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Early Warning System for Financial Crisis
Hangyong Lee
December, 2015
List of Chapters



Chapter 1


Chapter 2
National Early Warning System in Korea

1. Structure of the System·

2. KCIF’s Early Warning System

3. FSS and Financial Industry EWS

4. EWS for Financial Markets

5. EWS for Real Estate Market

6. EWS for Petroleum and Commodity

7. EWS for Labor Market


Chapter 3
EWS for Currency Crisis

1. Methodology: Signal Approach

  1.1. Dating Historical Crisis Periods

  1.2. Selecting Leading Indicators

  1.3. Evaluating Forecasting Power of Indicators

  1.4. Composite Index

2. Applications


Chapter 4
EWS for Financial Industry and Institutions

1. Daily Financial Soundness Indicators

2. Early Warning Models of the FSS

  2.1. Risk Index Model

  2.2. Leading Risk Index

  2.3. Early Warning Models for Individual Financial Institutions

3. CAEL Rating System

  3.1. To Select CAEL Candidate Indicators

  3.2. To Set Rating Intervals of Each Indicator

  3.3. To Compute Composite Rating

4. Macroprudential Indicators


Chapter 5
Policy Recommendations for EWS

1. Qualitative Monitoring

2. Other Policy Recommendations·


Chapter 6

Capital Flows and Crisis Prevention Policy

1. Foreign Exchange Policy

2. Prudential Regulations

3. Capital Controls

4. Sovereign Wealth Fund

5. Bilateral Swaps and Global Financial Safety Nets (GFSNs)


Chapter 7








Since the Mexican crisis in 1994 and the East Asian crisis in 1997, interest in developing early warning systems has soared in emerging market countries. The global financial crisis also increased interest in developing an effective early warning system. Indeed, immediately after the onset of the global financial crisis, the G20 asked the IMF and the FSB (Financial Stability Board) to establish an early warning system for a periodic assessment of system-wide risks.


 A financial crisis is a combined result of vulnerability of an economy and specific trigger events. Given that past experience tells us that trigger events are almost unpredictable, an early warning system should aim to identify vulnerabilities of an economy. Thus, IMF(2010) points out that an early warning system is a “flag-raising” exercise, signaling trends that could make markets or countries vulnerable to unanticipated events. If an early warning system can identify vulnerabilities and assess downside tail risks sufficiently in advance, preemptive policy measures can be implemented to reduce the risk of a crisis.


 As a part of the effort to prevent another crisis from taking place, the Korean government decided to build up a national early warning system. In 2004, the Presidential Office in Korea launched the project of establishing the national early warning system and it has been in operation since the next year. The national early warning system covers seven different sectors in the economy to detect early symptoms of crisis in each sector. In addition, the system is designed to monitor potential spillover effects across different sector in a more comprehensive way. The seven sectors are foreign exchange market, domestic financial market, domestic financial institutions and industry, petroleum, commodity market, labor market, and real estate market. Each sector is equipped with different quantitative early warning models independently developed by different public research institutions. Among the seven sectors, early warning systems for the foreign exchange market and financial industry are particularly important.


 The early warning system for currency crisis was developed and operated by the Korea Center for International Finance (KCIF). The KCIF was established in 1999 by the Korean government and the Bank of Korea. Having learned that the Asian financial crisis was caused by a foreign currency liquidity problem, the Korean government needed a public institution that could assist the government in preventing currency crises. Thus the main responsibilities of the KCIF are monitoring international financial markets and operating an early warning system for currency crisis. The early warning models in the KCIF employ the signal approach which was first developed and used by Kaminsky and Reinhart (1999). The underlying assumption of the signal approach is that the economy shows unusual behavior shortly before a financial crisis and that this pattern would recur in the next crisis in a systematic way.


 The Financial Supervisory Service (FSS) in Korea developed the Financial Industry Early Warning System (FIEWS). The early warning system in the FSS includes the Daily Financial Soundness Indicators (DFSI) and the early warning models. The DFSI, also called the Handy Index Assessment System, is a real time crisis detection system using a small
range of handy indices. The early warning models in the FSS include six different models for nine financial sectors and have been in operation since 2007.

 The global financial crisis highlights that macroprudential policy is important to limit the vulnerabilities of the economy. To implement macroprudential policy, which aims to achieve the safety and soundness of the financial system as a whole, the authority needs early warning indicators to identify when bank asset growth is excessive. The credit-GDP gap and the ratio of core to noncore liabilities, among other indicators, may point to financial cycle phase, thus serving as useful guidelines for macroprudential policies.

 This report also makes several policy recommendations on effective build-up and operation of early warning systems. First, a crisis management manual is required, specifying contingency policies depending on the riskiness. Second, continuous update and revision are important for better performance of the early warning models. Third, as high
quality leading indicators are essential prerequisites for a successful early warning system,
the government should improve the overall statistical capacity by enhancing the expertise of staff members, adapting new methodologies and upgrading the IT infrastructure. Fourth, it is recommended that simple models are developed before more sophisticated models. In the long-term, auxiliary models are required as supplementary tools to minimize model risks.


 It is true that an early warning model is useful for timely assessment of the risk in the economy, yet it is also clear that all the quantitative models cannot be perfect. This suggests that the governments should strengthen qualitative monitoring on financial markets and institutions. Qualitative monitoring helps identify imminent risk and supplements the
quantitative models.

 Massive capital inflows may result in economic overheating and asset price bubbles, and the following sudden reversal of capital flows is likely to cause a foreign exchange liquidity problem and, if severe, trigger a currency crisis. This report also describes appropriate policy responses to surges in capital inflow. First, the basic direction of foreign exchange
policy is to maintain flexibility of the foreign exchange rate and hold adequate stock of foreign exchange reserves. Past crisis episodes demonstrate the importance of foreign exchange reserves as a self-insurance for the liquidity problems of foreign exchanges.

Second, in order to maintain sound a banking system and thereby to prevent a banking crisis, policymakers may strengthen prudential regulations to contain the risks generated by crossborder financial transactions. Third, if these policies are not sufficient, capital controls can be introduced to manage massive capital inflows. Fourth, commodity exporting countries may consider establishing a sovereign wealth fund (SWF). Since commodity exporting countries are vulnerable to swings of commodity prices, a well-managed commodity-based sovereign wealth fund can shield the economy against volatile commodity prices. Fifth, emerging market countries can access the IMF’s lending facilities including the multicountry Flexible Credit Line (FCL) and the Precautionary Credit Line (PCL) before the outbreak of a crisis. They can also establish and use regional financial arrangements.



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