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Systemic risk diagnostics: coincident indicators and early warning signals

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Abstract

We propose a novel framework to assess financial system risk. Using a dynamic factor framework based on state-space methods, we construct coincident measures (‘thermometers’) and a forward looking indicator for the likelihood of simultaneous failure of a large number of financial intermediaries. The indicators are based on latent macro-financial and credit risk components for a large data set comprising the U.S., the EU-27 area, and the respective rest of the world. Credit risk conditions can significantly and persistently de-couple from macro-financial fundamentals. Such decoupling can serve as an early warning signal for macro-prudential policy. JEL Classification: G21, C33.

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 1327.

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Length: 36 pages
Date of creation: Apr 2011
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Handle: RePEc:ecb:ecbwps:20111327

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Keywords: financial crisis; systemic risk; credit portfolio models; frailty-correlated defaults; state space methods.;

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