The signaling approach to early warning: Application for systemic banking crises

With a growing focus on macroprudential policy in the aftermath of the financial crisis of 2007/2008, there is a need for early warning systems. The object of the thesis is to present a toolbox for signaling systemic banking crises that can be applied to policy. To this end I evaluate the existing methodology, identify the best performing early warning indicators as well as their optimal threshold values. The noise-to-signal ratio has been a workhorse of the signaling approach since the seminal papers of Kaminsky et al. (1997) and Kaminsky and Reinhart (1999), yet I will show that this may not be an appropriate tool for finding optimal thresholds. I will instead evaluate the signaling performance of indicators based on measures that either takes explicit account of the preferences of the policy maker or incorporate the full range of possible threshold values. The thesis also shows that country specific threshold values given as the percentile of the distribution seems to be best suited for Norwegian data In line with most of the existing literature, the private credit to GDP gap is found to be the best performing single indicator, closely followed by private credit exuberance. Both indicators also produce stable threshold values for probable ranges of the policy makers relative preference between correctly and falsely signaling crises. With the use of two indicators for signaling, more than one signaling scheme can be used to define the signal. The standard approach in the literature has been to require both indicators to breach their respective threshold values for a signal to be issued. I will in this thesis present an alternative scheme that will be shown to significantly increase the signaling performance in a bivariate analysis, compared with the standard scheme. The best performing pair of indicators is found to be private credit exuberance and the global house price to income gap