Early Warning Systems for Systemic Banking Risk: Critical Review and Modeling Implications

Abstract

Growing complexity and episodic turmoil in the financial system call for reassessment of existing early warning systems (EWSs) for systemic risk. This paper critically reviews the extensive EWS literature and typology and proposes a new class of supervisory models. The paper also discusses important design implications for an efficient EWS. The new class of supervisory models for systemic risk should be built from an integrated perspective and model EWS according to the users' objectives and competencies. It should incorporate both microprudential and macroprudential perspectives, as well as the structural considerations of the financial system itself. From the financial supervisor's point of view, an EWS involves an ex ante approach to regulation designed to highlight conditions that have in the past been associated with systemic risk. Forward-looking supervisory instruments become more important as they allow ex ante policy action and can reduce the need for ex post regulation.