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An Early-warning and Dynamic Forecasting Framework of Default Probabilities for the Macroprudential Policy Indicators Arsenal

Xisong Jin () and Francisco Nadal De Simone ()

No 75, BCL working papers from Central Bank of Luxembourg

Abstract: The estimation of banks? marginal probabilities of default using structural credit risk models can be enriched incorporating macro-financial variables readily available to economic agents. By combining Delianedis and Geske?s model with a Generalized Dynamic Factor Model into a dynamic t-copula as a mechanism for obtaining banks? dependence, this paper develops a framework that generates an early warning indicator and robust out-of-sample forecasts of banks? probabilities of default. The database comprises both a set of Luxembourg banks and the European banking groups to which they belong. The main results of this study are, first, that the common component of the forward probability of banks? defaulting on their long-term debt, conditional on not defaulting on their short-term debt, contains a significant early warning feature of interest for an operational macroprudential framework driven by economic activity, credit and interbank activity. Second, incorporating the common and the idiosyncratic components of macro-financial variables improves the analytical features and the out-of-sample forecasting performance of the framework proposed.

Keywords: financial stability; macroprudential policy; credit risk; early warning indicators; default probability; Generalized Dynamic Factor Model; dynamic copulas; GARCH (search for similar items in EconPapers)
JEL-codes: C30 E44 G1 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ban, nep-cba, nep-ecm, nep-for and nep-rmg
Date: 2012-07
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