Financial Crisis Prediction: Assessment of Early Warning Signs Report

This report assesses the reliability of predicting financial crises by examining various macroeconomic and financial variables. It investigates whether early warning signs of financial crises can be accurately measured, focusing on factors such as income inequality, credit booms, aggregate expenditure, boom and bust cycles, current account imbalances, budgetary crises, deposit systems, and global imbalances. The study analyzes data from 14 developed countries over a period of more than 100 years, employing a general-to-specific model selection process to evaluate the most consistent predictors. The findings reveal that income inequality has significant predictive power, often surpassing the influence of loan growth and other financial variables. The report also examines the predictive power of out-of-sample forecasts and the impact of various factors on financial stability, providing insights into the complex dynamics of financial crises. The research draws on secondary sources, including empirical studies, to explore the relationship between these variables and the occurrence of financial crises, aiming to identify potential indicators for future risk assessment and mitigation strategies.

Running head: ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY
PREDICTED
Assessment of Whether Financial Crises Can be Reliably Predicted
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1ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
Abstract
The study aims to find whether the early warning signs of financial crisis can be reliably
measured. It has discussed rationale such as macroeconomic variants for being the main factor
for causing financial crisis with the use of several secondary sources of research topic. The study
has been further able to explore the broad types of the “financial and macroeconomic variables”
and consider “general-to-specific model selection process” for evaluating the most consistent
predictors of financial crises across 14 developed countries. The total time considered for the
analysis was taken from the trend of more than 100 years. The “in-sample findings have been
able to show that the income inequality is having the predictive power beyond loan growth and
several other financial variables”. In addition to this, the out-sample forecasts made in the
previous studies are seen with “predictive power” which inclines to “vary considerably over
time”. However, the income equality is having predictive power for each of the “forecasting
period”. Other inferences made from the previous studies on financial crisis brought by the
current account imbalances has been able to signify that in most of cases the variables set for the
research neglects the early warning predictors despite of the prominence in the theory and the
case studies associated to the crisis. In addition to this, factors such as credit boom have been
held responsible for aftermath of the crisis, however they cannot be considered as the only
reason. The factors leading to financial crises can be ranging from several factors which includes
“private banknotes (during the Panic of 1819) to the runs on repo, commercial paper, and primer
broker balances during the crisis of 2007-2009”.

2ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
Table of Contents
Chapter 1..........................................................................................................................................5
Introduction to the topic...................................................................................................................5
1.1 Introduction............................................................................................................................5
1.2 Background of the Study.......................................................................................................5
1.3 Research Purpose...................................................................................................................7
1.4 Research Objectives...............................................................................................................7
1.5 Research Questions................................................................................................................8
1.6 Structure of the Dissertation..................................................................................................8
Chapter 2..........................................................................................................................................8
Literature Review............................................................................................................................8
2.1 Aggregate Expenditure..........................................................................................................8
2.2 Boom and Bust cycle.............................................................................................................9
2.3 Current account imbalances.................................................................................................10
2.4 Income Inequality................................................................................................................11
2.5 Budgetary Crisis..................................................................................................................12
2.6 Deposit system.....................................................................................................................12
2.7 Global imbalances...............................................................................................................13
Chapter 3........................................................................................................................................14
Methodology..................................................................................................................................14
3.1 Introduction to the data collection.......................................................................................14
3.2 Data Sampling Method........................................................................................................15
3.3 Research Approach..............................................................................................................15

3ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
3.4 Data collection Method........................................................................................................15
3.5 Dependent and Independent Variables................................................................................17
3.6 Data Analysis Method.........................................................................................................18
Chapter 4........................................................................................................................................22
4.1 Finding/Results....................................................................................................................22
4.3 Subsample Predictions.........................................................................................................25
4.4 Out of Sample Forecasting Performance: 1980-2008.........................................................28
4.5 Predictions made with income inequality............................................................................29
4.6 Aggregate expenditure impact on financial crisis...............................................................31
4.7 Prediction of financial crisis with current account imbalance.............................................32
4.8 Global imbalance impact on financial crisis........................................................................32
4.9 Deposit insurance impact in predicting financial crisis.......................................................33
Chapter 5........................................................................................................................................34
Conclusion.....................................................................................................................................34
List of Appendices.........................................................................................................................36
List of References..........................................................................................................................44

4ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
List of Figures
Figure 1: Global Income inequality within country and between country....................................29
Figure 2: Country wise risk of income inequality.........................................................................30
List of Tables
Table 1: Predictive variables summary statistics
Table 2: Summary of in sample results (1870-2008)
Table 3: In-sample results, loan growth and income inequality
Table 4: In-sample results with several predictors (1870-2008)
Table 5: In sample results for post WWII
Table 6: In-sample results with several predictors (1950–2008)
Table 7: In-sample results with selected predictors (1962–2008)
Table 8: Out-of-sample AUROCs for the sample (1980–2008)
Table 9: Out-of-sample AUROCs
Chapter 1
Introduction to the topic
1.1 Introduction
In modern economics financial crisis is seen as a recurring phenomenon. The crisis of
“2007-2009” was a stark recall of the “financial crashes” which shook the world by surprise. The
various types of the cause of the academic interest in the financial crises is considered with the
historical events. The discourse of the study aims to find whether early warnings of the financial
crises may be identified. The investigation of the research will rely on the previous work of the
economists and policy makers in recognition of the crises. Additionally, the early warning
indicators of the financial crisis is observed with the work of these “economists” and the policy
makers with the prevention and development of the crises. Despite of the several theories, there
has been no “consensus on whether the macroeconomic or the financial factors” has a significant
role in the prediction of the financial crises (Wang and Hua 2014).

5ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
In general, inequality in the income is identified with the increasing attention of the
“economic research in including the economic growth, political economy, schooling and saving
of the behaviour”. The concept of income equality was depicted with an augmented emphasis
before the crisis of “2007-2009 (as it was before the Great Depression)”. This concern has
remained constant in the developed economies. As stated by Lee, Sameen and Cowling (2015),
the potential role of driving the financial crisis has remained doubtful. Some of the other papers
on the income equality is further able to focus on the increase in the inequality and the
probability of the financial crises or impacts of credit booms. In other empirical research the
income equality is assessed to be consistent with the ingredient in growth for the bank loans or
the developmental activities during the financial crisis (Almamy, Aston and Ngwa 2016).
1.2 Background of the Study
In terms of the financial aspect, credit boom was identified as the key contributor for the
“financial crises in developed countries over the last 140 years”. A more recent study has
focused on the mortgage lending for the households, which has increased to a significant level in
the last century. The linking of the abnormal credit growth is recognised between 1970 and 2007.
However, in this period the linkages in the abnormal credit growth is observed in only out of the
three financial crises. Henceforth, credit boom by themselves are considered as an insufficient
prerequisite for the financial crises. The study has been able to take a further step in
understanding the relative role for the financial predictors and real roles driving the financial
crises. The evaluation of the probability of the financial predictors is seen to be considered with
the predictive “power of a broad set of potential” macroeconomic and financial factors over the
next 100 years. Instead of imposing a strong priori restriction on the empirical model, the main
emphasis is employed with general to specific model selection. This seen with the determination
of the predictive relative factors. The research study is able to employ a “general to specific
model selection process” for the determination of the appropriate predictors and the existing lags
(Adebambo, Brockman and Yan 2015).
The inclusion of the income “inequality and credit booms” along with other relevant
economic factors are able to clarify the occurrence of the “financial crises” included with the
collapses of “asset bubbles, deregulation, financial innovations, movements of real interest rates,
deposit insurance schemes, growth of the monetary base, and current account”. The research

6ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
study is also able to evaluate the potential interactions among the real and the financial factors
which are seen to be evident with case of income inequality. Empirical research has provided a
compelling evidence on the income equality with the primary drivers and the upsurge in the
“household debt” in the “United States during 1980s and 1990s” (Doogar, Rowe and Sivadasan
2015). Some of the other empirical evidences is further able to show that inequality may increase
the leverage among the middle-income and poor households due to the consumption smoothing
brought by borrowing against future incomes. The connection of these studies with the relevant
findings has stated on the credit boom literature implied with income equality which may be a
result of the actual real “side cause of risk of financial instability”. This risk is directly
attributable to the credit bubbles. In arguing of the rising nature of the inequality led by
redeployment in the form of “subsidized housing finance” housing boom and subsequent crashes
are taken into consideration for the discussion (Ahrend and Goujard 2014).
The important considerations of the paper are able to include the dataset of 14 developed
countries over 1870-2008, which is provided by other empirical research by “Karolin
Kirschenmann Department of Finance, Aalto University School of Business”. This study was
published in April 29, 2015. The main research will be based on secondary sources along with
qualitative analysis in terms of the depictions made in this research paper for the assessment of
financial crisis. The differentiating aspect of the study has included the work in two significant
behaviours. Firstly, the “predictive power needs to be” distributed among larger set of variables”
and examining these potential predictors and lags in the joint model. Secondly, the study has
employed a methodology for flexible and “general to specific model selection” between the
various predictors “without imposing restrictive assumptions on the channels through which,
income inequality impacts the risk of financial crises” (Persakis and Iatridis 2016).
1.3 Research Purpose
The main purpose of the paper has considered the “long-time series” which has exploited
to achieve the relation of the long-time series for determining the roles in different crises
situations. The “long-time series” format is important for accomplishment of the out-of-sample
forecasts. The main considerations for the long-term costs have gained the importance since
1980. During this time when financial liberalization began, the data indicators were based on the

7ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
consideration of deregulation and availability of the comparative short time periods. The paper
has also examined the robustness check between 1962-2008 which was available from the data
on the size of the U.S. joint fund industry. This is identified as a major indicator of the factors
leading of the financial innovation and deregulation which are available for shorter time periods.
The discourse of the study has examined the in-sample robustness “checked for the 1962-
2008 period”. The availability of the “data on the size of the US mutual fund industry” is
considered as an indicator for the investment for the “innovative and riskier investment classes”.
The results have been able to confirm the entire sample findings. Moreover, the results have
depicted that a larger U.S. mutual fund industry has been depicted with a higher financial risk
prior to the financial crisis.
1.4 Research Objectives
The main objectives set for the research are enumerated below as follows:
 Contribution of macroeconomic factor such as income equality in financial crisis
 Studying the role of aggregate expenditure in terms of financial crisis
 Role of economic expansion during boom and bust cycles in predicting the financial
crisis
 Global Imbalances contribution to financial crisis
 Impact of Budgetary crisis on financial crisis
1.5 Research Questions
The research questions formulated for the study are listed below as follows:
1. What is the role of income equality in determining financial crisis?
2. How is aggregate expenditure able to signal early signs of economic downturn in a
country?
3. What predictions of financial crisis are suggested with “boom and bust cycles”?
4. What is the impact of “current account imbalances in determining” financial crisis?
5. How well the changes in the deposit system and global imbalances able to predict
financial crisis?
6. What is the role of budgetary crisis in determining financial crisis?

8ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
1.6 Structure of the Dissertation
The study is segregated into five chapters. The first chapter is able to introduce to the
topic along with the research objectives, purpose, background and research questions. The
second chapter has organized the associated literature and the way it is able to motivate the
predictor variables in the data. The third section has outlined the methodology for conducting the
research and the fourth section has presented the results. The fifth section has concluded the
paper.
Chapter 2
Literature Review
2.1 Aggregate Expenditure
As stated by Borio (2014), aggregate expenditure is identified as the measure of the
national income. This is seen to be defined as a present value for all the “finished goods and
services present in the economy”. The consideration of the “aggregate expenditure” is considered
with the “sum of the expenditures undertaken in the economy” and the factors considered in a
particular time frame. This is further referred as the expenditure which are incurred on the
“consumer goods, planned” investments and expenditures made by the government in the
economy. The situation in the open economy is included with the difference among the imports
and exports. The investment expenditure is also
The important considerations in the seminar paper has been able to link the systematic
nature of the banking panics caused in the business cycles. The strongest signal of the recession
identified with the decline in the investment expenditures. The nature of the investment is able to
reflect the total level of the “aggregate demand” for the “capital goods in the economy”.
Furthermore, the nature of the investments may be able to affect the likelihood of a crisis. The
money available in the economy is seen to be invested in a productive manner rather driving the
consumption. Therefore, the accounting of changes in the “real gross investments” is considered
in the empirical analysis (Gilchrist et al. 2017).

9ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
2.2 Boom and Bust cycle
As per Rey (2015), the bust and boom cycle is considered as the “process of economic
expansion” and contraction which has occurred repeatedly. The “boom and bust cycle” is
considered as the key characteristics for the capitalist economies. In case of a boom cycle, the
economy is discerned with plenty of jobs and market can bring high return to the investors. The
subsequent study in bust can include the consideration for economy shrinks. in such a situation
people losing their source of income and investors lose money. The boom and the “bust cycle”
acts as the key factor for the variations in the time and severity.
It needs to be further discerned that the main idea of the financial crisis is discerned in
terms of the financial crises which is determined by credit boom and bust cycles. This has “long
been stipulated in the literature”. In the recent studies there are several types of large credit
booms which are related to the financial crises. The improved influence and simultaneous
decrease in the lending standards has introduced several fragilities in the banking system and
made it more vulnerable. The measurement for the “evolution of credit in each country” has been
depicted with the changes in the real bank loans. In general, the bank loans are not scaled as per
GDP, as such a scaled measure is able to include the several types of the considerations which is
seen to be related to the proxy for the nature of the financial systems rather than including the
proxy for the financial crisis in the sample developed in the economies (Reinhart, Reinhart and
Trebesch 2016).
The various types of the similarities among the previous and recent crisis is able to
include the asset price booms. The increase in the asset price can consider the increase in the
lending as per higher collateral values, which has further increased the asset price. Once the
spiral activity stops, the households and the firms are seen struggle in terms of the paying back
the accumulated debt. This consideration is able to include the type of asset price boom and
eventually, which is able to “threatens the stability of the financial system”. This consideration is
detected in the US and various countries in Europe in the runup to the recent crisis (Ho et al.
2016). The “tech bubble in the end of 1990s and beginning of 2000s did not result in massive
systematic financial crisis”. The result of the empirical research there had been several types of
the other constraints which are seen to be related to the different type the other aspects of the
financial system. This consideration is identified in U.S. and several European countries in the

10ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
recent crisis. The “tech bubble in the end of 1990s and beginning of 2000s did not result in
massive systemic financial crisis”. The empirical evidences have accounted for booms in the
asset price and changes in the real value of the stock market indexes (Akins et al. 2016).
2.3 Current account imbalances
As per the depictions made by Liu (2015), it needs to be understood that the various type
the imbalances in the current account is identified with short-interest rates which may be
contributed as per the development of the financial crises. The various types of the “capital
inflows may lead to the stock market bubbles and excessive expansion in terms of the domestic
credit and inflationary pressures”. The change in the real value of the current account is
considered with the measures of the international capital flows which depicts the environment
with lower interest rates and increasing mortgage lending and booms in the housing price which
will ultimately lead instability to financial inconsistency. The increasing interest rate may hurt
the balance of the bank’s balance sheet. This is done in case the banks cannot increase the banks
are not able to quickly increase their rates for lending. In case the interest is passed to the
borrowers, this would lead to increase in the “non-performing loans and the risk” in terms of the
moral hazard on the borrower’s part. In the empirical analysis is able to account for the real
“short-term interest rate” (Arthur, Tang and Lin 2015).
The recent studies in the literature has been developed as per the theories and arguments
to show the various instances of income inequality which may be able to contribute to the
financial “instability and increase the likelihood of the crisis through various channels”. This is
considered with the emphasis on the various channels such as “credit and asset price booms or
current account imbalances”. These channels will be able to emphasize on the asset and credit
bubbles which might be able to asset in developing the actual results for the real cause.
2.4 Income Inequality
There has been number of studies with the “body of literature” which has developed the
concepts and influences on how the “income inequality” has contributed towards the financial
instability. There has been significant nature of the increasing likelihood of the crisis through
several channels. These aspects have been seen with “channels such as credit” and “asset price
booms or current account imbalances”. The” channels are able to accentuate that the credit

11ASSESSMENT OF WHETHER FINANCIAL CRISES CAN BE RELIABLY PREDICTED
bubbles” and assets have been actually able to develop the results from the real causes (Sun and
Wang 2015).
In several instances the increasing nature of the “inequality forced” by the US politicians
is able to enact measures for improving the situation of “low and middle-income households” for
avoiding and losing the voters. The redistribution in terms of the subsidized housing finance was
expedited. This provision is also seen to be inexpensive with the consideration of the “mortgage
lending” together taken with the “concurrent deregulation of the financial sector”. This has intern
led to housing boom and succeeding crashes (Proença, Laureano and Laureano 2014).
The assertion of a more direct link among the collective “debt levels” does not depend on
on the specific political systems. In a “closed economy”, the crisis consideration is seen to
emerge endogenously. This is seen because of “rising income inequality” due to low-income and
middle-“income households” for avoiding “losing them as voters”. There is significant
redeployment in form of the “social security payments or increased taxes”. The redistributions in
terms of the “social security payments” and “increased taxes for the rich are impossible” solution
in the US political environment and redeployment in form of the subsidized housing finance as
expedited. The provision of the cheap lending for mortgage taken into consideration with
concurrent deregulation of the financial sector observed with housing boom and subsequent
crash (Armantier et al. 2015).
A more direct link is taken into consideration with the connection with the increasing
debt level and income inequality which does not rely on the “specific political system”. The
closed economy model has showed several crises which emerged endogenously because of
increasing income inequality due to “income and middle-income households seeking” to
preserve appropriate consumption must “borrow more as their real wages decrease”. The
extended model in the “international environment” with the open economy is seen with the rising
inequality and risk of financial crisis as it “endogenously leads to credit expansion, increased
leverage and increased current account deficits” (Milne 2014).
In addition to this, there are several types of the other arguments which is able to show
that the increasing nature of the discrepancy in the income equality is able to be depicted in
terms of depressed aggregate demand. This is seen to be induced with central banks in