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Towards a new early warning system of financial crises

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Abstract

This paper develops a new Early Warning System (EWS) model for predicting financial crises, based on a multinomial logit model. It is shown that EWS approaches based on binomial discrete-dependent-variable models can be subject to what we call a post-crisis bias. This bias arises when no distinction is made between tranquil periods and crisis/post-crisis periods. We show that applying a multinomial logit model is a valid way of solving this problem and constitutes a substantial improvement in the ability to forecast financial crises. The empirical results reveal that the model would have correctly predicted a large majority of crises in emerging markets since the 1990s. Moreover, we derive general results about the optimal design of EWS models, which allows policy-makers to make an optimal choice based on their degree of risk-aversion against unanticipated financial crises. JEL Classification: F31; F47; F30.

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 145.

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Length: 67 pages
Date of creation: May 2002
Date of revision:
Handle: RePEc:ecb:ecbwps:20020145

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Keywords: Currency crises; early warning system; crisis prediction.;

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