An early warning system to prevent potential financial crises
The financial crisis wreaked havoc across the world economy and required governments to take significant, in some cases unprecedented, actions to curtail the damage. These included bailing out major financial institutions and injecting billions of euros into recession-hit economies to stimulate growth. The social cost has also been immense, with unemployment, stagnant wages and austerity policies causing misery to millions. With such heavy costs, the desire to ensure a financial crisis of such scale doesn’t happen again is high. Therefore, the EU-funded EARLINESS.eu (European early warning for systemic risk) project has devised their Early Warning System (EWS) to allow policymakers and regulators to receive advanced notice of new risks brewing within the financial system. Knowing when to sound the alarm “Systemic events are intimately related to a banking crisis. Even a limited banking crisis may lead to the failure of the involved banks causing a collapse of the entire system,” says Marie Curie fellowship recipient Dr Michele Costola, based at the SAFE Research Center, University of Frankfurt. “To cope with the vulnerabilities of the financial system following the crisis, the Basel III framework was implemented to enhance the capital and liquidity rules in the banking sector.” One of the key aspects of the framework is the countercyclical capital buffer (CCB), a key macro-prudential instrument, which aims to create a buffer of capital to protect the banking system from periods of excessive credit growth that may lead to the formation of systemic risk. “In short, the CCB should mitigate the risk of a credit crunch, which represents a destabilising factor to the real economy by carrying additional credit losses in the banking system,” explains Dr Costola. “Knowing when to activate mechanisms such as the CCB is the key conundrum to solve. That’s why an EWS, a system that issues a signal in case the likelihood of a crisis crosses a specified threshold, can play a crucial role in this aspect.” A building block EWS EARLINESS.eu’s EWS is structured in a ‘building block’ configuration and is meant to have a hierarchical structure. “This is particularly convenient given its modularity and flexibility which easily allows ad hoc interventions, extensions and modifications of the implemented systemic risk measures,” says Dr Costola. The system has three levels – first, it includes ‘raw’ financial and economic data, specifically financial data at single financial institutions and comprises stock market data (price, market value and trading volume) and balance sheet data (i.e. leverage ratio). The second level of the system concerns the micro and macro systemic risk measures estimated based on the first level data. Micro financial systemic risk measures are used to detect the contribution of a single institution (firm) to a systemic event while macro financial systemic risk measures represent the highest aggregated level of the system. Finally, the third level analyses the predictive ability of these systemic risk measures (signals) in terms of market and banking crises. “The aim of this configuration is to have (early) signals of systemic risk by identifying them in terms of source and location,” comments Professor Loriana Pelizzon, project supervisor. “The early warning signals can be monitored at global and European levels and for a given source of systemic risk. In this sense, these signals can help to prevent a potential crisis.” For each source of possible systemic risk from within the financial system, the EWS has alternative indicators that may provide a different or similar signal during some phases or may anticipate others, therefore allowing those using the system to always be able to see the bigger picture of the financial system’s overall health. Next steps The project team has been eager to engage with policymakers over the viability and usability of their system. Dr Costola spent his secondment period at the relevant policy division of the European Central Bank (ECB) dealing with systemic risk, of which close collaboration continued after his time there. The project also organised an open final workshop in Frankfurt and will be featured as part of ESOF 2018 (European Open Science Forum), the largest interdisciplinary meeting on science and innovation in Europe. Moving forward, Prof Pelizzon and Dr Costola will continue their work at SAFE and the EARLINESS.eu project has contributed to the development of the research centre’s Systemic Risk Dashboard (SRDB) and the soon-to-be-released Systemic Risk Platform (SFRP).
Keywords
EARLINESS.eu, Early Warning System, EWS, systemic risk, building block configuration, banking crisis