A Framework for Early-Warning Modeling with an Application to Banks

43 Pages Posted: 12 Oct 2018

See all articles by Jan Hannes Lang

Jan Hannes Lang

European Central Bank (ECB)

Tuomas A. Peltonen

European Central Bank (ECB)

Peter Sarlin

Hanken School of Economics; RiskLab Finland

Date Written: October 11, 2018

Abstract

This paper proposes a framework for deriving early-warning models with optimal out-of-sample forecasting properties and applies it to predicting distress in European banks. The main contributions of the paper are threefold. First, the paper introduces a conceptual framework to guide the process of building early-warning models, which highlights and structures the numerous complex choices that the modeler needs to make. Second, the paper proposes a flexible modeling solution to the conceptual framework that supports model selection in real-time. Specifically, our proposed solution is to combine the loss function approach to evaluate early-warning models with regularized logistic regression and cross-validation to find a model specification with optimal real-time out-of-sample forecasting properties. Third, the paper illustrates how the modeling framework can be used in analysis supporting both micro- and macro-prudential policy by applying it to a large dataset of EU banks and showing some examples of early-warning model visualizations.

Keywords: early-warning models, financial crises, bank distress, regularization, micro- and macro-prudential analysis

JEL Classification: G01, G17, G21, G33, C52, C54

Suggested Citation

Lang, Jan Hannes and Peltonen, Tuomas A. and Sarlin, Peter, A Framework for Early-Warning Modeling with an Application to Banks (October 11, 2018). ECB Working Paper No. 2182. Available at SSRN: https://ssrn.com/abstract=3265201

Jan Hannes Lang

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Tuomas A. Peltonen (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Peter Sarlin

Hanken School of Economics

PO Box 479
FI-00101 Helsinki
Finland

RiskLab Finland ( email )

Turku, 20520
Finland

HOME PAGE: http://risklab.fi/people/peter/

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