How to predict financial stress? An assessment of Markov switching models

Thibaut Duprey and Benjamin Klaus

No 2057, Working Paper Series from European Central Bank

Abstract: This paper predicts phases of the financial cycle by combining a continuous financial stress measure in a Markov switching framework. The debt service ratio and property market variables signal a transition to a high financial stress regime, while economic sentiment indicators provide signals for a transition to a tranquil state. Whereas the in-sample analysis suggests that these indicators can provide an early warning signal up to several quarters prior to the respective regime change, the out-of-sample findings indicate that most of this performance is due to the data gathered during the global financial crisis. Comparing the prediction performance with a standard binary early warning model reveals that the MS model is outperforming in the vast majority of model specifications for a horizon up to three quarters prior to the onset of financial stress. JEL Classification: C54, G01, G15

Keywords: continuous coincident financial stress measure; early warning model; time-varying transition probability Markov switching model (search for similar items in EconPapers)
Date: 2017-05
New Economics Papers: this item is included in nep-ets and nep-rmg
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Citations: View citations in EconPapers (14)

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Working Paper: How to Predict Financial Stress? An Assessment of Markov Switching Models (2017)
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Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20172057

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