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Strategies to Forecast Financial Crisis'

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In order to forecast the crisis performance, large scales of interpreters’ opinions have been taken into account. As already mentioned, expansionary monetary and fiscal policies, recessions, real exchange rate appreciations, high inflation, exaggerated credit cycles, loss of competitiveness and deterioration of the current account were represented as the main triggers of the different financial collapses. Eichengreen, Rose and Wyplosz (1995) find that devaluations are caused by political instability, budget and current account deficits and rapid increase of prices. Edwards and Santaella (1993) emphasize on the importance of domestic credit and fiscal policy expansions indicators, but also on the worsening of the current account and the capital flight in understanding the 69 devaluation episodes object of their study. Frankel and Rose (1996) show, in line with most studies, that crashes tend to occur when FDI inflows dry up, when reserves are low, when domestic credit growth is high, when exchange rates show overevaluation. Kaminsky (1999) focuses on currency and banking crisis. In the case of currency crisis a high world interest rate together with increasing gross foreign debt (the ratio of domestic residents’ liabilities in banks oversees to foreign exchange reserves), positive capital flight (the ratio of domestic residents’ assets in banks oversees to foreign exchange reserves) and the ratio of short term maturity foreign debt to total foreign debt are good indictors. In the case of banking crisis the indicators linked with the liberalization of the capital account and the domestic financial sector (M2 multiplier, domestic credit to GDP and stock prices) are the ones to prevail.

Together with the more traditional indicators we also consider the ones suggested by the new macroprudential literature starting from Borio and Lowe (2002), where the focus is on financial imbalances. They started to come up with the importance of asset price developments, which have up to that point received little attention in explaining banking crisis in part due to lack of data availability. Credit, on the other hand, was considered in previous studies, but the cumulative effect of credit, together with its interaction between asset prices and the real economy, was ignored. With the outburst of the recent financial collapse a new battery of studies introduced new indicators. In this literature house price appreciation, bank credit growth and the size of the current account (Claessens et al 2010), cumulative credit growth, fixed exchange rates and the current account (Lane and Milesi-Ferretti 2010), more liberal credit market regulations (Giannone et al 2010) affect crisis severity.

In this study we will consider both the more traditional indicators and the more recent ones. Domestic asset prices and bank credit dynamics are calculated respectively as the real annual growth of the main domestic equity index and the real annual growth of the amount of outstanding credit granted to the private sector (which excludes credit to banks and government), the deviation from trend of the stock market capitalization over GDP together with the Price Earnings Ratio is a proxy for asset price valuations, the amount of leverage in the economy is constructed with the deviation from trend of the private credit over GDP. The different interactions between asset price dynamics, asset price valuations, credit dynamics and leverage are considered, following Borio and Lowe 2002. The dataset is made of quarterly macro and financial data for period 1990:1-2009:4 for 28 countries, including 10 advanced economies4 and 18 emerging economies. All data is obtained either from Haver Analytics, Bloomberg, Datastream or IFS (IMF). Credit and money variables are seasonally adjusted using X12 seasonal adjustment while all the real variables are deflated with the CPI. We consider 22 indicators that sum up to 60, if we consider all their transformations, which are calculated in real time. Table 1 lists all the indicators with all their transformations.

Some members of the European Union (EU) initially viewed the financial crisis as a purely American phenomenon. According to Dennis Blair, Director of U.S.

National Intelligence, the global financial crisis and its geopolitical implications pose, “the primary near-term security concern of the United States.” In addition, he said, “The longer it takes for the [economic] recovery to begin, the greater the likelihood of serious damage to U.S. strategic interests. Roughly a quarter of the countries in the world have already experienced low level instability such as government changes because of the current slowdown.” For the United States and the members of the European Union the stakes are high.

Over the short run, both the EU and the United States are attempting to stop the downward spiral in the financial system, improve the financial architecture, and restore balanced economic growth. Over the long run, they likely will search for a regulatory scheme that provides for greater stability while not inadvertently offering advantages to any one country. The financial crisis and the economic downturn have become global events and likely will dominate the attention of policymakers for some time to come. The crisis has underscored the growing interdependence between financial markets and between the U.S. and European economies. As such, the synchronized nature of the current economic downturn probably means that neither the United States nor the EU is likely to emerge from the financial crisis or the economic downturn alone. The United States and the EU share a mutual

interest in developing a sound financial architecture to improve supervision and regulation of individual institutions and of international markets. This issue includes developing the organization and structures within national economies that can provide oversight of the different segments of the highly complex financial system. This oversight is viewed by many as critical to the future of the financial system because financial markets generally are considered to play an indispensible role in allocating capital and facilitating economic activity.

In the months ahead, Congress and the Obama Administration likely will consider a number of proposals to restructure the supervisory and regulatory responsibilities over the broad-based financial sector within the United States. At the same time, such international organizations, as the G-20, the Financial Stability Forum, the International Monetary Fund, the Organization for Economic Cooperation and Development, and the Bank for International Settlements likely will offer their own prescriptions for the international financial markets.

Financial Architecture

As policymakers address the issue of financial supervision, they likely will weigh the costs and benefits of centralizing supervisory responsibilities into a few key entities, such as the Federal Reserve, or dispersing them more widely across a number of different entities.

A centralized approach may avoid the haphazard way in which certain complex financial markets and transactions went largely unregulated. On the other hand, a broader dispersion of supervisory responsibilities may yield a more specialized approach to market supervision. In the UnitedStates, the Federal Reserve holds a monopoly over the conduct of monetary policy, mainly as a means of keeping such policy-making independent of political interests. The Federal Reserve also shares regulatory and supervisory responsibilities with a number of different agencies that are more directly accountable to elected officials and are subject to change. The EU system, however, is different from the U.S. system in ways that may complicate efforts at coordination. For instance, the European Central Bank is not strictly comparable to the Federal Reserve in both scope of its regulatory role and its role in supervising banks. In the EU system each EU member has its own institutional and legal framework for regulating its banking market, and national supervisory authorities are organized differently by each EU country with different powers and accountability.

Similarities between the crises: Although the relative importance of the sources of the current crisis will be debated for some time, the run-up to the current episode shares at least four major features with earlier episodes: rapid increases in asset prices; credit booms; a dramatic expansion in marginal loans; and regulation and supervision that failed to keep up with developments. Combined, these factors sharply increased the risk of a financial crisis, as they had in earlier episodes.

Asset Price Bubbles. While the specific sector experiencing a boom can vary across crises, asset price booms are common. This time it was house prices that sharply increased prior to the crisis, including in the U.S., the U.K., Iceland, Ireland, Spain and other markets that subsequently ran into problems. The patterns of house price increases are reminiscent of those in earlier major crises episodes. The overall size of the housing booms and their dynamics— including rising house prices in excess of 30 percent in the five years preceding the crisis and peaking prior to the beginning of the crisis—are remarkably similar to developments prior to previous banking crises in advanced economies, as observed by Reinhart and Rogoff (2008). These booms were generally fueled by fast rising credit resulting in sharply increased household leverage. As often before, the combination of rapid house prices increases and buildup in leverage turned out to be the most dangerous elements.

Credit Booms. As in most earlier crises, the rapid expansion of credit played a large role in the run-up to the crises. Credit aggregates grew very fast in the U.K., Spain, Iceland, Ireland, and several Eastern European countries, often fueling real estate booms.

Such episodes of rapid credit growth generally coincide, as they did again this time, with large cyclical fluctuations in economic activity. While aggregate credit growth was less pronounced, reflecting slower corporate credit expansion, household indebtedness in the U.S. rose rapidly after 2000, driven largely by increased mortgage financing, with historically low interest rates and financial innovation contributing. And in spite of low interest rates, debt service relative to disposable income reached historical highs. While historically not all credit booms end up in a crisis, the probability of a crisis increases with a boom, especially the larger its size and the longer its duration. The mechanisms linking credit booms to crises include increases in the leverage of borrowers and lenders, and a decline in lending standards. In the recent episode, both channels were at work. Increased leverage, in part due to inadequate oversight, left households vulnerable to a decline in house prices, a tightening in credit conditions and a slowdown in economic activity. Not only did the correction harm consumers––as they ran into debt servicing problems, it also led to systemic risks. And default rates were higher where credit growth had been more rapid with this pattern extended to other countries caught in crises.

Marginal Loans and Systemic Risk. Credit booms or, more generally, rapid growths in financial markets, are often associated with a deterioration in lending standards. They often mean the creation of marginal assets which are viable as long as favorable economic conditions last. In the U.S. and elsewhere this time, a large portion of the mortgage expansion consisted of loans extended to borrowers with limited credit and employment histories, and often on terms poorly suited to the borrowers’ conditions. Debt servicing and repayment were, hence, vulnerable to economic downturns and changes in credit and monetary conditions.

This maximized default correlations across loans, generating portfolios highly exposed to declines in house prices––confirmed ex-post through the large fraction of non-performing loans.

In other countries, the same pattern meant large portions of credit denominated in foreign currency.


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