Evaluating the Effectiveness of Early Warning Indicators: An Application of Receiver Operating Characteristic Curve Approach to Panel Data

Abstract

Early warning indicators (EWIs) of banking crises should ideally be judged on how well they function in relation to the choice issue faced by macroprudential policymakers. However, the effectiveness of EWIs depends upon the strength of the predicting power, stability, and timeliness of the signal. Using a balanced panel of 6 countries’ experience with banking and currency crises in recent times, this paper evaluates the effectiveness of EWIs using Receiver Operating Characteristics. Following the drivers of the banking crisis and currency crisis, the paper evaluates the effectiveness of aggregate credit growth, sectoral deployment of credit along and other macroeconomic indicators generally used as EWI. The paper observes that credit disbursements to non-financial sectors and the central government provides stable signals about systemic risks. Further debt service ratio, interbank rates and total reserves are also found to be useful in predicting these crises. Lastly, the effective EWIs are combined using shrinkage regression methods to evaluate the improvement of signal strength of the combination of EWIs. The predictive power of the combination of EWIs provides better signal strength in predicting the macroprudential crisis.