Can financial sector distress be detected early?

Abstract

Financial sector distress is a situation in which financial intermediation is either costly or impossible (or both) as proxied by tight financial conditions - high spreads, decline in equity value and high volatility. Tight financial conditions have been identified as a risk factor to the medium-run GDP growth. I therefore use different statistical methods aiming at extracting early warning signals from the cross-country data related to financial health and soundness of countries’ financial systems. The novelty of my approach is that I account for class imbalance - that is I adjust my results for the fact that financial distress periods are rare events. I contrast that to the previous literature. I find that it is possible to generate accurate warning signals about future distress well in advance and suggest which variables should be closely monitored as sources of financial vulnerabilities.