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Towards A New Early Warning System of Financial Crises

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  • Fratzscher, Marcel

    (European Central Bank)

  • Matthieu Bussiere

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, when economic fundamentals are largely sound and sustainable, and crisis/post-crisis periods, when economic variables go through an adjustment process before reaching a more sustainable level or growth path. We show that applying a multinomial logit model, which allows distinguishing between more than two states, 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, for a set of 32 open emerging markets from 1993 till the present, the model would have correctly predicted a large majority of crises in emerging markets. 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.

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Bibliographic Info

Paper provided by Royal Economic Society in its series Royal Economic Society Annual Conference 2003 with number 81.

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Date of creation: 04 Jun 2003
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Handle: RePEc:ecj:ac2003:81

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Web page: http://www.res.org.uk/society/annualconf.asp
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Keywords: currency crises; Early Warning System; crisis prediction;

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