How to Predict Financial Stress? An Assessment of Markov Switching Models

Thibaut Duprey and Benjamin Klaus

Staff Working Papers from Bank of Canada

Abstract: This paper predicts phases of the financial cycle by using 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 owing to the data gathered during the global financial crisis. Comparing the prediction performance with a standard binary early warning model reveals that the Markov switching model is outperforming the vast majority of model specifications for a horizon up to three quarters prior to the onset of financial stress.

Keywords: Business fluctuations and cycles; Central bank research; Econometric and statistical methods; Financial markets; Financial stability; Financial system regulation and policies; Monetary and financial indicators (search for similar items in EconPapers)
JEL-codes: C54 G01 G15 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2017
New Economics Papers: this item is included in nep-rmg
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Citations: View citations in EconPapers (15)

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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:bca:bocawp:17-32

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