Constructing a country-specific indicator for cyclical systemic risk

Cyclical systemic risk arises when macro-financial imbalances accumulate over time. Past financial crises which occurred in several countries around the world have shown that heightened cyclical risk can lead to exorbitant economic and financial costs if the appropriate macroprudential policies are not enacted at the correct time. Although many indicators are monitored in the conduct of macroprudential oversight and analysis, there are a lack of country-specific cyclical systemic risk indicators used by macroprudential authorities. This paper addresses this gap by building a country-specific composite indicator for cyclical systemic risk that is tailored for a specific country using data for the particular country. This indicator is first tested using data for Malta, and is then generalised to Cyprus, paving the way for future applications for other countries. In addition, the signalling properties of the composite indicator for Malta and Cyprus are tested using local projections. These are compared to the signalling properties of the respective existing credit-to-GDP gaps and a stressed indicator, which captures a fictitious financial crisis for Malta, to further enhance its generalisability. The composite indicator is driven mainly by variables reflecting credit developments and overvaluation in property prices amongst others, and the interaction of such variables to take into account potential nonlinear relationships (of a specific form) between variables in a Principal Component Analysis (PCA). These sub-indicators are chosen based on early warning properties and are believed to have early warning characteristics on financial distress. This indicator can form part of a central bank’s policy toolkit, complementing other tools that support the formulation of macroprudential policy recommendations.