Evaluating the Effectiveness of Early Warning Indicators: An Application of Receiver Operating Characteristic Curve Approach to Panel Data

Early warning indicators (EWIs) of banking crises should ideally be judged on how well they function in relation to the choice issue faced by macroprudential policymakers. Several practical features of this challenge are translated into statistical evaluation criteria, including difficulties measuring the costs and advantages of various policy interventions, as well as requirements for the timeliness and stability of EWIs. We analyze the balance panel of possible EWIs for six countries that have experienced currency crisis and banking crisis in recent times. Using possible early warning indicators, we evaluate the suitability of these EWIs in view of their predictive power and stability of signals. The paper observes that credit disbursements to non-financial sectors and central government provides stable signal about systemic risks. Further debt service ratio, inter bank rates and total reserves are also found to be useful in predicting these crisis. Lastly, the paper observes that linear combination of these indicators improves the predictive power of EWIs further.