of the candidate variable in order to identify the optimal signal horizon.
For those indicators with favorable results, respectively those in which the trend of bank stress
probabilities per decile is not a flat one, we optimized the number of risk classes by aggregating the
subintervals with similar crisis probabilities in the second stage of univariate screening. In this regard, we
employed the criteria of homogeneity of level of risk related to the sub-intervals of the same class and
the significant delimitation of the empirical probability of banking stress between the different risk
categories. The credit-to-GDP ratio as the key macroprudential indicator could serve as an illustrative
example to demonstrate this approach (Charts 3.1). 30
Chart 3.1 – Probability of banking stress based on Credit-to-GDP ranges
100% 100%
Probability of banking crisis
80% 80%
55.6%
60% 60%
37.9%
40% 40%
22.6%
20% 20%
0.0%
0%
0%
43.6 51.7 62.2 75.5 86.4 95.0 109.7 124.6 162.4 255.2 51.7 86.4 162.4
10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Credit-to-GDP at time t-2 (upper
Credit-to-GDP at time t-2 (upper limit/percentile) limit)
Source: World Bank, ECB/ESRB, authors’ calculations

Based on our data sample, the representation of the bank stress probability per deciles of the credit-to-
GDP ratio for a two-year time horizon indicates the existence of only four risk classes. The first two deciles
correspond to a level of banking intermediation of up to approx. 50%, does not account for cases of
30
The results for all 37 variables tested can be found in appendix. However, a few cases provided here are
sufficient to highlight the advantages of this procedure.
11
banking stress (zero risk). The third to fifth deciles with values between 51.7% and 86.4% resemble to
the incidence of banking crises approximately in one out of five cases (22.6%). The sixth to nineth deciles
with values between 86.4% and 162.4% match the probability of crisis about 40%. Finally, the tenth decile
with values higher than 162.4% corresponds to the incidence of banking stress episodes exceeding one
out of two cases.
Eloquent examples can also be found within the set of MIP indicators. One of the clearest cases is the
evolution of the exports market share, for which the optimal number of risk classes is the minimum,
respectively two. Statistical data indicates the existence of a single signal threshold (-4.6%) even when
using 20 bins. A five-year contraction in the market share of exports of more than 4.6% implies almost
50% likelihood of a banking crisis in the following year. Conversely, if the five-year change in the market
share of exports is above the -4.6% threshold, then the probability of a banking crisis occurring next year
drops to almost 10% (Charts 3.2).
Chart 3.2 – Probability of banking stress based on exports market share ranges
100% 100%

90%
80% 80%
70%
60% 60% 46%
50%
40% 40%
30% 13%
20% 20%
10%
0% 0%
-21.0 -17.5 -15.1 -12.6 -10.3 -8.5 -6.3 -4.6 -2.9 -0.3 0.9 2.7 6.0 9.3 11.9 17.7 24.0 33.3 53.2 95.6
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
-4.6
Export Market Shares (5 years %
Export Market Shares (5 years % change) at time t-1 (upper limit/percentile)
change) at time t-1 (upper limit)

The structure with two risk classes based on a single reference value, is identical to that used for the
purposes of alerting economic imbalances. However, the early warning threshold for banking stress
episodes (-4.6%) is slightly more prudent than the indicative value (-6%) used by the MIP scoreboard.
Another similar result was obtained in the case of the current account balance, expressed in terms of 3-
year average. A quadratic relation with thresholds -2% of GDP (lower limit) and 1.5% of GDP (upper
limit), respectively, for an impact interval of two years could be observed for this indicator (Charts 3.3).
Chart 3.3 – Probability of banking stress by current account balance ranges
100% 40%
90%
35%
80% 37%
70% 30% 33%
60%
50% 25%
40% 20%
30%
15% 11%
20%
10% 10%
0% -2.0 1.5 10.9
-11.1 -8.8 -7.3 -5.6 -4.3 -3.3 -2.6 -2.0 -1.3 -0.8 -0.3 0.1 0.8 1.5 2.2 3.1 5.0 6.1 7.7 10.9
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% Current account (3 years average)
at time t-2
Current account (3 years average) at time t-2 (upper limit/percentile)
12
Our results suggest that the risk of a banking crisis is relatively low (approx. 10%) when the current
account of the balance of payments is relatively balanced for a time horizon of two years. The likelihood
of banking stress increases at least three times with the current account balance going out of range [-2%
of GDP; + 1.5% of GDP].31 The two risk classes can be highlighted more clearly by transforming the
variable by its square (Charts 3.4).
Chart 3.4 – Probability of banking stress by ranges of squared current account balance
100% 50%

36%
80% 40%
60% 30%
40% 20%
20%
10%
0% 12%
0.4 1.0 3.6 5.8 10.2 21.2 33.6 56.3 87.8 441.0 0%
10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
3.6
Squared Current account (3 years
Squared Current account (3 years average) at time t-2 (upper average) at time t-2 (upper limit)
limit/percentile)
When the squared 3-year average of current account balance remains below 3.6 points, the risk of a
banking crisis is only 12% for a two-year time horizon, while for higher values the probability of bank
stress triples.
Other results with a similar profile to the analytical framework of MIP scoreboard were obtained in the
case of private sector credit flow (signal threshold of 11% for an impact interval of four years) and activity
rate (signal threshold of 1.2 pp for an impact interval of one year). In the case of four additional indicators
from the scoreboard, namely i) the share of public debt in GDP, ii) the residential real estate price index,
ii) long-term unemployment and iv) youth unemployment rate, the informational content for anticipating
banking stress episodes seems to be also substantial. However, the resulting structure by risk classes
for these macroeconomic variables is more granular than that provided for in the MIP scoreboard, which
essentially uses a single indicative threshold for each one (Table 3.2).
Table 3.2 - Alert thresholds for macroeconomic imbalance indicators: MIP versus banking stress
MIP (indicative Banking stress Banking

Indicators Unit
thresholds) (signal thresholds) stress (lags)
MIP scoreboard indicators (core set)
External imbalances
Current account balance (% GDP) 3 year average [-4%; +6%] [-2%; +1,5%] 2
Net international investment position (NIIP) % of GDP -35 (lower limit) - -
Real effective exchange rate 3 year % change +/-5 (ZE); +/-11(non-ZE) - -
Exports market share 5 year % change -6 (lower limit) -4.6 1
Nominal unit labor cost index 3 year % change +9 (ZE); +12(non-ZE) - -
Internal imbalances
Private sector credit flow % of GDP 14 (upper limit) 11 4
Private sector debt % of GDP 133 (upper limit) - -
31
This derived range for the purpose of quantifying the probability of banking stress is more demanding than the one used for
the purpose of identifying macroeconomic imbalances by the European Commission, respectively [-4% of GDP; + 6% of GDP].
13
General government gross debt % of GDP 60 (upper limit) 37/55/105 1
House price index 1 year % change 6 (upper limit) -7.6/1.4/5.2 1
Total financial sector liabilities 1 year % change 16,5 (upper limit) - -
Employment and social developments
Unemployment rate 3-years average 10 (upper limit) - -
Activity rate 3 year change in pp -0.2 (lower limit) +1.2 1
Long-term unemployment 3 year change in pp +0.5 (upper limit) -0.3/1.3 1
Youth unemployment 3 year change in pp +2.0 (upper limit) -3.9/0.5 1
MIP Auxiliary indicators (selection)t
Real GDP 1 year % change - -2.5/1.2/1.8/4.3 1
Gross fixed capital formation % of GDP - 15.8/23.6 1
NIIP excluding non-defaultable instruments % of GDP - 1
Current plus capital account % of GDP - -4.5 2
Consolidated banking leverage assets/equity - 10/12.4/21.8 1
Household debt % of GDP - 22.8/42.3/104.6 1
Based on our analysis, two out of five indicators included in the external imbalances set are relevant for
anticipating banking stress episodes, with one-two years in advance. For both the current account
balance and the export market share we find a similar signaling structure for banking stress episodes
with the corresponding ones provided by the macroeconomic imbalance procedure. Firstly, statistical
evidence suggests a quadratic convex functional relationship for a time horizon of two years in the case
of current account balance. Thus, for this indicator there should be both upper and lower limits in place,
as prescribed by the MIP scoreboard concerning economic imbalances. However, the derived range for
the purpose of quantifying the probability of banking stress, namely -2% of GDP (lower limit) and +1.5%
of GDP (upper limit), is more prudent than the one used for the purpose of identifying macroeconomic
imbalances by the European Commission, respectively [-4% of GDP; + 6% of GDP]. Alternatively, one
could use the squared current account balance as a risk factor. In this case, the indicative upper limit
would be 3.6 points. For longer time horizons, one could employ the auxiliary version of the external
position, as the cumulative value of current and capital accounts is able to point to possible banking
problems with three years in advance, using only one signal threshold. In this case, the lower limit would
be -4.5% of GDP. Secondly, for the export market share there seems to be a single threshold. In this
case, the signal threshold (-4.6%) for banking stress episodes is slightly more demanding than the
indicative threshold (-6%) used for the purposes of monitoring the economic imbalances. The remaining
MIP indicators for external imbalances, namely the net international investment position, the real effective
exchange rate and the nominal unit labour cost exhibit a rather low informational content for anticipating
banking stress events, as the relationship with the incidence of banking episodes is generally flat.
Nevertheless, the auxiliary version of NIIP from the supplementary MIP set, which is computed by
excluding non-defaultable instruments, could be considered for assessing the risk of a banking crisis. In
this case the signal threshold would be -33% of GDP (lower limit).
A more encouraging output resulted for the internal imbalances set. In this case, three out of five
indicators were statistically significant for anticipating banking stress episodes: i) public debt ratio; ii)
private sector credit flow; iii) house prices.
The reference value of 60% of GDP has a relatively modest signal strength, as the false alarm rate is
high and the incidence of banking crises becomes a major issue (about 50%) only for values above
105%. In addition, the use of a single signal threshold seems inadequate in this case. In fact, the granular
analysis by deciles indicates four risk classes, delimited by the following thresholds: i) 37% (probability
14
13%); ii) 55% (probability 22%); and iii) 105% (30% probability for values up to the threshold level and
53% for values above it). The central role of public finance stance among the internal imbalances set is
highlighted also by the growth rate of public debt, as the annual dynamics of public sector debt as share
of GDP could signal the likelihood of a banking crisis over a period of one year. Statistical evidence shows
that an increase of more than 6.7 pp in the public debt relative to GDP is associated with a probability of
a banking crisis of 67% for the following year (Charts 3.5).
Chart 3.5 – Probability of banking stress by ranges of annual change public sector debt
100% 100%

90%
80% 80% 67.3%
70%
60% 60%
50%
40% 32.1%
40%
30% 17.9%
20% 9.1%
20%
10%
0%
0%
-4.7 -4.0 -3.2 -2.6 -2.0 -1.5 -1.1 -0.6 -0.3 0.2 0.7 1.3 2.1 2.6 3.2 4.6 6.7 9.3 13.3 25.9 -3.2 0.7 6.7 25.9
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Public debt-to-GDP ratio (one-year
Changes of Public debt-to-GDP ratio one year ahead (upper limit in change) at time t-1 (upper limit)
p.p./percentile)
On the contrary, the risk of a banking stress event is relatively low (9%) if the share of public debt in GDP
is reduced by more than 3.2 pp, while the change between -3.2 pp and 0.7 pp are twice as risky (18%).
When the share of public debt in GDP increases by more than 0.7 pp, but less than 6.7 pp, the incidence
of banking stress episodes reaches one in three cases.
The risks induced by the public finance situation for banking stability are also strongly signaled with one
year in advance by long-term government bond yields that makes it into the top 3 internal imbalances
variables according to the horse race results.
The private sector credit flow is the only MIP indicator with the capacity of signaling a banking stress
episode with four years in advance. The risk analysis points to a single alert threshold (Charts 3.6), as
for the macroeconomic imbalances’ procedure, but with a slightly more conservative level (-3 pp, at 11%
compared with 14%).
Chart 3.6 - Banking stress probability by ranges of Private sector credit flow
100%
60%
90% 49%
80% 50%
70%
40%
60%
50% 30%
40% 17%
20%
30%
20% 10%
10%
0%
0%
-4.9 -3.0 -1.6 -0.6 0.2 0.9 2.1 2.8 3.3 4.6 5.4 7.1 8.8 11.1 12.6 14.4 16.8 20.8 27.6 146.2 0.11
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% Credit flow at time t-4 (upper limit)
Credit flow at time t-4 (upper limit/percentile)
15
House prices are also indicative for stress episodes with one year in advance. However, the risk analysis
suggests a negative relationship with the crisis probability, which is not the case for the MIP approach.
Chart 3.7 - Banking stress probability by ranges of House price index
100% 60% 55.0%

80% 50%
36.3%
40%
60%
30%
40% 17.2%
20%
7.3%
20% 10%
0% 0%
-9.9 -7.6 -5.0 -3.9 -2.1 -1.4 -0.3 0.2 0.8 1.4 2.1 3.1 3.9 4.5 5.2 6.5 7.5 9.7 13.9 45.5
-7.6 1.4 5.2 45.5
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
HPI (one-year change) at time t-1
(upper limit)
House Prices Index (1 year % change) at time t-1 (upper limit in pp/percentile)

Whenever the annual change of HPI was less than -7.6%, banking stress episodes incurred one year
later in 55% cases (Charts 3.7), while if the pace of residential prices was above +5% (close to the MIP
indicative threshold of 6%), banking crises emerged only once in 14 cases; in-between there seem to be
an additional threshold (1.4%), which segments the moderate risk area further into two additional buckets
with associated risk of 36.3% and 17.2% respectively. These statistical evidences are opposed to the
MIP approach, which triggers the alarm for values above 6%.
The remaining two indicators of the internal imbalances set have a relatively low predictive power for
banking stress episodes: i) private sector debt-to-GDP; ii) growth rate of financial system’s liabilities.
Although private sector indebtedness provides inconclusive signals about the imminence of banking
stress episodes, the share of households’ debt in GDP is one of the relevant factors for anticipating
banking crises, with an incidence rate of over 50% when the indicator exceeds 105% of GDP. At the
same time, whenever the share of the households’ debt in GDP was lower than 22.8%, no events of
banking stress were registered. Furthermore, although the level of private sector indebtedness appears
without significant potential to predict banking stress, its annual change is statistically relevant, using an
impact interval of three years. An increase of over 5.6 pp in the share of private sector debt in GDP is
followed by a banking stress event three years later, with a probability of approx. 50% (Charts 3.8).
Chart 3.8 – Probability of banking stress by ranges of annual change in private sector debt
100% 60%
48%
80% 50%
60% 40%
30% 21%
40%
20%
20% 5%
10%
0% 0%
-11.3 -8.3 -5.6 -4.2 -2.9 -2.0 -1.0 -0.4 0.8 1.9 2.7 3.3 4.4 5.6 6.8 9.0 10.9 12.5 18.6 129.0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% -4.2 5.6
Changes of Private debt-to-GDP ratio 3 years ahead (upper limit in Changes of Private debt-to-GDP ratio 3
p.p./percentile) years ahead (upper limit in p.p.)
16
The reduction of share of private debt in GDP by more than 4.2 pp implies the risk of banking stress event
over the next three years only 5%, while dynamics between -4.2 pp and 5.6 pp are associated with an
average risk (21%), close to the unconditional probability of the data sample (25%).
The set of labor market-specific variables also contains a significant number of indicators relevant as the
early warning of banking stress episodes, three out of four showing reasonable signal strength. Of these,
activity ratio is probably the most distinguished one, despite its lower individual discriminatory power
compared with long-term unemployment and youth unemployment, as it is the only one in this MIP
category for which the informational content seems complementary to the variables that form the core of
MIP multivariate configurations. Its signal threshold (1.2 pp) is significantly more prudent than that
provided by the MIP (-0.2 pp). For the remaining relevant labor-market indicators, namely long-term
unemployment rate and the youth unemployment rate, the indicative thresholds are also available in table
3.2. Risk analysis did not provide positive results for the unemployment rate expressed as a three-year
average.
The list of early warning indicators is completed with three other variables from the auxiliary set of MIPs:
i) economic growth; ii) investment rate; and iii) banking leverage. These three factors are the core of
multivariate configurations developed on the basis of MIP indicators, along with long-term government
bond yields. In fact, banking leverage seems to be the best MIP indicator when it comes to anticipating
strong turbulences within the banking sector with one or two years in advance. Moreover, it represents a
rather recent presence among the MIP indicators, being added to the list of additional variables in 2019,
indicating the risk for banking stability associated with the expansion of the volume of activity (assets)
without a similar evolution of its shock absorption capacity (equity). Its reference values can be found in
Chart 3.9.
Chart 3.9 – Probability of banking stress by banking leverage ranges
100% 100%
90%
75.0%
80% 80%
70%
60% 60%
50%
40% 40% 31.8%
30%
20% 15.2%
20%
10% 1.3%
0% 0%
10.0
10.7
11.4
12.4
12.9
13.5
14.0
14.7
15.4
16.4
17.7
18.4
20.1
21.8
24.2
34.2
7.4
8.0
9.1
9.5
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% 10.0 12.4 21.8 34.2
Asset-to-Equity Multiple at time t-1 (upper
limit)
Asset-to-Equity Multiple at time t-1 (upper limit/percentile)
While for values lower than 10 the risk is very low (1.3%), for banking leverage higher than 21.8 the risk
is 75%.
Among the financial soundness indicators compiled by the International Monetary Fund, the following are
statistically relevant for anticipating banking stress episodes: i) Tier 1 capital ratio (three-year signal
interval), ii) return on assets (1-year signal interval); and iii) Interest Margin to Gross Income (signal
interval of 1 year).
17
At the same time, along with the credit-to-GDP ratio, whose informational content for the early warning
purposes has already been highlighted (see Charts 3.1), its growth rate is also statistically significant for
anticipating banking stress episodes. The risk profile assessment per bins of all considered indicators
are presented in detail in the Annex.
After optimizing the number of risk classes and calculating the crisis probabilities associated with them
for each of the variables with statistical relevance in the manner explained above, the optimal signal
range was designated for each indicator. The result was then confirmed by running univariate estimates
of logit regression, using the variables having the actual values replaced, for each observation, with the
corresponding probability of banking stress. At the end of univariate screening process, the short list of
explanatory variables was selected by ranking the tested variables, specified separately on their own
lags of up to three years (t-3), based on area under the ROC curve indicator (AUROC) and the pseudo-
R-square value (McFadden R-square) resulting from running the logit regression using only the
respective variable. From the MIP set, the following two indicators, based on their predictive power32,
stand on top: i) banking leverage (including the second lag) and ii) economic growth (table 3.3).
Table 3.3- Univariate outputs
Variabile Coeff. z-Stat. McFadden R-squared AUROC No. obs.
Macroeconomic Imbalances Indicators
Banking Leverage (-1) 5.794 6.918 0.196 0.75 315
Banking Leverage (-2) 6.293 6.356 0.171 0.74 287
Long-term government bond yields (-1) 6.168 7.047 0.149 0.73 378
Economic Growth (-1) 4.998 7.712 0.148 0.73 392
Change in Public Debt (-1) 4.754 7.034 0.130 0.71 364
NIIP excl. non-default. Instruments (-1) 4.938 7.164 0.122 0.66 381
Export Market Share (-1) 5.259 6.855 0.114 0.66 392
House Price Index (-1) 5.330 6.348 0.102 0.72 392
Change in Private Debt (-3) 5.295 5.667 0.101 0.69 308
Household Debt (-1) 5.970 6.069 0.099 0.69 392
Real Short-term Interest Rate (-2) 5.491 5.793 0.091 0.66 358
Private Sector Credit Flow (-4) 4.804 5.633 0.091 0.64 308
Youth Unemployment (-1) 3.875 5.779 0.081 0.66 392
Private Sector Credit Flow (-3) 4.531 5.129 0.091 0.62 336
Long-term unemployment (-1) 4.378 5.234 0.065 0.63 378
Squared Current Account (-2) 5.992 4.408 0.057 0.59 364
Public Debt (-1) 4.973 4.789 0.053 0.64 392
Gross Fixed Capital Formation (-1) 4.680 4.328 0.049 0.58 392
Current plus capital account (-3) 4.648 4.263 0.045 0.53 333
Activity Rate (-1) 4.532 3.126 0.023 0.56 392
Financial Soundness Indicators
Tier 1 Capital Ratio (-3) 5.333 7.784 0.285 0.80 275
Regulatory Capital Ratio (-3) 5.541 7.310 0.220 0.77 271
Return on Assets (-1) 4.918 7.671 0.167 0.74 335
32
pseudo-R-square of at least 10% and area under the ROC curve indicator of over 70%
18
Return on Equity (-1) 4.307 7.041 0.134 0.7 335
Interest Margin to Gross Income (-1) 5.069 5.526 0.089 0.69 329
Return on Assets (-2) 5.143 5.115 0.078 0.67 307
Interest Margin to Gross Income (-2) 5.532 4.668 0.069 0.66 304
NPLs-to-Capital (-1) 4.862 4.794 0.065 0.64 331
Liquid Assets Ratio (-2) 6.558 3.755 0.055 0.59 277
Credit-to-GDP
Credit-to-GDP (-2) 6.166 6.335 0.129 0.73 353
Credit-to-GDP (-1) 6.796 6.472 0.129 0.71 381
d(Credit-to-GDP(-3) 4.781 5.907 0.110 0.68 297
Credit-to-GDP (-3) 5.770 5.658 0.101 0.7 325
d(Credit-to-GDP(-2)) 4.396 5.259 0.074 0.63 325
Source: Eurostat, ECB/ESRB, IMF, World Bank, authors’ calculations
Among the control variables, those statistically relevant are the indicators on capital adequacy (tier 1
capital ratio and total own funds rate) and those on bank profitability (return on assets and the share of
interest margin in total income), along with credit-to-GDP related variables (expressed both in level and
as annual variation).
Despite the promising informational content highlighted, using the signal thresholds for each short-listed
indicator is of limited relevance in assessing the likelihood of banking stress episodes. Moreover, the
number of indicators with values exceeding the specified alert thresholds is of secondary importance.
What matters is the selection of variables with potentially worrying levels (European Commission, 2016).
In addition, one of the common finding of empirical research aimed at identifying simple rules for detecting
macro-financial risks is that they are associated with the combinations of factors simultaneously
exceeding the critical thresholds rather than with one variable (Manasse and Roubini, 2009). The
preferred solution, in this respect, is represented by the development of multivariate models, which allow
to establish the simultaneous statistical significance of several explanatory variables and their relative
importance. The results of this stage are presented in the next section.
4. Multivariate configurations of early warning indicators
Based on the results obtained in the univariate analysis, we aimed to find the optimal combinations of
variables with high explanatory power of banking stress episodes. To this end, the logit regression
method is employed, allowing the estimation of the weighting parameters of the selected variables within
a synthetic banking stress index.
As the limited availability of data prevents back-testing, the robustness of multivariate models based on
MIP indicators is verified using financial soundness indicators compiled by the IMF and bank credit-to-
GDP related indicators as control variables.
Applying the backward estimation method33, alternatively to the forward one, resulted in five combinations
of MIP indicators with high explanatory power (pseudo-R-square of about 50%; AUROC of about 90%)
of banking stress episodes at the level of EU Member States. The main components of these models are
banking leverage (signal interval of either one or two years), long-term government bond yields, economic
33
A general-to-specific approach is applied, i.e. the independent variables are removed one after the other with criterion the lowest statistical
significance.
19
growth and the investment rate34. In addition, the activity rate (MIP1 and MIP4), the exports market share
(MIP3 and MIP4), the current account balance expressed in quadratic form (MIP4), the household debt
(MIP1 and MIP2), the private sector credit flow (MIP3) and the share of public debt in GDP (MIP5),
expressed both in level and as a growth rate, were alternatively also included (Table 4.1).
Table 4.1 - Parameters of multivariate configurations
Variable MIP1 MIP2 MIP3 MIP4 MIP5 FSI1 FSI2 FSI3 MP1 MP2
Banking Leverage (-1) 3.05 6.06 2.78 7.47
Banking Leverage (-2) 4.48 3.80 6.42
Long-term gov. bond yields (-1) 10.28 9.49 8.33 8.79 8.12
Export Market Share (-1) 5.36 5.21
Economic Growth (-1) 2.35 2.90 2.15 1.98
Change in Public Debt (-1) 2.55
Household Debt (-1) 6.36 6.37
Private Sector Credit Flow (-4) 2.84
Squared Current Account (-2) 4.08
Public Debt (-1) 3.34
Gross Fixed Capital Formation (-1) 3.82 4.01 5.47 4.93 3.94
Activity Rate (-1) 5.03 4.72
Tier 1 Capital Ratio (-3) 3.68 4.01 5.82
Tier 1 Capital Ratio (-2) 4.46 2.89
Return on Assets (-1) 4.30 5.13 5.13
Interest Margin to Gross Income (-1) 3.82 6.96 7.19
Interest Margin to Gross Income (-2) 7.34
Liquid Assets Ratio (-2) 8.01
Credit-to-GDP (-2) 5.65
Credit-to-GDP (-1) 6.04
d(Credit-to-GDP(-3)) 2.79 2.61
d(Credit-to-GDP(-2)) 2.22 2.48
C -11.5 -9.7 -10.39 -11.85 -8.7 -10.3 -6.9 -6.7 -4.3 -4.3
McFadden R-squared 52.7% 52.4% 52.6% 52.6% 48.6% 53.7% 48.6% 48.0% 21.0% 21.3%
No. obs. 276 304 277 277 304 237 267 268 297 296
Crises 66 82 67 67 82 50 62 63 80 80
AUROC 0.91 0.91 0.91 0.93 0.89 0.92 0.92 0.92 0.79 0.78
Source: Eurostat, ECB/ESRB, IMF, World Bank, authors’ calculations; all coefficients are, generally, statistically significant at
1%.
Similarly, in the case of financial soundness indicators, we found three combinations with a good
predictive power comparable to that of the MIP models (pseudo-R-square of about 50% and AUROC of
90%). The core set of indicators is represented by the tier 1 capital ratio (three-year signal interval),
economic profitability measured by return on assets and the interest margin to gross income. In addition,
the tier 1 capital ratio (two-year signal interval), the liquid assets rate (two-year signal interval) and the
second lag of the net interest margin to gross income were also capitalized. At the same time, two
reduced multivariate specifications were developed based on the level and growth of bank credit-to-GDP.
The ten sectoral models (five based on MIP, three based on FSIs and two credit-to-GDP related) put
forward the statistically desirable combinations of early warning indicators for each category of variables
(MIP, FSIs and credit-to-GDP). Given that the number of banking stress episodes is greater than 60, with
34
Expressed by the gross fixed capital formation rate.
20
one exception, configurations of 5-6 variables35 are acceptable for obtaining asymptotically unbiased
estimators and valid standard asymptotic errors.
The robustness of the multivariate MIP models was cross-checked by using the core financial soundness
indicators (FSIs) as control variables. In addition, the credit-to-GDP ratio related variables (lags and
annual change) were also employed in this test. The verification was performed both on the basis of
composite indexes and by rerunning the backward estimation method with all variables selected for the
10 sectoral multivariate configurations. For the 15 possible combinations between each of the five
composite MIP indices and each of the three FSIs indices, the resulting integrated models performed
significantly better than each of the two components, which have always maintained their statistical
significance at a level of 1%. Thus, not only the robustness of the developed MIP configurations was
confirmed, but also the complementarity, at least partially, with the information contained in the FSIs
(table 4.2).
Table 4.2 - Parameters (weighting coefficients) of integrated synthetic models
Indices I1 I2 I3 I4 I5 I6 I7 I8 I9 I10 I11 I12 I13 I14 I15
MIP Models
MIP1 3.95 4.05 4.33
MIP2 3.47 3.91 4.28
MIP3 4.24 4.02 4.28
MIP4 4.22 3.89 4.14
MIP5 3.42 3.44 3.83
FSI Models
FSI1 6.19 6.48 6.56 6.26 6.60
FSI2 5.09 5.38 5.04 6.26 5.57
FSI3 4.72 4.99 4.62 4.63 5.12
C -4.7 -4.4 -4.4 -4.6 -4.4 -4.4 -4.8 -4.3 -4.3 -4.8 -4.3 -4.3 -4.6 -4.3 -4.2
McFadden R-squared 68.3% 63.0% 62.6% 67.9% 63.3% 63.1% 69.3% 62.5% 61.9% 68.8% 62.3% 61.7% 67.6%61.5% 61.0%
No. obs. 218 242 242 222 250 251 219 243 242 219 243 243 222 250 251
Default 43 51 51 45 56 57 44 52 51 44 52 52 45 56 57
AUROC 0.94 0.93 0.92 0.94 0.93 0.93 0.96 0.95 0.95 0.96 0.95 0.95 0.94 0.94 0.94
Source: Eurostat, ECB/ESRB, IMF, authors’ calculations; all coefficients are, generally, statistically significant at 1%.
In contrast, the composite indices based on derivates of credit-to-GDP ratio were not statistically
significant in combinations with both MIP and FSIs models. However, the growth of credit-to-GDP ratio
has proved its marginal utility in anticipating banking stress episodes in the European Union during the
second approach of the robustness checks. The second lag of this indicator has been retained, following
a rerunning of the backward procedure employing all the constituents of sectoral multivariate models,
within the configuration of one of the regressions with the highest performance (table 4.3), taking into
account even the best combinations of composite/synthetic indicators.
35Peduzzi et al. (1996) argue that in cases where there are less than 10 events per variable, the coefficients of the regressions
could be biased. However, Papadopoulos et al. (2016) indicate that at least 6 events per independent variable can be considered
as fairly reliable for robust standard errors.
21
Table 4.3 - Parameters of inter-dimensional configurations
Variable T1 T2 T3
MIP Indicators
Banking Leverage (-1) 5.62
Banking Leverage (-2) 6.39 3.32
Export Market Share (-1) 6.19
Change in Public Debt (-1) 3.64
Private Sector Credit Flow (-4) 3.81
Gross Fixed Capital Formation (-1) 3.93 3.68 4.45
Activity Rate (-1) 7.95
Financial Soundness Indicators
Return on Assets (-1) 8.30 7.74 6.19
Interest Margin to Gross Income (-1) 9.82 8.81 6.32
Other Macroprudential Indicators
Change in Credit-to-GDP(-2) 6.77
C -14.6 -14.6 -12.4
McFadden R-squared 69.1% 65.8% 60.3%
No. obs. 256 252 272
Crises 57 52 61
AUROC 0.96 0.97 0.96
Source: Eurostat, ECB/ESRB, IMF, World Bank, authors’ calculations; all coefficients are, generally,
statistically significant at 1%.
Within this specification, three MIP indicators (banking leverage, investment rate and dynamics of the
share of public debt in GDP) and three core FSIs (tier 1 capital ratio, return on assets and interest margin
to gross income) were selected. In the case of the remaining two inter-sectoral configurations, the annual
change of public debt-to-GDP was successively replaced by the activity ratio and, respectively, by the
private sector credit flow and the exports market share. At the same time, the alternative configurations
for the FSIs category included the second lag of the tier 1 capital ratio, first in addition to the third lag of
this factor, and then as a substitute.
5. Decision-making rules
Although the selected sectoral, integrated and inter-sectoral configurations perform well in terms of
statistical inference for the past banking stress episodes within the European Union, the guidance of
macro-prudential policy measures depends on the formulation of a decision-making rule. In this respect,
the quantification of the probability of banking stress by running the selected models must be
complemented by at least one decision threshold. Its establishment implies, instead, a tradeoff between
the two types of forecast errors, namely the non-identification of crises and false alarms. A good early
warning system is the one that has a high rate of identifying stress events, given a low false alarm rate.
If the signal threshold is set too low, then there will generally be a high number of false alarms. On the
other hand, if the decision threshold is set too high, then many of the stress events would be unreported.
Unlike the usual approach of the single decision threshold calibrated in terms of a unitary ratio between
the costs associated with missed crises and false alarms, the current paper proposes a more granular
staged approach, which involves the use of rating scales with 3-4 risk categories. In short, we suggest
22
employing the traffic light approach for these purposes too. In fact, the synthetic indicators that quantify
the probability of stress are not infallible, as reflected by the percentages of banking stress related to
each risk category. Illustrative, in this sense, is the case of the MIP436 model (Charts 5.1).
Chart 5.1 – Banking stress risk-scale for MIP4 model
100% 100%

80.4%
80%
80%
60%
60%
40%
34.5%
40%
20%
20%
7.5%
0%
0.0%
0.06%
0.12%
0.28%
0.48%
0.70%
1.26%
1.77%
2.75%
4.28%
6.34%
8.63%
20.44%
62.74%
12.03%
24.60%
46.14%
73.04%
82.81%
87.88%
99.79%
0%
5% 10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100% 6.3% 12.0% 62.7% 99.8%
MIP4 score (upper limit/percentile) Rating classes (upper score)
Thus, as long as the probability calculated based on the model is lower than 6%, the risk of banking
stress is insignificant. Only when the probability level exceeds 12% (alert threshold), the risk of crisis
becomes substantial (once in three cases). This would be the window of opportunity for the adoption of
macroprudential measures. The banking crisis becomes imminent (risk over 80%) when the estimated
probability exceeds the value of 63% (alert threshold), and the adoption of some measures could be
ineffective. The mechanism described can function reasonably in conditions of slow-accumulating
systemic vulnerabilities. In contrast, in the case of rapidly spreading shocks, the usefulness of the early
warning system becomes limited, even if it may reflect the alert increase in the likelihood of banking
stress.
6. Final remarks
The assessment of the capabilities of MIP scoreboard indicators for anticipating banking stress episodes
in European Union has yielded moderately positive results in the majority of cases. Out of the fourteen
MIP indicators, eight of them, distributed relatively evenly among the three subcategories (external
competitiveness, internal imbalances and the labor market), show significant information content for early
warning purposes at least one year in advance. However, the predictive power of some indicators
selected from the auxiliary MIP set, which complements the core one, is materially higher. Both banking
leverage and economic growth are among the main components in multivariate MIP models, along with
the long-term government bond yields. Nevertheless, core MIP indicators remain statistically significant.
Among the external sector subsection of MIP indicators, the export market share stands at the very top.
In this case, the signal threshold (-4.6%) for banking stress episodes is slightly more demanding than the
indicative threshold (-6%) used for the purposes of monitoring the economic imbalances. Based on our
analysis, the second comes the current account balance, where the signaling structure is also similar to
36Remaining risk scales are not included to save space. Moreover, the technical solution resembles that employed al indicators
level.
23
the coordinates provided by the macroeconomic imbalance procedure. Statistical evidence suggests a
quadratic convex functional relationship for a time horizon of two years. Thus, for this indicator there
should be both upper and lower limits in place, as prescribed by the MIP scoreboard concerning economic
imbalances. However, the derived range for the purpose of quantifying the probability of banking stress,
namely -2% of GDP (lower limit) and +1.5% of GDP (upper limit), is more prudent than the one used for
the purpose of identifying macroeconomic imbalances by the European Commission, respectively [-4%
of GDP; + 6% of GDP]. Alternatively, one could use the squared current account balance as a risk factor.
In this case, the indicative upper limit would be 3.6 points. For longer time horizons, one could employ
the auxiliary version of the external position, as the cumulative value of current and capital accounts is
able to point to possible banking problems with three years in advance, using only one signal threshold.
In this case, the lower limit would be -4.5% of GDP. Along with them, the net international investment
position (calculated excluding non-defaultable instruments, which is the auxiliary version of the core MIP
unadjusted NIIP indicator) could also be considered for assessing the risk of a banking crisis with the
signal threshold -33% of GDP (lower limit).
Another encouraging output resulted for the internal imbalances set. On top of it stand the private sector
credit flow and public debt ratio. The reference value of 60% of GDP for the latter has a relatively modest
signal strength, as the false alarm rate is high and the incidence of banking crises becomes a major issue
(about 50%) only for values above 105%. In addition, the use of a single signal threshold seems
inadequate in this case. In fact, the granular analysis by deciles indicates four risk classes, delimited by
the following thresholds: i) 37% (probability 13%); ii) 55% (probability 22%); and iii) 105% (30% probability
for values up to the threshold level and 53% for values above it). The central role of public finance stance
among the internal imbalances set is highlighted also by the growth rate of public debt, as the annual
dynamics of public sector debt as share of GDP could signal the likelihood of a banking crisis over a
period of one year. Statistical evidence shows that an increase of more than 6.7 pp in the public debt
relative to GDP is associated with a probability of a banking crisis of 67% for the following year. The
private sector credit flow is the only MIP indicator with the capacity of signaling a banking stress episode
with four years in advance. The risk analysis points to a single alert threshold, as in the macroeconomic
imbalances’ procedure, but with a slightly more conservative level (-3 pp, at 11% compared with 14%).
Moreover, although private sector indebtedness provides inconclusive signals about the imminence of
banking stress episodes, the share of households’ debt in GDP is one of the relevant factors for
anticipating banking crises, with an incidence rate of over 50% when the indicator exceeds 105% of GDP.
At the same time, whenever the share of the households’ debt in GDP was lower than 22.8%, no events
of banking stress were registered.
The set of labor market-specific variables also contains a significant number of indicators relevant as the
early warning of banking stress episodes, three out of four showing reasonable signal strength. Of these,
activity ratio is probably the most distinguished one, despite its lower individual discriminatory power
compared with long-term unemployment and youth unemployment, as it is the only one in this MIP
category for which the informational content seems complementary to the variables that form the core of
MIP multivariate configurations. Its signal threshold (1.2 pp) is significantly more prudent than that
provided by the MIP (-0.2 pp).
The preliminary screening procedure short-listed approximately 20 macroeconomic imbalance indicators

from almost 70 factors (23 variables with 3 lags each), including 3 lags (1-3) for real short-term interest
rate, two lags (1-2) for banking leverage and two lags (3-4) for private sector credit flow. Applying
24
alternatively backward and forward regression estimation methods, we arrived at five combinations with
strong explanatory power of banking stress episodes in the European Union (pseudo-R-squared over
50%; AUROC around 90%). The main components of these models are banking leverage (signal interval
of either one or two years), long-term government bond yields, economic growth, investment rate and
activity ratio. Alternatively, the exports market share, the squared current account balance, the
households’ debt and the share of public debt in GDP, expressed both in level and in growth rate, were
also included. Despite its promising univariate results, the real short-term interest rate did not make it into
the multivariate configurations, as it does not seem to bring material additional information for anticipating
banking stress episodes to the above-mentioned specifications.
The robustness of these results was validated by using the core financial soundness indicators compiled
by the International Monetary Fund as control variables. In addition, derivates of credit-to-GDP ratio were
also employed for this purpose. The assessment was performed both on the basis of combining
composite indexes from each category (MIP, FSI, credit-to-GDP) based on the selected multivariate
models, and by the backward estimation method employing all the constituents of selected multivariate
models. Previously, the univariate filtering procedure was applied to the control factors as well. In the
case of financial soundness indicators compiled by the IMF, the tier 1 capital ratio with a signal interval
of three years, the return on assets with a signal interval of one year and the share of net interest income
in total income were short-listed. Around these three factors, three multivariate FSI models with a
predictive power comparable to that of MIP models were built. In all 15 one-by-one combinations of the
five composite MIP indexes with the three FSIs indexes, the resulting integrated models performed
substantially better than each of the two components, which always maintained their statistical
significance at a level of 1%. Thus, not only the robustness of the developed MIP configurations was
confirmed, but also the complementarity, at least partially, with the information contained in the FSI
indicators. In contrast, the composite indexes based on derivates of credit-to-GDP ratio were not
statistically significant in combinations with both MIP and FSIs models. However, the growth of credit-to-
GDP ratio has proved its marginal utility in anticipating banking stress episodes during the second
approach of the robustness checks. Employing the constituents of selected multivariate models, the
second lag of this indicator has been retained, following a rerunning of the backward procedure, within
the configuration of one of the models with the highest performance, taking into account even the best
combinations of composite/synthetic indicators. Within this specification, three MIP indicators (banking
leverage, investment rate and growth of public debt in GDP) and the three main FSI indicators (tier 1
capital ratio, return on assets and interest margin to total income) were selected. In the case of the other
two interdimensional configurations selected, the dynamics of public debt was successively replaced by
the activity ratio and, respectively, by the private sector credit flow and the exports market share. At the
same time, alternative configurations of FSIs included the second lag of the tier 1 capital ratio, first in
addition to the third lag of this factor, and then as a substitute.
In conclusion, the contribution of this research is to highlight the usefulness of a significant number of
MIP indicators for anticipating banking stress episodes in the European Union, providing indicative
thresholds and combinations of indicators with good predictive power. In addition, their ability to anticipate
banking crises can be enhanced by the complementary use of at least three of the IMF-compiled financial
stability indicators, namely the Tier 1 capital ratio, return on assets and the interest margin to total income,
for which we also provided signal thresholds and multivariate configurations.
25
All data collected and employed in this study are public and available free of charge, being downloaded
from the databases of Eurostat, the European Central Bank, the International Monetary Fund and the
World Bank. Thus, the results presented can be reproduced without any restriction. In addition, the
methodology applied in this paper can also be reused for the purpose of developing early warning
mechanisms for currency or public debt crises.
The aim of this study was not primarily to provide a "turnkey" procedure for guiding macroprudential
measures, but rather to highlight the opportunity to capitalize on MIP indicators for the purposes of
assessing banking stability in the EU. However, the described research method and conclusions might
be useful references for decision-makers and analysts in supervisory authorities, central banks and public
administration as well as for experts of credit institutions with a role in risk management.
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29
Annex – Preliminary non-parametric screening of candidate variables
A. MIP Indicators
1. Current Account Balance

Typology of relationship: Quadratic with a minimum
Optimal lag: 2 years
Statistical evidence: A relatively balanced three-year average current account, namely ranging between
-2 percent of GDP and +1.5 percent of GDP, is three times less risky than in the cases of substantial
unbalances (11% compared with 35% otherwise); compared with the MIP indicative thresholds (-4%;+6%),
this range is substantially thinner;
Banking stress probability based on ranges of Current Account balance
100% 40%

90%
80% 35%
37%
70%
30% 33%
60%
50% 25%
40%
20%
30%
20% 15% 11%
10%
0% 10%
-11.1 -8.8 -7.3 -5.6 -4.3 -3.3 -2.6 -2.0 -1.3 -0.8 -0.3 0.1 0.8 1.5 2.2 3.1 5.0 6.1 7.7 10.9
-2.0 1.5 10.9
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Current account (3 years average) at
Current account (3 years average) at time t-2 (upper limit/percentile) time t-2
Moreover, if the squared current account balance stays below 3.6 points, then the probability of banking
stress over the next two years is only 12%, while above that value, it jumps to 36%
Banking stress probability based on ranges of Squared Current Account
100% 100%
80% 80%
60% 60%
36%
40% 40%
20%
20%
0% 12%
0%
0.4 1.0 3.6 5.8 10.2 21.2 33.6 56.3 87.8 441.0 3.6
10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Squared Current account (3 years
average) at time t-2 (upper limit)
Squared Current account (3 years average) at time t-2 (upper
limit/percentile)
30
2. Current Account plus Capital Account
Typology of relationship: linear (negative)
Statistical evidence: Once in every two cases of external deficit larger than 4,5% of GDP is associated
over three years with a banking crisis, while for lower values the probability is around 25%
Banking stress probability based on ranges of Current plus Capital Accounts
100% 100%

80% 80%
60% 60% 51%
40%
40%
20%
20%
23%
0%
-8.5 -4.5 -2.5 -1.1 0.4 1.5 2.8 4.4 6.2 14.2 0%
10% 20% 30% 40% 50% 60% 70% 80% 90% 100% -4.5
Current plus Capital Account at time t-3
Current plus Capital Account at time t-3 (upper limit/percentile) (upper limit)
3. Export Market Share

Optimal lag: 1 year
Statistical evidence: A strong contraction (more than 4,6 percent during a five-years period) of export market
share in the previous year is associated with a 46% probability of banking stress, while changes better than
-4.6 percent bear 3,5 times lower risk of crisis (13%); the result is in line with the provisions of MIP, which
use an indicative threshold of -6%.
Banking stress probability based on ranges of Export Market Shares
100% 100%
90%
80% 80%
70%
60% 46%
60%
50%
40%
40% 30% 13%
20%
20% 10%
0%
-4.6
0%
-21.0 -17.5 -15.1 -12.6 -10.3 -8.5 -6.3 -4.6 -2.9 -0.3 0.9 2.7 6.0 9.3 11.9 17.7 24.0 33.3 53.2 95.6 Export Market Shares (5 years %
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% change) at time t-1 (upper limit)
Export Market Shares (5 years % change) at time t-1(upper limit/percentile)
31
4. Net international investment position
Typology of relationship: cubic
Optimal lag: 1 year
Statistical evidence: Once in two cases of NIIP lower than -82.4% is a banking stress event; then, the risk
plummets to one in nine if the NIIP is no higher than -13.7%, but increases to one in almost 2.5 events
afterwards until NIIP reaches 35.6%, and decreases once again for values above this last threshold; the
MIP indicative threshold (-35%) provides no meaningful signal for banking stress events.
Banking stress probability based on ranges of Net international invest. position
100% 100%
90%

80% 80%
y = -0.0008x3 + 0.0288x2 - 0.2975x + 1.0358 70%
60% R² = 0.7761 60%
50%53% 37%
40% 40%
30%
20% 20% 13%
10%
0% 0% 11%
-128.3 -91.7 -72.3 -60.1 -45.9 -28.1 -13.7 -2.0 19.7 51.6
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
-82.4 -13.7 35.9
NIIP at time t-1 (upper limit)
NIIP at time t-1 (upper limit/percentile)
5. Net international investment position excluding non-defaultable instruments

Optimal lag: 1 year
Statistical evidence: If net international investment position excluding non-defaultable instruments is
lower than -33% of GDP, than the risk of experiencing a banking crisis in one-year time is above 50%,
while, otherwise, the probability of a banking stress is three and a half times lower.
Banking stress prob. based on ranges of NIIP excl. non-defaultable instrum.
100% 100%
80%
80%
60%
60% 52%
40%
40%
20%
20%
0% 15%
-33
0%
-252 -104 -70 -54 -43 -33 -29 -25 -22 -19 -15 -12 -10 -6 -2 5 15 26 52 268
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% NIIP (excluding non-faultable
instruments) at time t-1 (upper limit)
NIIP (excluding non-faultable instruments) at time t-1 (upper
limit/percentile)
32
6. Real effective exchange rate
Typology of relationship: unclear
Optimal lag: -
Statistical evidence: Inconclusive direction of relationship; while the linear model seems appropriate for
the instantaneous impact and first lag (slightly negative slope, especially in the second case), the quadratic
form with a maximum seems the most probable one for lags 2&3; the MIP indicative thresholds (+/-5% for
euro area and +/-11% for non-euro area countries) do not improve the predictive power of the REER in
relation with banking stress episodes.
Banking stress probability based on ranges of real effective exchange rate
100% 100%
80% 80%
60% 60%
40% 40%
20% 20%
0% 0%
-7.8 -4.2 -2.8 -1.7 -0.6 0.5 2.0 3.4 5.8 12.2
-7.8 -4.3 -2.9 -1.8 -0.9 0.2 1.7 3.1 5.8 12.6
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%
100%
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100%
REER (3 years % change) at time t-1 REER (3 years % change) at time t-2
7. Nominal unit labour cost

Typology of relationship: unclear
Optimal lag: -
Statistical evidence: Inconclusive typology of relationship; generally, the cubic specification fits best, with
flat trend as second best; some information content (discriminatory power) for the second lag is available,
case in which a meaningful quadratic form with a minimum could be derived, but with only 3 buckets (a
three-year variation of NULC from two-years ago between -2,1% and 4,2% is associated with a banking
stress probability of half that beyond those thresholds, namely 16% at low fluctuations of NULC and 33%
in case of large, both negative and positive, deviations from the central interval); the MIP indicative
thresholds (9% upper limit for the euro area countries and 12% for the non-euro area countries) do not
improve the predictive power of the NULC in relation with banking stress episodes.
Banking stress probability based on ranges of Nominal unit labour cost
100% 100%
80% 80%
60% 60%
40% 40%
20% 20%
0% 0%
-4.9 -0.2 2.2 3.6 5.0 6.4 8.1 10.0 13.3 23.4 -5.1 -0.3 2.2 3.7 5.0 6.5 8.2 9.9 12.9 23.9
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%
100% 5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%
100%
NULC (3 years % change) at time t-1 NULC (3 years % change) at time t-2
(upper limit/precentile) (upper limit/precentile)
33
8. Public Debt
Typology of relationship: linear (positive)
Optimal lag: 1 year
Statistical evidence: Banking stress is four times less probable for government debt-to-GDP ratios below
37% than for public indebtedness levels above 105% (13% probability compared with 53% probability of
banking crises); in-between, empirical evidence points to another meaningful threshold (55%), which is
close to the Maastricht limit for government indebtedness (60%); government debt-to-DGP levels ranging
between 37% and 55% bear a 22% risk, while indebtedness levels above 55%, but lower than 105%, bear
a risk of 30%.
Banking stress probability based on ranges of public debt-to-GDP ratio
100% 100%

80% 80%
60% 60% 53%
40% 40% 30%

22%
20% 13%
20%
0% 0%
11.9 26.5 37.3 41.5 50.3 61.9 70.0 81.2 98.8 127.7
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
37 55 105 181
Public debt-to-GDP ratio at time t-1
(upper limit)
Public debt-to-GDP ratio at time t-1 (upper limit/percentile)
9. Change in Public Debt

Optimal lag: 1 year
Statistical evidence: Every two out of three economies registering an annual increase of public
indebtedness higher than 6.7 pp have experienced a banking crisis the following year, while only one out
of three has recorded a major banking problem if the annual change of public debt-to-GDP exceeded 0,7
pp (but less than 6.7 pp); the risk is significantly lower (around 18%) if the indebtedness level is stable (-3
pp;+0.7 pp) ; moreover, the risk further halves if the indebtedness level is reduced with more than 3 pp per
year.
Banking stress probability based on ranges of changes in public debt-to-GDP ratio
100% 100%
80% 80% 67.3%
60% 60%
40% 32.1%
40%
17.9%
20% 9.1%
20%
0%
0%
-4.7 -4.0 -3.2 -2.6 -2.0 -1.5 -1.1 -0.6 -0.3 0.2 0.7 1.3 2.1 2.6 3.2 4.6 6.7 9.3 13.3 25.9 -3 1 7 26
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95%100% Public debt-to-GDP ratio (one-year
Changes of Public debt-to-GDP ratio one year ahead (upper change) at time t-1 (upper limit)
limit in p.p./percentile)
34
10. Private sector debt
Typology of relationship: Unclear (non-linear with complex representation)
Optimal lag: -
Statistical evidence: Exponential up to 100% and U-shaped afterwards with minimum touching zero
around 150%; cubic features after optimizing bins structure (four buckets: 10%/50%/10%/40%); the MIP
indicative threshold (133%) would be inadequate for anticipating banking crises
Banking stress probability based on ranges of Private sector debt
100% 100%

90% 90%
80% 80%
70% 70%
60% 60%
50% 50%
40% 40%
30% 30%
20% 20%
10% 10%
0% 0%
0.57 0.75 0.95 1.12 1.21 1.33 1.54 1.85 2.11 2.93 0.58 0.75 0.97 1.13 1.22 1.33 1.56 1.85 2.11 2.90
5% 10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100% 5% 10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100%
Private debt-to-GDP at time t-1 (upper limit/percentile) Private debt-to-GDP at time t-3 (upper limit/percentile)
11. Change in Private Sector Debt

Statistical evidence: Almost half of the economies experiencing an annual increase of the private
indebtedness higher than 5.6 pp have registered banking stress after three years.
Banking stress probability based on ranges of changes in private debt-to-GDP ratio
100% 100%
80% 80%
60% 60% 48%
40% 40%
21%
20% 20% 5%
0% 0%
-11.3 -5.6 -2.9 -1.0 0.8 2.7 4.4 6.8 10.9 18.6 -4.2 5.6
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95%100% Changes of Private debt-to-GDP ratio 3
Changes of Private debt-to-GDP ratio 3 years ahead (upper limit in years ahead (upper limit in p.p.)
p.p./percentile)
12. Private sector credit flow
Optimal lag: 3/4 years
Statistical evidence: One in every two economies registering credit flows larger than 14% of GDP has
experienced banking stress after two years; the resulting threshold from this filtering procedure is identical
with the reference value used by the macroeconomic imbalances’ procedure employed by the European
Commission; however, the indicative threshold decreases to around 11% when we employ the 3&4 years
lags.
35
Banking stress probability based on ranges of Private sector credit flow
100%
60%
90% 49%

80% 50%
70%
40%
60%
50% 30%
40% 17%
20%
30%
20% 10%
10%
0%
0%
-4.9 -3.0 -1.6 -0.6 0.2 0.9 2.1 2.8 3.3 4.6 5.4 7.1 8.8 11.1 12.6 14.4 16.8 20.8 27.6 146.2 0.11
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% Credit flow at time t-4 (upper limit)
Credit flow at time t-4 (upper limit/percentile)
13. House price index

Optimal lag: 1 year
Statistical evidence: Whenever the annual change of HPI was less than -7.6%, banking stress episodes
incurred one year later in 55% cases, while if the pace of residential prices was above +5% (close to the
MIP indicative threshold of 6%), banking crises emerged only once in 14 cases; in-between there seem to
be an additional threshold (1.4%), which segments the moderate risk area further into two additional
buckets with associated risk of 36.3% and 17.2% respectively. These statistical evidences are opposed to
the MIP approach, which triggers the alarm for values above 6%.
Banking stress probability based on ranges of House price index
100% 60% 55.0%
80% 50%
36.3%
40%
60%
30%
40% 17.2%
20%
7.3%
20% 10%
0% 0%
-9.9 -7.6 -5.0 -3.9 -2.1 -1.4 -0.3 0.2 0.8 1.4 2.1 3.1 3.9 4.5 5.2 6.5 7.5 9.7 13.9 45.5
-7.6 1.4 5.2 45.5
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
HPI (one-year change) at time t-1
(upper limit)
House Prices Index (1 year % change) at time t-1 (upper limit in pp/percentile)
14. Financial sector liabilities

Typology of relationship: Flat
Optimal lag: -
Statistical evidence: Risk variates across all ranges around the unconditional probability of crisis .
36
Banking stress probability based on ranges of Financial sector liabilities
100% 100%

80% 80%
60% 60%
40% 40%
20% 20%
0%
-6.2 -3.2 -1.3 -0.1 0.9 1.8 2.8 3.9 4.5 5.2 6.5 7.4 9.2 10.311.313.716.119.828.566.1 0%
-6.3 -1.1 1.4 3.3 4.8 6.8 9.6 11.7 16.7 29.6
5% 10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100%
5% 10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100%
Financial Sector Liabilities (1 year % change) at time t-1 Financial Sector Liabilities (1 year % change) at time
(upper limit/percentile) t-2 (upper limit/percentile)
15. Activity Rate

Optimal lag: 1 year
Statistical evidence: When the three-year change of the activity rate was below 1.2 pp, a banking stress
event incurred once in three cases, while only one in 8 otherwise. This result seems more exigent that the
MIP indicative threshold (-0.2 pp).
Banking stress probability based on ranges of Activity Rate
100%
100%

80%
80%
60%
60%
40% 33%
40%
20% 16%
20%
0%
-0.6 0.0 0.3 0.6 0.9 1.2 1.6 2.1 2.7 6.0 0%
10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 1.2
Three year change in the Activity Rate at time t-1 (upper limit in Activity Rate (3-year change in pp) at
time t-1 (upper limit)
p.p/percentile)
Source: Eurostat, ECB/ESRB, author’s calculations
16. Long-term Unemployment

Optimal lag: 1 year
Statistical evidence: A banking stress event emerged only once in 9 cases one year after the three-year
change of long-term unemployment decreased with more than 0.3 pp, while a banking crisis incurred in half
of the cases when the risk indicator increased by more than 1.3 pp; in-between (-0.3pp;+1.3 pp), the stress
probability is close to 25%; the MIP indicative threshold (+0.5 pp) seems to have only weak predictive
power in case of banking crises.
37
Banking stress probability based on ranges of Long-term Unemployment
100% 100%

80% 80%
60% 60% 51%
40% 40% 26%
20% 20%
11%
0% 0%
-3.9 -3.1 -2.1 -1.7 -1.4 -1.1 -0.7 -0.5 -0.3 -0.1 0.0 0.1 0.3 0.5 0.7 0.9 1.3 2.5 4.6 12.8
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
-0.3 1.3
LT-UR (3y change) at time t-1
Three-year changes of Long-term Unemployment at time t-1 (pp/percentile) (upper limit)
17. Youth Unemployment

Optimal lag: 1 year
Statistical evidence: A banking stress event emerged only once in 11 cases one year after the three-year
change of long-term unemployment decreased with more than 3.9 pp, while a banking crisis incurred in half
of the cases when the risk indicator increased by more than 8.8 pp; in-between there seem to be an
additional threshold (0.5 pp), which segments the moderate risk area further into two additional buckets
with associated risks of 23% and 38% respectively; the MIP indicative threshold (+2.0 pp) seems to have
only moderate predictive power in case of banking crises.
Banking stress probability based on ranges of Youth Unemployment
100% 100%
80% 80%
53%
60% 60% 38%
40% 40% 23%
20% 20% 9%
0% 0%
-9.9 -6.3 -3.9 -2.2 -1.0 0.5 2.1 5.0 8.8 29.6
10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
-3.9 0.5 8.8
Youth Unempl. (3y change) at time t-1
Three-year changes of Youth Unemployment at time t-1 (upper limit)
(pp/percentile)
18. Unemployment Rate

Optimal lag: -
Statistical evidence: Risk variates across all ranges around the unconditional probability of crisis; the MIP
indicative threshold (10%) seems to contain weak predictive power in case of banking crises with one or
two years in advance.
38
Banking stress probability based on ranges of Unemployment Rate
100% 100%

80% 80%
60% 60%
40% 40%
20% 20%
0% 0%
4.9 5.8 6.5 7.1 7.9 8.6 9.8 11.3 14.2 26.3 4.9 5.9 6.7 7.4 8.0 8.6 9.8 11.4 14.2 26.3
10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Three-year average of Unemployment Rate at time t-1 Three-year average of Unemployment Rate at time t-2
(percent/percentile) (percent/percentile)
19. Economic Growth

Optimal lag: 1 year
Statistical evidence: Two out of three countries registering an economic contraction larger than 2.5%
experienced a banking crisis one year later, while only once in 12.5 cases when economic growth was
higher than 4.3%. Stagnant economies (growth between -2.5% and 1.2%) face a crisis probability of 46%.
Moderate growth economies (+1.2%; +4.3%) are segmented further into two categories with risk of banking
crisis of 27% and 15% respectively depending on how they stand against the 1.8% threshold.
Banking stress probability based on ranges of Real GDP Growth
100%
100%
80%
80%
65%
60%
60% 46%
40%
40% 27%
20%
15%
20% 8%
0%
-2.5 0.3 1.2 1.8 2.3 2.8 3.5 4.3 5.8 25.2 0%
10% 20% 30% 40% 50% 60% 70% 80% 90% 100% -2.5 1.2 1.8 4.3 25.2
Economic growth at time t-1 (upper
limit)
Economic Growth at time t-1 (upper limit/percentile)
20. Consolidated banking leverage

Optimal lag: 1/2 years
Statistical evidence: Banking stress episodes incurred only rarely (1.3%) when the leverage was below
10; however, three out of four cases were banking crises when the assets-to-equity multiple went beyond
21.8 in the year before; in-between there seem to be an additional threshold (12.8), which segments the
moderate risk area further into two additional buckets with associated risks of 15.2% and 31.8%
respectively.
39
Banking stress probability based on Banking Leverage
100% 100%

75.0%
80% 80%
60% 60%
40%
40% 31.8%
20%
15.2%
20%
0% 1.3%
10.0
10.7
11.4
12.4
12.9
13.5
14.0
14.7
15.4
16.4
17.7
18.4
20.1
21.8
24.2
34.2
7.4
8.0
9.1
9.5
0%
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
10.0 12.4 21.8 34.2
Asset-to-Equity Multiple at time t-1
Asset-to-Equity Multiple at time t-1 (upper limit/percentile) (upper limit)
21. Gross Fixed Capital Formation

Optimal lag: 1 year
Statistical evidence: If the share of gross fixed capital formation in GDP is less than 15.8%, then the
probability of having a banking crisis next year exceeds 70%; however, when the risk indicator is higher
than 23.6%, then the crisis probability decreases to 18%; in-between, the chance of a banking stress
episodes next year is around 25%.
Banking stress probability based on Gross Fixed Capital Formation
100% 100%

80% 80% 71%
60% 60%
40% 40%
26%
18%
20% 20%
0%
0%
15.8 17.4 18.0 18.6 19.2 19.7 20.1 20.5 21.1 21.5 22.1 22.5 22.8 23.1 23.6 24.5 25.4 27.1 29.1 37.3 15.8 23.6 37.3
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
GFCF-to-GDP at time t-1 (upper limit)
GFCF-to-GDP at time t-1 (upper limit/percentile)
22. Household Debt

Optimal lag: 1 year
Statistical evidence: No crisis incurred while household indebtedness was lower than 22.8%; however,
when household debt-to-GDP exceeded 105%, once out of every two cases was a banking stress event
one year later; in-between there seem to be an additional threshold (42.6%), which segments the moderate
risk area further into two additional buckets with associated banking crisis probability of 15% and 33%
respectively.
40
Banking stress probability based on Household Debt
100% 100%

80% 80%
60% 60% 53%
40% 40%
33%
20% 15%
20%
0%
0% 0%
22.8 29.0 35.6 42.3 51.2 56.8 62.4 82.6 104.6 142.5
10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
22.8 42.3 104.6 142.5
HHDebt-to-GDP at time t-1 (upper
Household Indebtedness at time t-1 (upper limit/percentile) limit)
23. Long-term government bond yields

Optimal lag: 1 year
Statistical evidence: Only once in 40 cases a banking stress event occurred whenever the long-term gov.
bond yields were below 0.8%; however, when the risk factor exceeds 3.7%, the crisis probability is almost
50% (44%); in-between there seem to be an additional threshold (2.4%), which segments the moderate
risk area further into two additional buckets with associated banking crisis probability of 6.6% and 17%
respectively.
Banking stress probability based on ranges of Long-term gov. bond yields
100% 100%
80% 80%
60%
60% 44%
40%
40%
17%
20% 6.6%
20% 2.6%
0%
0% 0.8 2.4 3.7 22.5
0.8 1.5 2.5 3.2 3.7 4.3 4.5 4.7 7.0 22.5 10 years government bond yields one
10 years government bond yields one year in advance (upper limit-%) year in advance (upper limit)
24. Real short-term interest rates

Statistical evidence: Whenever the real short-term interest rates were below -0.4%, a banking stress
event occurred two years after only once in 8 cases (12% probability); however, when that indicative
threshold was exceeded, the crisis probability went 3.5 times higher (41%); these results provide some
evidence on potential competing interests between monetary and financial stability during prolonged
economic booms.
41
Banking stress prob. based on ranges of Real Short-term Interest Rates
100%
100%

80%
80%
60%
60%
41.3%
40%
40%
20%
20% 12.1%
0%
0% -0.4
-2.6 -1.7 -1.1 -0.8 -0.4 0.2 0.8 1.5 2.5 25.3 Real Short-term Interest Rate
at time t-2 (upper limit)
10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Real Short-term Interest Rate at time t-2 (upper limit/percentile)
Source: Ameco, ECB/ESRB, author’s calculations
B. Financial Soundness Indicators (IMF)

25. Regulatory Capital Ratio
Typology of relationship: Logarithmic
Statistical evidence: No crisis incurred while the regulatory capital ratio was above 19.4%; a regulatory
capital ratio below 12.8% implies, however, a crisis probability of almost 60% in three-year time; in-between
there seems to be an additional threshold (17%), which segments the moderate risk area further into two
additional buckets with associated banking crisis probability of 20% and 4% respectively.
Banking stress probability based on Regulatory Capital Ratio ranges
100% 100%
90%
80%
80%
70% 58%
60%
60% 50%
40%
40% 30% 20%
20%
10%
4% 0%
20%
0%
12.8 17.0 19.4 35.7
0% Regulatory Capital Ratio at time t-3
10.5 11.6 11.9 12.3 12.8 13.5 13.9 14.5 14.9 15.4 16.0 16.5 17.0 17.5 18.0 18.8 19.4 20.8 22.4 35.7
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
(upper limit)
Regulatory Capital Ratio at time t-3 (upper limit/percentile)

Source: IMF, ECB/ESRB, author’s calculations
26. Tier 1 Capital Ratio
Statistical evidence: No crisis incurred while the Tier 1 capital ratio was above 17.3%; a tier 1 capital ratio
below 9.6% implies, however, a crisis probability of almost 80% in three-year time; in-between these limits,
there seems to be an additional threshold (14.2%), which segments the moderate risk area further into two
42
Banking stress probability based on Tier1 Capital Ratio ranges
100%
100%

79%
80% 80%
60% 60%
40% 40%
21%
20% 7%
20%
0%
0%
0% 9.6 14.2 17.3 35.2
8.1 9.0 9.6 10.5 10.9 11.4 11.8 12.1 12.8 13.2 13.7 14.2 14.8 15.6 16.1 16.5 17.3 19.1 20.9 35.2
Tier1 Capital Ratio at time t-3 (upper
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
limit)
Regulatory Tier 1 Capital Ratio three-years ahead (upper limit/percentile)
27. Nonperforming Loans Ratio

Optimal lag: -
Statistical evidence: Risk variates across all ranges around the unconditional probability of crisis.
Banking stress probability based on Nonperforming Loans’ Ratio ranges
100% 100%
80% 80%
60% 60%
40% 40%
20% 20%
0% 0%
0.7 1.7 2.7 3.3 4.2 5.1 6.3 9.7 14.0 21.8 0.7 1.7 2.8 3.6 4.3 5.2 6.4 10.0 14.3 22.3
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100% 5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%
100%
NPL Ratio at time t-2 (upper limit/percentile)
NPL Ratio at time t-1 (upper limit/percentile)
28. Non-performing loans-to-Capital

Optimal lag: 1 year
Statistical evidence: When NPLs-to-Capital exceeds 64.6%, the crisis probability reaches 58%, while if
the risk parameter stays below 5.5%, a banking stress event is 10 times less probable (6%); in-between
there seems to be an additional threshold (28.1%), which segments the moderate risk area further into two
43
Banking stress prob. based on Non-performing loans-to-Capital ranges
100% 100%

80% 80%
58%
60% 60%
40%
34%
40% 23%
20%
6%
20%
0%
0% 5.5 28.1 64.6 413.6
3.5 7.2 10.3 13.7 17.4 22.3 28.1 37.0 49.8 95.4
NPLs-to-Capital at time t-1 (upper limit)
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
NPLs-to-Capital at time t-1 (upper limit/percentile)
29. Return on Assets

Optimal lag: 1 year
Statistical evidence: When the ROA is lower than 0.2%, then the crisis probability goes above 60%, while
for value higher than 0.7% the risk is only 11%; in-between, only once in four cases a banking stress event
emerges in one-year time.
Banking stress probability based on Return on Assets ranges
100% Probability of banking crisis 100%
80% 80%
61%
60% 60%
40% 40%
25%
20% 20% 11%
0% 0%
-1.33 -0.08 0.24 0.39 0.54 0.67 0.83 1.09 1.24 1.62
0.2 0.7 3.5
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95%100%
ROA at time t-1 (upper limit)
ROA at time t-1 (upper limit/percentile)
30. Return on Equity

Typology of relationship: Logarithmic/ Quadratic with a minimum
Optimal lag: 1 year
Statistical evidence: When the ROE is lower than 3.7%, then the crisis probability goes above 60%, while
for value higher than 9.4% the risk is only 14%; in-between, only once in five cases a banking stress event
emerges in one-year time. However, some indication of quadratic relationship for lags 2&3, as higher levels
of ROE (>10%) could be associated with larger leverage.
44
Banking stress probability based on Return on Equity ranges
100% 100%

80% 80%
63%
60% 60%
40% 40%
22%
20%
14%
20%
0% 0%
-12.7 -6.5 -0.7 1.5 3.7 5.5 6.4 7.2 7.8 8.4 9.4 10.1 11.0 12.0 13.0 14.5 16.2 17.3 19.6 33.3 3.7 9.4 33.3
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
ROE at time t-1 (upper limit)
ROE one year ahead (upper limit/percentile)
31. Interest Margin to Gross Income

Optimal lag: 1 year
Statistical evidence: A banking crisis arises twice at every three cases one year after when the share of
interest margin in gross income exceeds 78.6%, while if the risk parameter stays below 57.2%, then a
banking stress event occurs once at every 8 cases; in-between there seems to be an additional threshold
(64%), which segments the intermediate risk area further into two additional buckets with associated
banking crisis probability of 28% and 40% respectively.
Banking stress probability based on ranges of Interest margin

100% 100%
80% 80%
65%
60% 60%
40%
40% 28%
40%
20% 13%
20%
0%
0% 57.2 64.0 78.6 103.2
37.2 45.6 50.6 54.1 57.2 60.0 64.0 67.4 72.9 78.6
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% Interest margin share at time t-1
Interest margin to gross income at time t-1 (upper limit/percentile) (upper limit)
These results suggest some beneficial effects of diversification on banking stability, as reported by Köhler
(2014) using a sample with 25,966 observations on 3362 banks from 15 EU countries, between 2002 and
2012. However, it might also reflect the non-interest income shrinkage, especially trading income, during
the financial turbulences preceding systemic episodes. Thus, more detailed information on banking income
structure is required in order to provide more clarity on the matter. In this respect, it’s worth noting that
Saunders et al. (2020) show that a higher fraction of non-interest to interest income was not associated
45
with a larger contribution to systemic risk in the period 2002–2013, based on a dataset covering around
17,000 quarterly observations on more than 600 US bank holding companies, using the ∆CoVaR measure
proposed by Adrian and Brunnermeier (2016).
32. Liquid Assets Ratio

Typology of relationship: Quadratic with a minimum
Statistical evidence: A relatively moderate Liquid Asset Ratio, namely ranging between 19% and
23.4%, is at least four times less risky than in the cases of substantial deviations (both positive
and negative) from these levels (7% percent compared with at least 27% in case of positive gaps
and 37% for negative gaps).
Banking stress probability based on ranges of Liquid Assets Ratio
100% 50%

37%
80% 40%
30% 27%
60%
40% 20%
7%
10%
20%
0%
0%
9.8 13.4 15.1 17.2 19.0 20.8 21.4 22.4 23.4 24.5 25.4 27.0 29.3 30.8 32.8 36.0 39.7 44.9 54.3 60.0 19.0 23.4 60.0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100%
Liquid Asset Ratio at time t-2
Liquid Asset Ratio at time t-2 (upper limit/percentile)
(upper limit)
33. Non-interest expenses share in gross income

Optimal lag: -
Banking stress probability based on ranges of Non-interest expenses share in gross income
100%
100%
80% 80%
60% 60%
40% 40%
20% 20%
0% 0%
45.8 49.9 53.6 56.1 59.2 62.4 65.2 68.8 74.1 87.0 45.9 49.9 53.7 56.0 58.9 62.2 65.0 68.7 74.2 87.0
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95%100% 5% 10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%100%
Non-interest expenses to gross income at time t-1 Non-interest expenses to gross income (upper
(upper limit/percentile) limit/percentile)
46
34. Liquid Assets to Short Term Liabilities
Optimal lag: -
Banking stress probability based on Liquid Assets to Short Term Liabilities ranges
100% 100%
80% 80%
60% 60%
40% 40%
20% 20%
0%
20.2 28.9 33.2 37.9 42.8 50.5 57.2 68.5 86.3 156.3 0%
20.1 29.6 34.9 40.0 45.4 52.0 61.6 68.9 88.3 156.3
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%
100%
5%10%15%20%25%30%35%40%45%50%55%60%65%70%75%80%85%90%95%
100%
Liquid Assets to Short Term Liabilities at time t-1 (upper
Liquid Assets to Short Term Liabilities at time t-2
limit/percentile)
(upper limit/percentile)

35. Net Open Position in Foreign Exchange to Capital
Optimal lag: -
Banking stress prob. based on ranges of Net Open Position in Foreign Exchange to Capital
100% 100%
80% 80%
60% 60%
40%
40%
20%
20%
0%
0% -10.5 -1.0 0.1 0.4 0.9 1.6 2.3 3.5 5.4 15.5
-10.5 -0.9 0.1 0.4 0.8 1.6 2.3 3.4 5.4 15.3
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95%100%
5% 10% 15% 20% 25% 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95%100%
Net Open Position in Foreign Exchange to Capital (upper Net Open Position in Foreign Exchange to Capital a
limit/percentile) time t-1 (upper limit/percentile)
47
C. Macroprudential Indicators
36. Credit-to-GDP (level)

Statistical evidence: No crisis incurred while the credit to private sector-to-GDP was lower than 51.7%;
however, when credit-to-GDP exceeded 162.4%, more than once out of every two cases (55.6%) was a
banking stress event two years later; in-between there seems to be an additional threshold (86.4%), which
segments the moderate risk area further into two additional buckets with associated banking crisis
probability of 22.6% and 37.9% respectively.
Banking stress probability based on Credit-to-GDP ranges
100% 100%

80% 80%
55.6%
60% 60%
37.9%
40% 40%
22.6%
20% 20%
0.0%
0% 0%
43.6 51.7 62.2 75.5 86.4 95.0 109.7 124.6 162.4 255.2 51.7 86.4 162.4
10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Credit-to-GDP at time t-2 (upper limit)
Credit-to-GDP at time t-2 (upper limit/percentile)
Source: World Bank, ECB/ESRB, author’s calculations

37. Credit-to-GDP (variation)
Statistical evidence: Once in every five cases was a banking stress event two-years after the yearly
change of credit-to-GDP were below 2.6 pp; however, when the risk factor exceeds 8 pp, the crisis
probability goes well above 60% (62.5%); in-between there seems to be an additional threshold (4.2 pp),
which segments the intermediate risk area further into two additional buckets with associated banking crisis
probability of 34.4% and 48.4% respectively.
Banking stress probability based on ranges of Credit-to-GDP annual changes
100% 100%
90%
80% 80%
70% 62.5%
60% 60% 48.4%

50%
34.4%
40% 40%
30% 20.5%
20% 20%
10%
0% 0%
-7.8 -4.4 -2.8 -1.4 0.4 1.5 2.6 4.2 8.0 31.5
10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
2.6 4.2 8.0
Credit-to-GDP variation at time t-2
Credit-to-GDP (one-year change) at time t-2 (upper limit/percentile) (upper limit)
Source: World Bank, ECB/ESRB, author’s calculations
48

Banking Stress and MIP Indicators

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Banking Stress and MIP Indicators

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Prediction of banking stress episodes in EU using macroeconomic

imbalance scoreboard indicators

Petr JAKUBIK Bogdan Gabriel MOINESCU

JEL Codes: G01, G21, G28.

3. Data and preliminary analysis

27 Data available starts from 2007.

Probability of banking crisis

Source: World Bank, ECB/ESRB, authors’ calculations

Probability of banking crisis

Source: Eurostat, ECB/ESRB, authors’ calculations

Probability of banking crisis

Source: Eurostat, ECB/ESRB, authors’ calculations

Probability of banking crisis

MIP (indicative Banking stress Banking

Probability of banking crisis

Probability of banking crisis

Source: Eurostat, ECB/ESRB, authors’ calculations

Source: Eurostat, ECB/ESRB, authors’ calculations

4. Multivariate configurations of early warning indicators

Probability of banking crisis

The preliminary screening procedure short-listed approximately 20 macroeconomic imbalance indicators

1. Current Account Balance

Probability of banking crisis

Source: Eurostat, ECB/ESRB, authors’ calculations

Source: Eurostat, ECB/ESRB, authors’ calculations

Probability of banking crisis

60% 60% 51%

Source: Eurostat, ECB/ESRB, authors’ calculations

3. Export Market Share

Export Market Shares (5 years % change) at time t-1(upper limit/percentile)

Source: Eurostat, ECB/ESRB, authors’ calculations

Probability of banking crisis

Source: Eurostat, ECB/ESRB, authors’ calculations

5. Net international investment position excluding non-defaultable instruments

Source: Eurostat, ECB/ESRB, authors’ calculations

7. Nominal unit labour cost

Probability of banking crisis

60% 60% 53%

40% 40% 30%

9. Change in Public Debt

Probability of banking crisis

80% 80% 67.3%

Probability of banking crisis

Source: Eurostat, ECB/ESRB, authors’ calculations

11. Change in Private Sector Debt

Probability of banking crisis

60% 60% 48%

Probability of banking crisis

13. House price index

Source: Eurostat, ECB/ESRB, authors’ calculations

14. Financial sector liabilities

Probability of banking crisis

Source: Eurostat, ECB/ESRB, authors’ calculations

15. Activity Rate

Probability of banking crisis

16. Long-term Unemployment

Probability of banking crisis

Probability of banking crisis

60% 60% 51%

40% 40% 26%

17. Youth Unemployment

Probability of banking crisis

18. Unemployment Rate

Probability of banking crisis