4 - Early Warning System of Finance Stress For India Guru Review of Applied Economics 2016

International Review of Applied Economics
ISSN: 0269-2171 (Print) 1465-3486 (Online) Journal homepage: http://www.tandfonline.com/loi/cira20
Early warning system of finance stress for India

Anuradha Guru
To cite this article: Anuradha Guru (2016) Early warning system of finance
stress for India, International Review of Applied Economics, 30:3, 273-300, DOI:
10.1080/02692171.2015.1102206
To link to this article: http://dx.doi.org/10.1080/02692171.2015.1102206
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Date: 27 July 2016, At: 03:20
International Review of Applied Economics, 2016

VOL. 30, NO. 3, 273300
http://dx.doi.org/10.1080/02692171.2015.1102206
Early warning system of finance stress for India

Anuradha Guru
Department of Commerce, Government of India, New Delhi, India
Downloaded by [Central University of Tamil Nadu] at 03:20 27 July 2016
ABSTRACT
This paper develops a composite Financial Sector Stress Index (FSSI) for
the Indian financial system as a whole by combining three sub-indices
for currency markets, the banking sector and the stock market, to
gauge the level of financial stress in the Indian financial system. Such a
continuous-valued index can be used to track the varying magnitude
and dynamics of financial stress in the country over time. The FSSI
provides an ordinal measure of stress in the financial system. Changes
in the FSSI are useful in assessing whether financial stress is rising or
falling, and in ascertaining extreme events in the financial system.
The paper, then, objectively identifies extreme stress periods in the
financial system based on movements of the index. We recognise that
such extreme/tail events pose special econometric challenges as they
are rare events but with a big impact. Hence, we use a more robust
and analytically sound technique of Extreme Value Theory (EVT) to
identify extreme events in the financial system. Once the extreme
stress events are identified, we use a binary dependent variable model
(logit model) to estimate the impact of various macroeconomic and
financial variables on the probability of extreme stress in the financial
system.
ARTICLE HISTORY
Received 25 February 2015

Accepted 28 September 2015
KEYWORDS
Exchange market pressure;

financial sector stress;
Extreme Value Theory; peakover-threshold approach;
early warning systems of
financial crises
JEL CLASSIFICATIONS
C10; G10
1.Introduction
Financial crises, like, contagious disease, threaten not only the host organism, namely the
financial market, but the entire economic environment in which that host resides. (Eichengreen
and Portes 1987)
The long history of financial crises has lent importance to the study of their causes and the
identification of explanatory variables for such crises. The most recent sub-prime crisis
of 20072009 has, once again, emphasised the importance of understanding, measuring
and predicting financial crises, especially considering that with ever-increasing volumes
of transactions in financial markets, increasing inter-linkages of the markets worldwide
and complexity of new instruments coming to the markets,1 any kind of financial crisis is
proving costly for domestic as well as the world economy. Researchers have been engaged
in recognising what variables, if any, can serve best as quantitative measures of financial
stress in various economies. While each episode of financial crisis is different in its origin,
CONTACT Anuradha Guru

2016 Taylor & Francis
anu_guru@nic.in
274
A. Guru
causes and impact, some common trends can be deciphered upon detailed study. Reinhart
and Rogoff (2009) make an important observation in this regard: This time may seem
different, but all too often a deeper look shows it is not. Encouragingly, history does point
to warning signs that policy-makers can look at to assess risk if only they do not become
too drunk with their credit bubble-fuelled success and say, as their predecessors have for
centuries, This time is different.
Studies show that certain financial and economic variables tend to behave differently in
the run up to a crisis. Based on such studies and in light of the understanding and experience gained over time from observing the patterns of occurrence of financial crises, Early
Warning System (EWS) models for financial crises have been developed. Characteristically,
an EWS has an empirical structure with financial and economic indicators that are likely
to contribute to an economys vulnerability to financial crisis. The focus of EWS literature
is on detecting vulnerabilities of the economy prior to a crisis as opposed to attempting to
predict the exact timings of crises or triggers of crises.
In this paper, we build an EWS for the Indian financial system. This will contribute to the
sparse literature on the early warning system of financial crises for developing countries in
general and for India in particular. While building an EWS for Indias financial system, we
recognise that while there have been no crisis events in the Indian economy in the common
usage2 of the term and the manner in which it is defined in the literature, there have been
instances of extreme stress in the financial system. We hypothesise that the probability
of occurrence of such extreme stress events are affected by certain macroeconomic and
financial variables. In addition, given the increased integration of the Indian economy to
the world economy, the likelihood of a future extreme stress event in the country cannot
be ruled out. Thus, it would be useful to put together a framework for detecting signs of
impending stress situation in the Indian financial system using such indicators of underlying
macroeconomic and financial vulnerabilities. This framework would require a quantitative
measure of financial stress. It would need to ascertain whether certain macroeconomic and
financial variables can explain the probability of extreme movements of this quantitative
measure.
The rest of the paper is organised as follows. Section 2 presents a literature survey of
EWS models. In Section 3, the methodology for the study is detailed. Section 4 builds the
EWS and presents key results. Section 5 presents the summary and conclusions of the study.
2. EWS models: a literature review

EWS models of financial crises help in identification of conditions and behaviour of certain macroeconomic and financial variables that can antedate the inception of a financial
crisis. These early warning models exploit the systematic relationships visible in historical
data between economic and financial variables associated with the build-up to a crisis and
the actual incidence of crisis. The aim of such an exercise is to forewarn the policy makers
about the likelihood of an impending crisis so as to take pre-emptive measures. According
to Edison (2000), an EWS consists of a precise definition of a crisis and a mechanism for
generating predictions of crises. Gramlich et al. (2010) conceptualise EWSs as:
functional, data-driven approaches that draw attention to variables associated with past crises in
order to alert policy makers of potential for future crises. They are grounded in economic theories of financial crisis and are designed to provide risk alerts on an objective, systematic basis.
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The underlying assumptions in building EWS models are (a) there is causality between
crises and certain economic and financial variables and (b) these economic and financial
variables can be identified ex-ante. However, it is important to bear in mind that EWSs
cannot predict a crisis. They can, at best, detect vulnerabilities in underlying economic or
financial variables and sound a warning. In this regard, Ghosh, Ostry, and Tamirisa (2009)
make an important observation that all crisis events reflect the underlying vulnerabilities
in the system and a specific crisis trigger.3 This, in effect, implies that because specific
event(s) that trigger the crisis is (are) unpredictable, so are crises. Thus, an early warning
effort can only realistically aim to identify underlying vulnerabilities without which crises
are unlikely to occur.
The empirical literature has attempted to identify statistically significant explanatory
variables of an impending crisis. The methodologies used in this literature can be grouped
into two main categories, namely (a) non-parametric indicators or signals approach; (b) a
parametric linear regression or limited dependent variable approach.4
The signals approach compares the behaviour of a set of selected variables in the period
preceding the crisis with their empirical patterns in normal times and identifies those variables whose distinctive performance could be used to help assess the likelihood of a crisis
or, in other words, send an early warning signal of an approaching crisis. What is meant by
an early warning is defined by specifying an optimal threshold for each indicator. When
an indicator exceeds this threshold, then that indicator is said to have issued a signal that
a crisis could take place in the next h months, called the crisis or signalling window. The
usefulness of a variable to serve as an early indicator of crisis is judged by its noise-to-signal ratio. The formative work on this approach to predict currency crises was the leading
indicators5 model of Kaminsky, Lizondo, and Reinhart (1998), followed by Kaminsky and
Reinhart (1999), Goldstein, Reinhart, and Kaminsky (2000), Edison (2000), etc.
A second strand of empirical literature on EWSs utilises parametric binary regression
models, namely logit/probit models. The methodology assumes that the probability that a
crisis occurs is a function of a vector of explanatory variables. A logit/probit econometric
model is fitted to the data and an estimate of the crisis probability is obtained by maximum
likelihood method. Thus, the model produces estimates of the probability of crisis, making
use of the information in the explanatory variables. The impact of each of the possible
covariates of crises, as hypothesised, on the crisis probability is derived by testing the significance of each of their coefficients. Examples of such studies are Eichengreen, Rose, and
Wyplosz (1995); Frankel and Rose (1996); Kamin, Schindler, and Samuel (2001); Lestano,
Jacobs, and Kuper (2003) for currency crises and Demirg-Kunt and Detragiache (1998)
and Hardy and Pazarbasioglu (1998) for banking crises.
3. Methodology steps in construction of an EWS

The construction of an EWS of financial crises involves the following stages, namely defining
the notion of a crisis/stress event; drawing up a list of potential variables that can explain
crisis/stress events and deciding the criterion to classify the behaviour of a variable as either
a signal of a crisis/stress event or normal event.
As a first step, we need to have a well-defined notion of what we are classifying as a crisis/stress event. For this purpose we construct a Financial Sector Stress Index (the FSSI),
putting together crises indices for currency, banking and stock markets in India over the
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A. Guru
period April, 2001 to December, 2012. The sub-indices for the three segments of the financial
markets are constructed based on available literature.6 Briefly, the various segment specific
indices we construct are as follows.
For the currency markets, we construct an Exchange Market Pressure Index (EMPI),
which is a composite measure incorporating at least two of the following three variables,
namely the exchange rate, international reserves and interest rates.7 The computation of
the EMPI is as follows:
EMPIt = et e rt + e it ,
(1)
r
i
where, et=relative change in nominal exchange rate of Indian rupee against the US dollar
(USD) in month t, rt=relative change in the ratio of gross forex reserves to narrow money
(or reserves-to-M1) in month t, it=relative change in interest rate in month t, e, r and i
are the standard deviations of et, rt and it respectively.
For the banking sector, with the aim of constructing a quantitative index comprising of
variables that reflect potential symptoms of banking stress in India, we use the following
variables, namely the ratio of gross non-performing assets to gross advances of scheduled
commercial banks in India (GNPA), Capital to Risk Weighted Assets Ratio (CRAR) and
Returns on banking sector index of the National Stock Exchange (BIR).
We define the Banking Sector Stress Index (BSSI) as:
BSSIt = gt
g
c
ct
g
b
bt
(2)
where: gt is the rate of change of gross non-performing assets to gross advances of scheduled commercial banks ct is the rate of change of Capital to Risk Weighted Assets Ratio as
per BASEL-I requirements at period t; bt is returns on NSE CNX Bank index in period t.
g, c and b are standard deviations of gt, ct and bt respectively. The weighting scheme
for this index is along the lines of the weighing scheme used for EMPI construction. BSSI
increases with an increase in GNPA and falls with an increase in CRAR and BIR. Higher
values of the index indicate higher stress. We use monthly data for the period April 2001
to December 2012 to construct this index.
In order to quantify extreme stress in stock markets, we construct a CMAX index along
lines of available literature.8 The measure compares the current value of a stock market index
with its maximum value over the previous T periods to gauge the extent of a fall or rise
in the stock markets. The advantage of using this measure is that it increases the visibility
of sharp declines in stock prices making it easier to date a crisis in comparison to looking
at movements of raw stock market indices. The CMAX measure is calculated as follows:
CMAXt =
It
max[I (Itj j = 0, 1, ....T)]
(3)
where It is the monthly average stock market index level at time t. The rolling maximum
in the denominator is defined as the maximum monthly average stock market index level
over a short period of 12months (i.e. T=12) to avoid losing too many data points. The rate
277
of change of CMAX then serves as a measure of stress in the stock markets. We name this
measure the Stock Market Stress Index (SMSI), given by:
SMSIt = (CMAXt CMAXt1 )CMAXt1
(4)
The FSSI for India is constructed by combining the above three indices. Such a combined
index seems to be practical in the wake of growing domestic integration of the various
segments of the Indian financial system. Various sectors of the Indian financial system were
largely segmented by regulatory and institutional barriers prior to 1990s. However, they
were gradually liberalised through a number of reforms commencing from 1991.9
We build the FSSI using principal components analysis (PCA)10 method since we suspect
that the different sub-components of the index are likely to be correlated and affected by a
common factor. The weights for EMPI, BSSI and SMSI to be used to combine into a FSSI,
are obtained from the eigenvector corresponding to the largest eigenvalue of the correlation
matrix of the three components. The total variance accounted for by the first PCA is given
by the value of the largest eigenvalue of the correlation matrix. We use the first principal
component as the overall financial sector stress index representing the common systematic
risk in the three sub-market indices.
Having constructed a FSSI for India, we need to have a well-defined notion of what we
are classifying as a crisis/stress event. Researchers have used arbitrary- or normal-distribution-based thresholds for the indices of crises that they have constructed for dating the crises
(Eichengreen, Rose, and Wyplosz 1994, 1995; Kaminsky, Lizondo, and Reinhart 1998). We
use the Extreme Value Theory (EVT) to identify extreme stress events in the Indian financial
system using the overall FSSI that we shall be constructing. The use of EVT in identifying
extreme stress events in the financial markets is relatively new. It is a special branch of
probability theory that deals with the asymptotic behaviour of extreme observations of a
random variable. It is useful because it provides techniques for estimating models that predict events occurring at extremely low probabilities, usually referred to as extremes or tail
events. This approach takes into account the non-normal behaviour of financial time series
and hence proves to be a more objective manner of dating crises periods. Studies that have
used the EVT based approach have found that it is better able to identify and characterise
crisis events (e.g. Pozo and Dorantes 2003, Lestano and Jacobs 2007).
Statistically, extreme positive observations of the FSSI can be considered as indicative of
high stress in the financial system as a whole. Extreme observations are rare in nature, i.e.
they occur with a very small probability. Our definition of a financial sector stress entails
pre-specification of this small probability. If we pre-specify the probability of a crisis event
at level p (p being very small), a value of the index series that exceeds its 100(1p)th percentile will indicate a stress situation. Thus, with pre-fixed (small) probability p of a crisis,
the 100(1p)th percentile provides a threshold value for the identification of stress/crisis
events. If the observed value of each of the index series is more than this threshold, then
the financial system can be considered to be under stress. If the crisis probability is fixed
at 0.05 and 0.01, then the 95th percentile and the 99th percentile on the distribution of the
FSSI series serves as threshold for identification of a stress situation. These quantiles are
located in the tail regions of the distribution; hence, identification of stress events requires
the knowledge of the tail behaviour of the distribution of the FSSI series.
Specifically, we employ an EVT method, known as Peaks-Over-Threshold (POT) method,
for estimating the tail quantiles. The POT method is based on the Pickand-Balkema-de
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A. Guru
Haan theorem that establishes that the distribution of the observations (of a random variable), in excess of certain high threshold u (referred to as peaks-over-threshold u) can be
approximated by a Generalized Pareto Distribution (GPD), regardless of the distribution
of the variable, provided the underlying distribution satisfies the Fisher-Tippett theorem.11
The GPD is a two-parameter distribution, given by
{
G, (z) = 1 (1 + z)1 for 0
{
(5)
= 1 exp(z)for = 0
where >0 and z0 when 0 and 0z / when <0.
The scale parameter is always positive, while the shape parameter can be positive,
negative or zero, depending on the underlying distribution. When >0, it implies that the
underlying distribution belongs to the Frechet class (a family of fat-tailed distributions),
when =0 it implies that the underlying distribution belongs to the Gumbel class (thintailed distributions) and <0 implies that the underlying distribution belongs to the Weibull
family (distributions without a tail). Thus, the estimated shape parameter of the GPD
fitted to the peaks-over-threshold can be used to judge the tail-thickness of the underlying
distribution. In the POT method, first a threshold u is identified to define the beginning
of the tail region. Then a GPD is fitted to the peaks or excesses over the threshold u, by
using a Maximum Likelihood (ML) procedure. Once the GPD parameters are estimated
for the exceedances of a threshold u, the pth quantile on the tail of the distribution of the
underlying variable X can be estimated by the following formula:
xp = +
n
{ (1 p) 1}
k
(6)
where n is the total number of observations and k is the number of observations above the
threshold u. and are the maximum-likelihood estimates of the GPD parameters and p
is the stress probability.
Thus, using the POT approach one can parametrically estimate any tail-quantile of the
underlying FSSI distribution. If the stress probability is fixed at 0.05, then the 95th percentile
will serve as the stress-threshold while if it is 0.01, then the 99th percentile will be the stress
threshold. Using formula (6), the entire tail region can be estimated. While implementing
the POT approach, the choice of an optimal threshold level u, that defines the start of the
tail region, can be a big challenge.12 Researchers using the POT approach have tackled this
challenge in various ways. 13
Further, we suspect that the FSSI series may display time varying dynamics in mean
and/or variance. If its variance is time varying, we would need a methodology to calculate
time-varying tail quantiles on its probability distribution. To do this, we shall follow McNeil
and Frey (2000) who propose a method for estimating risk measures describing the tail of
the conditional distribution of a heteroscedastic and fat-tailed financial return series. The
authors follow a two-step approach in modelling the tail of return distributions. Step one
is to fit an appropriate ARMA-GARCH model on the series using pseudo-maximum-likelihood (PML) estimation14 to obtain estimates for the conditional volatility and ensuring
that the residuals series from the model is i.i.d., although with heavy tails. For this, we need
to have a specification of the time series dynamics of the returns series15 in order to obtain
an i.i.d. residual series to which we can apply the EVT analysis. If Xt is the stationary time
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series representing the FSSI, we assume that the series can be described by the following
time series process:
xt = t + t Zt
(7)
where t describes the time varying mean and t is the time varying volatility dynamics and
Zts are strict white noise residuals with zero mean, unit variance and cumulative distribution
function Fz(Z). The application of the POT approach to residuals requires that Zt should
be i.i.d., so that it is critical to have appropriate specifications of t and t such that Zt are
free of any time dependence.
As a first step towards estimation of a GPD using POT technique, we need to define a
threshold u, which marks the distinction between the centre and the tail of the distribution. As noted earlier, a number of methods have been used by researchers to arrive at the
value of threshold u in the POT approach.16 We consider the largest 20% of the FSSI series
values to be extreme observations, i.e. the tail-threshold u is chosen at a value such that the
probability of the FSSI being higher than this is 0.2. We use a 20% threshold in the interest
of having enough observations in the tail for a good GPD fit, keeping in view the total
number of observations we have. We then fit a GPD to the excesses over this u for the FSSI
and use the estimated GPD parameters to compute zq (which is the upper qth quantile of
the marginal distribution of Zt) given by the 95th percentile (for crisis-probability=0.05)
and the 99th percentile (for crisis-probability=0.01). This is fitted in equation (7) to get
the time varying conditional quantiles, xqt . We then compare xqt with xt+1, for q = {0.95 and
0.99}, wherever xt+1 > xtq, in other words, when the index observation at time t+1 exceeds
the qth quantile at period t, it implies the observation is an extreme observation signifying
a stress situation in the financial system as a whole.
Having identified the crisis events, the next step is to ascertain macroeconomic and
financial variables that are statistically significant in explaining the probability of a financial
crisis/extreme stress as measured by the FSSI. We select such variables, based on some a
priori assumptions and available literature on the likelihood of such variables impacting the
probability of a stress event in the Indian context. Our aim in selecting a list of independent variables for the model is to have a parsimonious model that has reasonable predictive
power for past (i.e. in-sample) as well as future crises (i.e. out-of-sample). The focus of our
study is on the likely impact of fundamentals of the Indian economy on the probability of
financial stress. These indicators are then put in a regression framework to ascertain if they
are significant in explaining a stress event.
Further, some of the potential explanatory variables used in the literature already form
part of the FSSI we have constructed so these cannot now be included as regressors.17 Our
choice of variables is also guided by the availability of consistent data over time and at the
desired monthly frequency.18 For some of the data available on a quarterly frequency, such
as the GDP and total external debt, intrapolation is carried out to get a monthly series for
the study.
Instead of estimating a single logit regression with a number of regressors, we divide our
set of independent variables into three groups, namely macroeconomic, external sector and
financial sector variables and estimate three regressions. From each of these regressions,
the statistically significant variables are then selected and put into a final fourth regression
to ascertain the significant variables in explaining the probability of extreme stress events
in the Indian financial system. The set of variables used to form the vector of independent
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A. Guru
variables for our binary dependent variables model are: (i) macroeconomic variables, these
are Gross Domestic Product (GDP), Inflation, Index of Industrial Production (IIP) and
Gross Fiscal Deficit (GFD); (ii) external sector variables (including Gross External Debt
Brent Crude Oil Price Index, MSCI Emerging Markets Index and Terms of Trade); and (iii)
financial sector variables (Ten-year benchmark GOI bond yields: Total Bank Credit Total
Bank Deposits Foreign Institutional Investments)
The rationale for including these variables as independent variables in the EWS for India
may be seen in the Appendix 1. As the variables are considered over time, we need to check
for their stationarity. Using non-stationary data series in the regression may lead to the
problem of spurious regressions and invalidity of traditional statistical tests. In order to
ensure validity of our regressions, all non-stationary variables are transformed into a rate of
growth (or change) before including them in the regression. Using rate of change instead of
the levels can also provide better interpretation of results. All of the transformed variables
are found to be stationary. The data sources, transformations of the variables, notations
and expected signs of the above-mentioned variables used in the logit regression are also
summarised in the Appendix 1.
The next step requires arriving at a critical/threshold probability beyond which a warning
signal of a crisis/extreme stress event should be issued by policy makers of the country.
In other words, we need to specify whether the estimated probability of extreme financial
stress/crisis from the parametric model is large enough for policy-makers to issue a warning
and take preventive actions. Choice of this critical cut-off probability or noise-to-signal level
is crucial as there are costs involved in issuing a false alarm and taking preventive action or
missing a crisis. This threshold or critical probability level has been calculated differently by
researchers. In a parametric framework of EWS, Demirguc-Kunt and Detragiache (1999)
followed a decision maker's loss function approach to arrive at the threshold probability
level. They suggested that the choice of threshold probability to call a crisis should depend
upon the probability of type I and type II errors associated with the threshold, the unconditional probability of a crisis and the cost to the decision-maker of taking preventive action
relative to the cost of missing a crisis. Wong, Wong, and Leung (2007) assumed that the
policy-makers place equal weights on type I and type II errors. Hence, they selected the
threshold probability , which minimised the sum of in-sample type I and type II errors.
We follow Wong, Wong, and Leung (2007) and IMF (2013) and choose that level of
which minimises the sum of in-sample type I and type II errors. While doing so, the underlying assumption that we make is that the policy-makers, namely the Central Bank and the
Government, would like to place equal weights on the errors of missing an extreme stress
event and issuing false alarms.
4. EWS for India

We construct the currency, banking and stock market stress indices and the overall FSSI
using PCA, as detailed in Section 2. The results of PCA, namely the eigenvalues and eigenvectors are reported in Table 1. The first PC, obtained using the three sub-indices, is able
to explain 56.3% of the variance. The eigenvalue of first PC is the highest at 1.688, so that
it explains most of the variance in the variables. The eigenvectors or weights for the three
components are 0.556 for BSSI, 0.553 for EMPI and () 0.620 for SMSI. The weights of
BSSI and EMPI are positive, which is in accordance with our expectation that an increase
281
Table 1.Principal components analysis.

Principal components
Eigenvalues
First PC
1.688
Second PC
0.743
Third PC
0.569
Eigenvector of first PC (loadings or weights)
BSSI
0.556
EMP
0.553
SMSI
0.620
Proportion of total variance explained by respective components

0.563
0.248
0.189
6
4
2
0
-2
-4
Figure 1.Movement of FSSI2 Series (April 2001 to December 2012).

Table 2.Descriptive statistics and time series tests of FSSI2 series (April 2001 to December 2012).
Mean
Maximum
Minimum
Std. Dev.
Variance
Skewness
Kurtosis
Jarque-Bera
Stationarity tests
ADF test statistic
PP test statistic
Autocorrelation test
Ljung-Box Q statistic for the series
Q(5)
Q(10)
Q(20)
Q(30)
Q(40)
Heteroscedasticity test
Ljung-Box Q statistic for squared series
Q(5)
Q(10)
Q(20)
Q(30)
Q(40)
0.000
4.539
3.369
1.304
1.700
0.324(0.10)
4.226(0.01)*
11.297(0.004)*
9.773 (0.00)*
9.773 (0.00)*
12.152 (0.033)**
12.683 (0.242)
20.892(0.424)
26.958(0.625)
45.443(0.256)
14.758(0.011)*
20.351(0.026)**
41.850(0.003)*
47.794(0.021)**
52.672(0.086)
Figures in the brackets are p-values.

*Denotes statistical significance at 1% level of significance.
in their values leads to an increase in overall financial market stress. The weight of SMSI is
negative, which is also intuitive, and along expected lines that a rise in stock market index
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A. Guru
PACF of SS.1
FSSI
0.1 0.2
-0.1
PACF
0.6
-0.2 0.2
ACF
1.0
ACF of FSSI
10
lag
15
20
20
PACF
-0.1
0.1
0.3
1.0
0.6
ACF
-0.2 0.2
15
PACF of squared
SS.1FSSI
ACF of squared FSSI
10
lag
10
lag
15
20
10
lag
15
20
Figure 2.Autocorrelation and partial autocorrelation functions of FSSI series.

Table 3.Time series specification of FSSI MA(1)-ARCH(1) model.
Estimate
Standard error
p-value
C
MA(1)
Variance equation
Parameter
0.041
0.459
0.117
0.080
0.727
0.00*
C
ARCH(1)
DW = 2.348
AIC =3.149 ; SIC =3.233
Q-Stat for residuals:
Q(20)= 22.018 (0.283)
Q(30)= 27.530 (0.543)
Q(40)= 35.342 (0.637)
ARCH-LM test for heteroscedasticity
0.757
0.580
0.145
0.165
0.00*
0.00*
1.511 (0.221)
*Denotes statistical significance at 1% level of significance.
will lead to lower stress in the financial system as a whole. With these weights, the FSSI
series is constructed as the first principal component of the three variables.
A graphical presentation of the movement of this index series is shown in Figure 1.
The FSSI series attains its maximum value of 4.540 in August 2007. Other high values of
the index seen are 4.280 (October, 2008); 2.676 (June, 2006); 2.565 (December, 2011) and
2.534 (August, 2011). The descriptive statistics and time series properties of FSSI series are
reported in Table 2. The FSSI series is stationary, non-normal and not i.i.d.
4.1. A Peaks-over-Threshold analysis of FSSI
We use the GPD/POT methodology to identify extreme stress events in the Indian financial system, as detailed in Section 2, using the FSSI constructed above. For the purpose,
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Table 4.GPD estimation on the residuals of the MA(1)-ARCH (1) fit on the FSSI series (right tail).
Percentage
of observations above
threshold
20%
Number of
observations above
threshold
Threshold
(u)
Shape parameter ()
Scale parameter()
95th percentile
99th percentile
28
0.8549
0.0358(0.1619)
0.8179(0.2014)
2.0414
3.4666
Figures in the brackets are standard errors of the estimates.
we need to first check if the FSSI series is i.i.d and, if it is not, we need to model its time
series structure and use the i.i.d residuals from the appropriate model for the purposes of
the GPD/POT methodology.
The autocorrelation and partial autocorrelation functions of the FSSI series and its square
values are reported in Figure 2. The graphs show spikes at lower lags implying an ARMAGARCH process in the series.
Thus, we follow the McNeil and Frey (2000) methodology for estimating risk measures
describing the tail of the conditional distribution of a heteroscedastic and fat-tailed financial return series. We fit various ARMA-GARCH models to the FSSI series and choose the
MA(1)-ARCH(1) model as the best fit model based on AIC-SBC criteria (Table 3). Both
the MA(1) and ARCH(1) coefficients are significant at the 1% level of significance. The
diagnostic checks on the residuals of this equation show that there is no autocorrelation
or heteroscedasticity in the residuals, as indicated by the insignificant ARCH-LM statistic.
Thus, the model fits the FSSI series well. We can now use the i.i.d. residuals of this model
to estimate a (GPD) as suggested by McNeil and Frey (2000).
In the POT method, we need to first identify a threshold u to define the beginning of the
tail region of the i.i.d. residuals from the above MA(1)-ARCH(1) model fitted on the FSSI
series. Then the GPD parameters have to be estimated for the exceedances of the observations over the threshold u. The pth quantile on the tail of the distribution of the underlying
variable (i.e. FSSI) can then be estimated by formula (6) presented above.
As explained earlier, we consider the largest 20% of the residuals from the above
MA(1)-ARCH(1) model to be extreme observations, i.e. the tail-threshold u is chosen
at a value such that the probability of the residuals series being higher than this is 0.2.19
The value of u chosen in this manner is 0.8549. We then fit a GPD to the excesses over
u=0.8549 and use the estimated GPD parameters to compute zq, which is the upper
quantiles (95th and 99th percentiles) of the marginal distribution of the white noise
residuals. In Table 4 we report the results of the GPD estimation with 20% threshold.
The estimated shape and scale parameters are reported in columns 4 and 5 and the
estimated 95th and 99th quantiles on the i.i.d residuals are reported in columns 6 and
7 of the table. The shape parameter is found to be 0.0358. The positive shape parameter indicates the residual series follows a Frechet or heavy-tailed distribution. This is
in accordance with our expectations given that the FSSI series is also a leptokurtic or
heavy-tailed distribution.
The last two columns of Table 4 report the 95th and 99th percentiles on the distribution
of the i.i.d residuals of FSSI series. z0.95is estimated to be 2.0414 and z0.99 is estimated to
be 3.4666. These figures are plugged into equation (7) above to calculate the time varying
conditional quantiles (xtq) for q of 0.95 and 0.99.
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The identification of extreme stress events in the financial system, according to our
definition, entails comparing xtq with xt+1 for q={0.95 and 0.99}. Wherever xt+1>xtq or in
other words, when the index observation at time t+1 exceeds the quantile at period t, it
implies the observation is an extreme observation signifying a stress situation. If our model
specification is adequate, then with 140 monthly observations, we expect about seven stress
episodes with stress probability fixed at 0.05 and about two episodes of extreme stress
situations with a stress probability of 0.01. Following the above methodology, we are able
to identify eight episodes of stress at 0.05 probability and two episodes of stress with 0.01
probability during the period April 2001 to December 2012. Thus, the GPD/POT approach
is found to perform reasonably well in estimating the number of extreme stress months.
The months of extreme stress in financial markets using 95th percentile are as follows:
June 2006; March 2007; August 2007; March 2008; June 2008; October 2008; August 2011
and December 2011. The 99th percentile identifies August 2007 and October 2008 as periods
of extreme pressure in the Indian financial system.
4.2. Regression framework: binary dependent variable model
We use a binomial logit regression approach to obtain statistically significant macroeconomic and financial sector variables, which can explain the probability of crisis/extreme
stress. The impact of each of these possible covariates of crises, as hypothesised, on the
crisis/stress probability is obtained by testing the significance of each of their coefficients.
The dependent variable is binary and measures whether there is an extreme financial
market stress situation or not. We convert the FSSI series into a binary variable series, which
takes a value of 1 if there is an extreme stress situation and 0 in case of no extreme stress. We
call this dummy variable FSSI_STRESS. It takes a value of 1 for the eight identified months
of extreme stress (at 0.05 probability) in the sub-section above. The time series dynamics
of the FSSI series, reported in Table 3, show that the series has a MA(1) lag structure. Thus,
we give a value of 1 to FSSI_STRESS for the month preceding each of the identified extreme
stress months given that its present value depends on one-period preceding values. Thus,
we have 16 out of 140 monthly observations of FSSI_STRESS take the value 1 (denoting a
period of extreme stress or a tail event) and rest of the 124 observations take the value 0.
In other words, we use a crisis window of 2months.
The above manner in which we construct our dependent variable is similar to other
studies that have used the regression approach to construct EWSs expect for the length of
the signalling horizon. Various studies have used a crisis horizon of 12months (e.g. Berg
and Pattillo 1999; Bussiere and Fratszcher 2006) or 18months (Duca and Peltonen 2011) or
24months (e.g. Comelli 2013; Ho 2008; Kaminsky, Lizondo, and Reinhart 1998). They have
given a value of 1 to the dependent crisis variable if a crisis is observed within the next 12
or 18 or 24months. Thus, in effect, these studies give a value of 1 to the binary dependent
variable for all 12/18/24months preceding a crisis observation. As pointed out by Bussiere
and Fratzscher (2006), choice of the length of crisis window requires balancing two conflicting requirements. A shorter crisis window is desirable given the fact that macroeconomic
and financial variables are likely to show signs of weakness as the financial system is closer
to a crisis situation. Thus, a crisis can be predicted more reliably closer to the actual crisis
observation. On the other hand, policy-makers would prefer to have an early indication
of impending crisis and identify vulnerabilities visible in underlying macroeconomic and
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Table 5.Logit regression with macroeconomic variables (Regression 1).
Variable
Coefficient Std. error z-statistic
p-value
marginal effects
odds-ratio
0.224
0.001
0.075
0.022
0.000
0.042
0.000
0.098
0.994
2.179
0.793
1.000
0.650
0.999
0.008
0.021
1.081
1.243
C
2.326
0.513
4.532
0.000
IIP
0.006
0.121
0.051
0.959
Inflation
0.779
0.462
1.685
0.092***
GDP
0.232
0.180
1.286
0.199
Gross fiscal deficit
0.000
0.000
1.100
0.271
Inflation(12months lagged)
0.430
0.455
0.945
0.345
Gross fiscal deficit(12months
0.001
0.000
1.198
0.231
lagged)
IIP (12months lagged)
0.078
0.127
0.613
0.540
GDP (12months lagged)
0.218
0.206
1.060
0.289
McFadden R-squared
0.063
LR statistic
6.030
Prob(LR statistic)
0.644
All variables are in terms of monthly rates of growth. Inflation is rate of growth of WPI.
***Denotes statistical significance at the 10% level.
financial variables so as to be able to take pre-emptive measures well in advance. Thus, they
would prefer a longer crisis window. Given our relatively small sample size and country
level study, we use a short crisis window of 2months using the fact that our FSSI has lagged
dependence at lag 1. Thus, we use the dependent variable such that it assumes a value of 1
for the crisis month and the month proceeding the crisis month.
The probability of the event of extreme stress occurring, i.e. FSSI_STRESS (denoted
as Y) taking a value of 1, in a logit regression, assumes the following cumulative logistic
distribution function (F):
e0 +X
Pr ob(Yi = 1) = (F(0 + X ) =
1 + e0 +X
(8)
where X is the vector of explanatory variables and is the vector of coefficients.

The logit regression is estimated by using maximum likelihood estimation techniques.
The sign of the coefficients indicate the direction of the relationship between dependent
and independent variables. We can also compute the marginal effects of the explanatory
variables from the logit regressions. The marginal effect of change in independent variable
xj on conditional probability of Yi is given by:
E(Yi X)
= f (xi )j
xj
(9)
where f is the density function corresponding to F. Thus, j is weighted by a factor f that

depends on the values of all of the regressors in X. The equation shows that the direction
of the effect of a change in j depends only on the sign of the j coefficient.
4.3. Results of logit regressions
With FSSI_STRESS as the dependent variable, constructed as detailed in Section 2, we
estimate separate logit regressions for each of the three categories of variables mentioned
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Table 6.Logit regression with external sector variables (Regression 2).
Variable
Coefficient
Std. error
z-statistic
p-value
C
4.244
0.877
4.838
0.000
Gross external debt
1.009
0.359
2.811
0.005*
Brent crude oil
0.104
0.040
2.575
0.010*
price index
MSCI EM index
0.181
0.069
2.600
0.009*
Terms of trade
0.015
0.010
1.544
0.123
Gross external
0.512
0.299
1.714
0.087***
debt (12months
lagged)
Brent crude oil
0.030
0.041
0.746
0.456
price index(12months
lagged)
Terms of
0.003
0.003
0.881
0.378
Trade(12months
lagged)
MSCI EM index
0.104
0.057
1.830
0.067***
(12months
lagged)
McFadden R0.376
squared
LR statistic
36.231
Prob(LR statistic)
0.000*
Note: All variables are in terms of monthly rates of growth.
*, **and ***denote statistical significance at the 1, 5 and 10% levels respectively.
Marginal
effects
Odds-ratio
0.160
0.038
0.004
0.014
2.743
1.109
0.007
0.001
0.019
0.835
0.985
1.669
0.001
0.970
0.000
1.003
0.004
1.109
Table 7.Logit regression with financial sector variables (Regression 3).

Variable
Coefficient Std. Error z-statistic p-value Marginal effects Odds-ratio
C
GOI bond yields
Total bank deposits
Total bank credit
FII investments
GOI bond yields(12months lagged)
Total bank deposits(12months lagged)
16.149
1.533
0.058
0.227
0.000
0.196
0.343
3.688
0.452
0.261
0.220
0.000
0.251
0.269
4.379
3.394
0.222
1.031
0.529
0.779
1.276
0.000
0.001*
0.824
0.302
0.597
0.436
0.202
0.883
0.084
0.003
0.012
0.000
0.011
0.019
0.000
4.632
0.944
1.254
1.000
1.216
1.409
Total bank credit(12months lagged)

FII investments(12months lagged)
0.057
0.000
0.223
0.000
0.255
0.611
0.799
0.541
0.003
0.000
0.945
1.000
McFadden R-squared
LR statistic
Prob(LR statistic)
0.222
21.425
0.006*
Note: All variables are in terms of monthly rates of growth except GOI bond yields.
*Denotes statistical significance at 1% level.
above, namely macroeconomic, external and financial sector variables. A fourth regression
is estimated using only the significant variables from each of these three regressions. In each
regression, we use contemporaneous independent variables, which test the concomitant
indicators of a stress event, and 12months lagged variables to serve as a test of the ability
of regressors to predict the probability of stress 12months in advance. 20 The results are
reported below.
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Table 8.Logit regression with significant variables from regressions 1 to 3 (Regression 4).
Variable
Coefficient Std. error z-statistic
p-value
Marginal effects Odds-ratio
C
Inflation
Gross external debt
Brent Crude oil price index
MSCI EM index
GOI bond yields
Gross external debt(12months
lagged)
MSCI_EM index(12months lagged)
10.275
0.026
0.763
0.105
0.174
0.837
0.407
3.940
0.478
0.322
0.049
0.066
0.528
0.260
2.608
0.055
2.366
2.139
2.643
1.586
1.563
0.009
0.957
0.018**
0.033**
0.008*
0.113
0.118
0.745
0.002
0.055
0.008
0.013
0.061
0.029
0.000
1.026
2.145
1.111
0.841
2.311
1.502
0.062
0.048
1.304
0.192
0.004
1.064
McFadden R-squared
LR statistic
Prob(LR statistic)
0.378
36.462
0.000*
Note: All variables are in terms of monthly rates of growth except GOI bond yields. Inflation is rate of growth of WPI.
*and **denote statistical significance at the 1 and 5% levels respectively.
In the first regression with macroeconomic variables, reported in Table 5, only the coefficient of inflation is significant (at the 10% level of significance) in explaining the logit, i.e.
odds in favour of a stress event occurring. The coefficient of growth rate of WPI or inflation
is 0.779, implying that, holding other variables constant, if inflation increases by a unit, on
average the estimated logit is likely to increase by 0.779, indicating a positive relationship
between the two. The odds ratio is 2.179, suggesting that odds for extreme stress in the
financial system are likely to increase by 2.2 times for a unit change in inflation. The marginal effect of this variable on the logit is 0.075, implying that the probability of an event
of extreme stress occurring is likely to increase by 7.5% with a unit increase in inflation.
The other variables in the regression are not significant in explaining the probability of
financial stress in the economy.
We report the Likelihood Ratio (LR) statistic21 in the table. This statistic tests the joint
null hypothesis that all the slope coefficients (other than the constant) are zero, i.e. it tests
the overall significance of the model. The p-value of the LR test for this regression is not
significant, implying that the regression is not significant. The McFadden R-squared22 statistic is also reported for the regression, which has a small value. Thus, we can infer that
the set of macroeconomic variables does not have significant explanatory power for the
probability of stress events in the Indian financial system.
In Regression 2, we regress the binary stress variable on a set of external sector variables and report the results in Table 6. The significant LR statistic and value of McFadden
R-squared show that the overall fit of the regression is reasonably good.
The coefficient of the growth rate of external debt, growth rate of Brent crude oil price
index, rate of change of MSCI EM index, 12months lagged growth rate of external debt
and 12 monthly lagged rate of change of MSCI EM index are significant in explaining the
probability of stress in the Indian financial system. As per our a priori expectations, a rise
in growth rate of gross external debt and growth rate of Brent crude oil index is found to
lead to an increase in probability of stress, with a marginal effect of 3.8% and 0.4% respectively. The odds ratio for a growth rate of gross external debt is 2.743 and 1.109 for the Brent
crude oil index, implying that odds for extreme stress in the financial system increase by
2.7 times for a unit change in the former and by 1.1 times in case of the latter. Similarly,
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as expected, with a unit increase in MSCI EM index, the probability of financial stress is
likely to witness a fall of 0.7%.
The growth rate of external debt is found to have explanatory powers for extreme stress
12months in advance as well. The coefficient of 12months lagged growth rate of gross
external debt variables is 0.512, with a marginal effect of 1.9%.
The 12 months lagged rate of change of MSCI EM index is positively significant in
explaining the probability of stress in the Indian financial system. A one unit change in the
12months lagged index, on average, is likely to lead to an increase in the estimated logit by
0.104, indicating a positive relationship between the two. This is a counter-intuitive result as
we would expect that a rise in MSCI EM index will be associated with rising stock market
trends on the domestic stock exchanges as well. This is expected to lead to a rise in SMSI,
which will mean a fall in probability of an extreme stress event in the financial system.
However, the level of significance of this variable is low (i.e. 10%).
In Regression 3, reported in Table 7, which uses financial sector variables as regressors,
only the coefficient of 10year GOI bond yields is found to be significant in impacting the
probability of financial stress in the economy. The overall fit of the regression is good with
a significant LR statistic and McFadden R-squared value of 0.222.
Results indicate that a unit increase in bond yields is likely to lead to an 8.4% increase
in probability of financial stress, with the odds for extreme stress increasing by 4.6 times
(odd-ratio of 4.632). This could be explained in terms of fact that the risk premium and
financial crises are interconnected. A rise in risk premium is a sign of uncertainty in the
financial markets. This leads to an increase in required returns and thus interest rates causing investors to invest more in cash or gold and leading to a fall in prices of bonds (or rise
in bond yields) and stocks. There could be another channel of transmission of stress in
the bond markets to stock markets and hence to the financial system as a whole. This has
been pointed out by Hakkio and Keeton (2009) who suggest that the correlation between
returns on stocks and Treasury bonds turn negative during a crisis episode since, during
times of stress, investors perceive stock markets to be riskier than government bonds and
hence allocate more funds to the latter. This appears to the case in Indian financial markets.
We estimate an overall regression with significant variables from each of the above three
regressions and report the same in Table 8. In this regression, we find the rate of growth of
external debt and rate of growth of Brent crude oil price index to have a positive impact on
the probability of financial stress. Their marginal effects on the probability of stress are 5.5%
and 0.8% respectively. Further, as expected, a unit rise in rate of change of MSCI EM index
is seen to have a negative impact on log-odds of an extreme stress event occurring, which
is likely to decrease by 0.174. The overall fit of this regression is good with a significant LR
statistic and reasonably good value of McFadden R-squared.
Summarising, the results of logit regressions with a binary financial stress variable in the
Indian context show that it is the external sector variables that have high significance in
impacting the probability of extreme financial stress in the country. The rate of change of
external debt of the country significantly and positively impacts the stress probability. Thus,
our regression results suggest that policy-makers may need to watch this variable to gather
any signals of an impending stress event in the financial markets. These results are in line
with the findings of Licchetta (2009) who found external balance sheet variables impacting
the probability of currency crises, especially in emerging economies. Jeanne and Rancire
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(2006) also found that an economy with a higher level of total gross external liabilities to
GDP ratio is likely to witness a sudden stop in capital inflows.
Further, the Brent crude oil price index is another variable that is seen to be influencing
the Indian financial system significantly. India is highly dependent on imports of crude oil
to meet its domestic demand. The high degree of dependence on imported crude oil makes
Indias economy vulnerable to oil price shocks. The US Energy Information Administrations
International Economic Outlook, 2013, projects that India will have the fastest regional GDP
growth, averaging 6.1% per year from 2010 to 2040. In light of this, the report projects that
Indias demand for liquid petroleum and oil products will increase by 3.1% per year over
20102040. This augurs well with our regression results, which suggest that movements in
international prices of crude oil may need to be tracked closely as a possible early indicator
of an impending extreme stress in the Indian financial system.
The significance of MSCI EM index in explaining the probability of stress in the Indian
economy could be attributed to growing linkages between returns in the Indian stock markets and the international markets. Globalisation has had a profound effect on financial
market integration across the worlds financial markets, following which linkages between
returns of various individual local markets have generally been observed. A number of
empirical studies have documented transmission of volatility from one market to another.23
The effect of one market largely spreads to another through Foreign Institutional Investors
(FII) who simultaneously track different market indices and continuously move funds
between markets. These FIIs track the MSCI EM index to make their investment choices
amongst various emerging economies. In addition, stocks of companies are listed on more
than one exchange, spread across nations, so that their movements in one market impact
their prices in other markets where they are listed and traded. In the Indian context, the
linkages between Indian markets and international stock markets can also be explained by
investments through the American Depository Receipts (ADR)/Global Depository Receipts
(GDR) route, whereby Indian shares are listed and traded on the US and other international
stock exchanges.
Our logit regression results suggest that changes in the MSCI EM index is another important variable that the policy-makers may need to track as an early indicator of stress likely
to be transmitted to the Indian financial system.
4.4. Building an early warning system using estimated probabilities
Having estimated the logit regressions above, we now come to the next step in building the
EWS for financial crisis/stress in India. To build the EWS, we use Regression 4 above. This
regression has good predictive power given that the value of 0.378 of Mcfaddens R-squared
is reasonably adequate. In addition, the Likelihood Ratio (LR) statistic is significant. Thus,
the null hypothesis that the set of selected explanatory variables used in the regression is not
significant in explaining the probability of financial stress is rejected. Further, the regression
captures the likely impact of significant explanatory variables from each of the categories
of variables, namely macroeconomic, external and financial, on the probability of financial
stress. Hence, we expect that this regression can serve as a good basis for construction of
EWS. To do this, we follow the methodology suggested by Demirguc-Kunt and Detragiache
(1999). The steps are as follows.
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A. Guru
Sum of T1 and T2
1.00
0.80
0.60
0.40
0.20
0.00
Threshold probabilities ()
Figure 3.Sum of probabilities of Type I and II errors for different levels of threshold probabilities.
From Regression 4, we estimate the in-sample probability of financial stress over the
period of the study. Next, we need to ascertain the critical/threshold probability level, .
When the crisis/stress probability crosses this threshold probability, policy makers would
issue a warning signal of an extreme stress situation in the financial system. To arrive at
this critical probability level, we calculate the in-sample probabilities of type I errors, i.e.
the proportion of times in the sample when the model fails to issue a signal, when actually
there was an extreme stress situation, and type II errors, which is the proportion of the
times in the sample when the model issues a false signal of extreme stress but actually there
was no stress event.
As explained by Demirguc-Kunt and Detragiache (1999), the type I and type II probabilities are functions of the critical level of probability . There could be different ways of
arriving at the critical probability level. For example, if the decision-maker is risk averse,
she would choose that level of probability which minimises the type I errors. Alternatively,
the threshold level of probability () may be chosen as the one where probability of type I
and II errors are equalised. As noted in section 3 follow Wong, Wong, and Leung (2007)
and IMF (2013) and choose that level of which minimises the sum of in-sample type I
and type II errors.
Using the notation of Demirguc-Kunt and Detragiache (1999), let A() and B() be
the probability of type I and type II errors respectively. For a fixed value of (0 1),
we can estimate A() as the percentage of extreme stress/crisis events in the sample where
the estimated probability (P) was less than the critical probability level of (i.e. no crisis
signal was issued), given that there is actually a crisis event (i.e. Yi=1). Thus, this captures
those months when our model missed calling a crisis when in fact there was a crisis event.
Expressing this mathematically:
( )
P <
Count Yi =1
i
(10)
A() =
N
where N is the number of actual extreme stress events in the sample.
We then calculate B(), the probability of issuing a warning when no extreme stress
occurs. It is the percentage of non-extreme stress observations where an extreme stress event
was signalled (i.e. estimated stress probability was above the critical probability level) when
in fact there was no extreme stress event. In other words, B() calculates the percentage
291
Table 9.Arriving at threshold /critical probability for an EWS.

Threshold
probability
levels ()
0.15
0.23
0.24
0.25
Number of
type I errors
Probability
of type I
error(A())
Number of
type II errors
Probability of
type II error
(B())
3
4
4
4
18.75
25.00
25.00
25.00
14
7
7
7
12.50
6.25
6.25
6.25
Sum of probability of type

I and type II
errors
31.25
31.25
31.25
31.25
of non-crisis (or normal/no-stress period) observations where false signals were issued.
Mathematically:
( )
P >
Count Yi =0
i
(11)
B() =
M
where M is the number of normal/no-stress months in the sample.
Figure 3 plots the sum of A() and B() for ~ [0,1] computed from estimates of in-sample probabilities of extreme stress using Regression 4 above. As the threshold probability
levels increase from 0 to 1, the probability of missing a crisis (i.e. type I error) increases and
the probability of issuing false alarms (i.e. type II error) decreases. At =0, the probability
of type I error is zero and that of type II is 1, so that the sum of the two probabilities is 1.
At =1, the probability of type II error is 0 and that of type I error is 1, so that their sum is
again 1. This explains the U-shaped plot of the sum of the probabilities of type I and II errors.
We find four levels of at which the sum of the probabilities of type I and II errors are
minimised, namely for =0.15, 0.23, 0.24 and 0.25. With critical probability of 0.15, the
probability of type 1 error is 18.8% and that of type II error is 12.5%. With critical probability of 0.23, 0.24 as well as 0.25, the probability of type I error is 25% and that of type
II error is only 6.25%. With 0.15 probability level, seven more non-crisis events are being
misclassified as compared with probability levels of 0.23, 0.24 and 0.25. On the other hand,
with probability levels of 0.23, 0.24 and 0.25, only one extra extreme stress event is being
missed compared with probability level of 0.15. This can be noted from Table 9 below.
Thus, in the interest of not issuing too many false signals as compared with only missing
one extreme stress event and hence having a higher percentage of correct classifications,
we choose an average of 0.23, 0.24 and 0.25 probability levels, i.e. 0.24, to be the threshold
critical probability level for the EWS.
This 0.24 probability level is an optimal threshold where the sum of type I and type II
errors are minimised. It is optimal in the sense that it discriminates best between crisis and
non-crisis events (Comelli 2013). We expect that this threshold would produce minimal
forecasting error in contrast to an arbitrary level of threshold probability.
4.5. Evaluating the performance of the model
4.5.1. In-sample performance of the model
The conventional method to evaluate an EWS models performance is to construct a twoway contingency table categorising each predicted outcomes into a two-by-two matrix on
the lines of Kaminsky and Reinhart (1999). This is as follows:
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Table 10.In-sample performance of the model (Regression 4).
The model issues a warning signal

The model does not issue a warning
signal
Stress situation/tail event

occurs
A=12
C=4
No stress situation/tail event

occurs
B=7
D=105
There are four measures that can be derived from this table to enable us to assess the
accuracy of the model in making predictions about the probability of a stress/tail event. We
calculate these using the derived threshold critical probability of =0.24:
(a)proportion of correct classifications, which is (A+D)/(A+B+C+D), found to be
91.41%;24
(b) proportion of correct signals=A/A+C, which is equal to 75%;
(c)type I error, i.e. the probability of not issuing a warning signal when in fact there
was a stress/tail event, which is C/A+C; which works out to 25%;
(d)type II error, which is the probability of issuing a warning signal when there is no
stress situation, i.e. B/B+D, which is equal to 6.25%.
A model can be said to perform well if the values of (a) and (b) are high and those of (c)
and (d) are low. These results are presented in Table 10.
The above results show that our model is able to correctly classify 91.41% of 128 observations. The type I error is 25% and type II error is 6.25%. Thus, overall, the in-sample
accuracy of the model, namely Regression 4, to predict an occurrence of a stress or tail
event in the financial markets is found to be reasonably good.
4.5.2. Out-of-sample predictive power
A second method to evaluate our model is to assess its out-of-sample predictive power. To
do this, we obtain forecasts of probability of financial stress, by using the binary dependent
variable model (Regression 4) for the time period April 2001 to December 2008 (estimation
window) and use the estimated model to obtain out-of-sample probabilities of extreme
stress over the period January 2009 to December 2012 (forecast window). From the estimations over the period April 2001 to December 2008, in-sample probabilities of stress are
estimated. With these estimated probabilities, the threshold or critical level of probability
is found following the methodology detailed above. These forecast probabilities of stress
over the period January 2009 to December 2012 are compared with the calculated critical
probability level from the in-sample estimations, assuming that the past stress events are
representative of such conditions in the future. To judge the performance of the model, we
check whether it is able to generate stress probability above the critical level when indeed
there was a stress situation, i.e. the number of correct signals issued by the model.
Over the period January 2009 to December 2012, there are four extreme stress observations, which are July 2011, August 2011, November 2011 and December 2011. With
Regression 4, the in-sample threshold probability that minimises the sum of type I and II
errors, over the estimation window, is found to be 0.16. With this threshold probability, the
model is able to correctly predict all four tail event months in the forecast window. Thus,
there is no type I error in this forecast window. However, with the critical probability level
of 0.16, the model generates a type II error of 66.66%.
293
5. Summary and conclusions

In this paper, we have built sector specific crisis/stress indices for the currency, banking
and equity markets in the country. While we follow the existing literature for construction
of currency markets and stock market stress indices, our banking sector index is thought
to be the first such index for India. It combines three important indicators of stress in the
banking sector, namely the ratio of gross non-performing assets to gross advances; capital to
risk weighted assets ratio, and returns on banking sector stock market index. These indices
serve as useful tools to understand the movements of stress levels in these segments of the
financial system, over time.
We have constructed a Financial Sector Stress Index (FSSI) by suitably combining the
three sub-indices of currency, banking and stock markets. This is again, a different manner
in which we have constructed a stress index. The existing literature has generally considered
various segments of a financial system in isolation, and combined over 1015 variables to
form an overall stress index. This ignores the inter-linkages between the sectors, which
have been well-documented in the literature. The FSSI is a valuable measure of the contemporaneous level of financial stress in the Indian financial system. It has proved useful
in highlighting and identifying stressful months in the Indian financial system. Changes
in the index, over time, provide information on evolution of stress in the financial system.
Using the FSSI, we identify its extreme observations as extreme stress events in the
Indian financial system. Another contribution of the paper is the use of a more objective
statistical approach of EVT to classify these tail events/stress events. Specifically, we use
the Generalised Pareto Distribution/Peaks-over-Threshold approach for our purpose. This
approach does not require any a priori assumption on the distributional properties of the
FSSI series.
Once the extreme stress events are identified, we use a binary dependent variable model
(logit model) to estimate the impact of various macroeconomic and financial variables on
the probability of extreme stress in the financial system. We find that the Indian financial
system is impacted significantly by external sector variables, namely external debt, the
MSCI Emerging Market index and the Brent crude oil index. These results are indicative
of greater integration of our financial system with the international economic and financial
system. In the regression with financial sector variables, 10 year GOI bond yield was found
to be statistically significant in explaining the probability of financial stress. These are the
vulnerabilities that policy-makers may need to be aware of and watch closely.
The macroeconomic variables such as inflation, GDP, IIP and gross fiscal deficit were
not found to have significant explanatory power for probability of financial stress in the
Indian economy.25 In addition, variables such as commercial bank credit and deposits and
terms of trade have also not emerged as indicators having a significant predictive ability
for financial stress in the Indian financial system. This result is in contrast with most other
EWS studies that have found indicators such as GDP (Duca and Peltonen., 2011; Hardy and
Pazarbaiolu 1998; Lestano, Jacobs, and Kuper 2003 etc.); inflation (Eichengreen, Rose,
and Wyplosz 1995; Hardy and Pazarbaiolu 1998); bank credit (Eichengreen, Rose, and
Wyplosz 1995; Kamin, Schindler, and Samuel 2001) and terms of trade (Kamin, Schindler,
and Samuel 2001) as leading indicators for banking or currency crises. The difference in our
results from earlier studies could be partly explained by differences in methodology used by
this study in constructing the overall financial sector stress index and identifying extreme
294
A. Guru
stress observations. Further, these were panel studies with data pertaining to a number of
countries, across time, and not country-level studies. Our study is a country-level study
for India, which does not find macroeconomic variables to be helpful in explaining the
probability of stress in the Indian financial system.
We have assessed the in-sample and out-of-sample performance of our parametric EWS
by calculating optimal cut-off values for the crisis probabilities, which minimise the sum
of type I and II errors.
The literature review indicates that there does not seem to be a unanimous opinion
on the practical usefulness of EWS models. However, researchers and policy-makers do
recognise certain advantages of EWS models. For example, these models process the data
on macroeconomic and financial environment in a mechanical manner without any information content based on biases from past experiences. Hence, they are more objective
and systematic. The literature also recognises that EWSs can only serve as limited tools
for identifying underlying vulnerabilities in an economy, which can potentially lead to a
crisis situation following a trigger for such a crisis. The existence of vulnerabilities is not
a sufficient condition that a crisis will ensue. As noted by IMF (2013), identification of
vulnerabilities in an economy is more feasible than identifying crisis timing and is also
relevant for policy-makers of a country. The level of vulnerabilities in an economy can be
used as an estimator for the likelihood of occurrence of a future crisis.
While improvement over our EWS is possible with the availability of more data, this
paper is a first step towards building an Early Warning System of financial crisis/stress in
the Indian financial system.
Notes
1.
Such as credit default swaps, collateralised debt obligations, credit spread products, total
return swaps and loan syndications, etc.
2.
The Oxford English Dictionary defines crisis as a time of severe difficultly or danger.
3.
For example, in the US subprime crisis of 20072009, the vulnerabilities in the economy were
reflected in a credit and house price boom, and weaknesses in financial regulation resulting
in a build-up of leverage and mispricing of risk, while the trigger of the crisis was the collapse
of the subprime mortgage market.
4.
Certain new innovative techniques are also being used by researchers to build EWSs. These
include binary recursive trees, artificial neural networks and Markov switching models (e.g.
Abiad 2003; Peria 2002).
5.
The term leading indicators in used in time series analysis to denote a lead-lag relationship
between variables. The term has been used in the signals approach literature to mean
indicators/variables which are able to signal an impending crisis certain months in advance.
6.
We have not presented this literature here in the interest of focusing more on the actual FSSI
and building of EWS around it.
7.
For details on this index see Girton and Roper (1977), Eichengreen, Rose, and Wyplosz (1994,
1995), Sachs, Tornell, and Velasco (1996), Kaminsky et al. (1998), Kaminsky and Reinhart
(1999) and Glick and Hutchison (2000).
8.
Refer to Patel and Sarkar (1998) and Vila (2000).
9.
One of the main policy objectives of financial reforms in India was to integrate various
segments of the financial system with the aim of reducing arbitrage opportunities so as to
achieve an efficient allocation of resources (Mohan 2005; Reddy 1999). This integration of
financial sectors has been attempted through various reform measures aimed at increasing
competition, deepening the sectors (in terms of introducing new instruments); enhancing
liquidly in the financial system; lowering transaction costs, etc. Such integration of the markets
295
has been quantified in the literature in terms of convergence of the prices in the financial
markets represented by the rate of interest in the respective sectors.
10.One of the advantages of PCA is that it enables determination of the individual importance of
each of the three components of the financial stress index so that the weight each receives is
in line with the respective historical evolution and significance in influencing the fluctuations
of the overall index.
11.One of the main advantages of this approach is that one is able to identify extreme observations
without making any assumptions about the shape of the unknown population distribution.
This is a major advantage over the standard-deviation based method, where the underlying
distribution is assumed to be normal.
12.The threshold u should be as high as possible for the Pickands-Balkema-de Haan theorem
to hold good so that the GPD provides a close enough approximation to the distribution of
peaks-over-threshold. However, in practice, too high a threshold would leave us with too few
observations for estimating the GPD parameters, leading to high variance in the estimates.
This is known in as bias-variance trade-off (McNeil and Frey 2000) in choosing u.
13.The threshold for GPD can be selected using graphical techniques such as quantile plots or
mean excess plots. Another approach to doing this is through estimation of the GPD model for
a range of threshold values and looking for stability of the parameter estimates. The estimate
of and of the GPD should be constant about a threshold u0 if this is a valid threshold
for excesses to follow the GPD. One can plot estimated and against different thresholds
u and select u0 as the lowest value of u for which the estimates remain near constant. One
of the simplest methods is to choose a value of u that intuitively corresponds to an extreme
event or some fixed percentile of the distribution. Commonly used percentiles are the 95th
of 99th percentiles (Coles 2001).
14.Under the PML method, use of normal distribution for the estimation does not imply the
assumption of normality for the distribution of residuals.
15.In our analysis, the series is the FSSI series, which is akin to financial return series in its
distributional properties.
16.The threshold for GPD can be selected using graphical techniques like quantile plots or
mean excess plots. Another approach to doing this is through estimation of a GPD model
for a range of threshold values and looking for stability of parameter estimates. The estimate
of and of the GPD should be constant about a threshold u0 if this is a valid threshold for
excesses to follow the GPD. One can plot estimated and against different thresholds u and
select u0 as the lowest value of u for which the estimates remain near constant. One of the
simplest method is to choose a value of u that intuitively corresponds to an extreme event or
some fixed percentile of the distribution. Commonly used percentiles are the 95th of 99th
percentiles (Coles 2001).
17.Examples of these variables are rate of interest (forms part of EMP index), rate of growth
of money supply (as part of EMP index), movements in the stock prices (forms the SMSI
index), and so on.
18.For example, we are not able to use rate of investment or savings, which have been used in
the literature on EWS as potential indicators of financial stress, as the data are available only
on an annual basis.
19.We use a 20% threshold in the interest of having enough observations in the tail for a good
GPD fit, keeping in view the total number of observations we have.
20.We follow Frankel and Rose (1996) who use one-year lagged explanatory variables to serve
as a test of the ability of regressors to predict crisis events in advance.
21.Under the null hypothesis, the LR statistic is asymptotically distributed as a chi-squared
variable and its degrees of freedom is the number of restrictions under the test.
22.This is an analogues statistic to R-squared reported for linear regression models and lies
between 0 and 1.
23.For example, the effects of the stock market crash of October 1987 and the Asian financial
crisis in 1997, were widely felt over the whole world. More recently, ripples from the sub-prime
crisis in the US and Europe have been felt across financial markets worldwide.
296
A. Guru
24.The number of observations is reduced from 140 to 128 since we have used 12months lagged
variables in the logit regressions.
25.Although inflation is significant in the macroeconomic variables Regression 1, its significance
level is low.
Acknowledgments
This work forms part of the PhD Thesis submitted at the Jawaharlal Nehru University, Delhi, India
in July, 2014 by the author. The author wishes to express gratitude to her PhD guide, Dr Mandira
Sarma, for her able guidance during the course of the PhD programme.
Disclosure statement
No potential conflict of interest was reported by the author.
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Hakkio C. S., and W. R. Keeton. (2009). Financial Stress: What is It, How Can It Be Measured and
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Wholesale price
index/Inflation
Index of Industrial
Production
Gross fiscal Deficit

of Central Government
3.
4.
Variable
GDP
2.
1.
None
None
Studies that have used the variable as an explanatory variable

for financial stress26
Kaminsky and Reinhart (1999),
Kamin, Schindler and Samuel
(2001) and Lestano, Jacobs, and
Kuper (2003)
Demirg-Kunt and Detragiache
(1998) and Lestano, Jacobs, and
Kuper (2003)
Explanation
Financial crises/stress situations are usually seen to be
preceded by a slump in economic activity. Hence, lower
GDP growth is likely to increase the vulnerability of the
economy to a financial stress situation
High inflation rate can be associated with macroeconomic instability and can adversely affect the financial
sector and the economy. Changes in WPI, in the Indian
context, are seen to be influencing key changes in the
fiscal and monetary policy of the authorities in the
country. High inflation leads policy-makers to increase
interest rates, thereby negatively influencing growth
and investments and leading to stress in the financial
markets
IIP is an index number that represents the status of
production in the industrial sector of the country
for a given short period of time. It serves as a single
representative number measuring the general level of
industrial activity in the Indian economy. We expect a
fall in IIP to be associated with enhanced probability of
stress in the overall financial system in the country
A rise in fiscal deficit of a Government puts pressures
on its finances, leading to rise in its borrowings. This is
turn puts an upward pressure on interest rates in the
economy. Higher fiscal deficits are expected to raise
the probability of crisis/stress since deficits increase
an economys vulnerability to shocks and decrease
investors confidence in the economy
Appendix 1. Variables tested as explanatory variables for financial stress
RBIs Online
database and
Controller General
of Accounts
Monthly
Ministry of
Statistics and
Programme
Implementation
Monthly
Office of Economic Adviser,

Department of
Industrial Policy
and Promotion
Monthly
Data source and

frequency at
which available
RBIs Online
database
Quarterly
12.118(0.00)
6.631(0.00)
5.863(0.00)
ADF test statistic for

unit root (for growth
rate transformation of
the variables)
9.355(0.00)
(+)
()
(+)
Expected sign
()
298
A. Guru
Brent crude oil

price index
MSCI EM index
7.
Variable
Gross External
debt
6.
5.
Slingenberg and de Haan (2011)
Slingenberg and de Haan (2011)

Frankel and Wei (2004), Jeanne
and Rancire (2006) and Licchetta
(2009)
Appendix 1.(Continued).
Explanation
Higher levels of external debt entail a larger reliance of
an economy on foreign sources of finance. This raises
its vulnerability to a possible reversal of capital inflows
that can be withdrawn suddenly and hence raise the
probability of a crisis situation in the domestic financial
markets
India imports a large proportion of its domestic oil
demand so that a rise in the prices of crude oil affects
the economy directly in terms of increasing domestic
inflation. Rise in oil prices implies a rise in import bill for
oil, exerting depreciating pressure on the domestic currency. Besides stimulating domestic inflation, the rising
crude oil prices also affect the fiscal situation when the
government tries to absorb a major part of the burden
of increased oil prices through increased subsidies
The MSCI Emerging Markets index27 captures large
and mid-cap stocks from across 21 Emerging Markets
(EM) countries. With the growing integration of the
Indian economy with the world economy, any adverse
movements in international stock markets are likely to
affect Indias financial markets. A rise in MSCI EM index
is likely to be associated with rising stock market trends
in the domestic stock exchanges as well and hence a
rise in SMSI translating into a fall in probability of an
extreme stress event in the financial markets
4.784(0.00)
4.962(0.00)
Bloomberg
Daily converted
to monthly
averages

the variables)
4.379(0.00)
Bloomberg
Daily-converted
to monthly
averages
Data source and

frequency at
which available
RBIs online
database
Quarterly
(-)
(+)
Expected sign
(+)

299
10year benchmark GOI bond

yields
Variable
Terms of Trade
Reuters
Daily converted
to monthly
averages
Data source and

frequency at
which available
RBIs Online
database
Monthly
3.456(0.05)(for level
series)

the variables)
11.690(0.00)
(+)
Expected sign
(-)
27
Most of the studies cited here have used the respective variables in the context of EWS for currency or banking crises.
Morgan Stanley Capital International (MSCI) is a US-based company that provides a number of stock market indices that were widely tracked by investors around the globe. MSCI indices are also
used as the benchmark indices for measurement of performance of global equity portfolios.
28
Yield to Maturity (YTM) of a bond is the annual percentage rate of return earned on a security which is a function of a securitys purchase price and coupon interest rate. Thus, yields of a bond
change with changes in face value, coupon and maturity. All of these characteristics of a bond influence its price.
26
9.
8.

Explanation
Kaminsky, Lizondo and Reinhart.
A rise (fall) in exports and fall (rise) in imports, implying
(1998)
positive (negative) terms of trade for the economy is
associated with better (worsening) financial conditions of the government, in turn, implying a fall (rise)
in financial stress in the economy. Favourable terms
of trade strengthen a countrys balance of payments
position and hence lower the probability of crisis/
stress, while deteriorating terms of trade may herald a
currency crisis
None
Bond yields are a proxy for risk free return on
investments. Yields and prices of bonds are inversely
related.28 Rising bond yields lead to fall in prices of
bonds which, in turn, lead to rise in interest rates. This
leads to a tightening of the liquidity condition in the
markets and hence the stress in the financial system is
likely to see a rise
300
A. Guru

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International Review of Applied Economics

ISSN: 0269-2171 (Print) 1465-3486 (Online) Journal homepage: http://www.tandfonline.com/loi/cira20

Early warning system of finance stress for India

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Date: 27 July 2016, At: 03:20

International Review of Applied Economics, 2016

Early warning system of finance stress for India

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Received 25 February 2015

Exchange market pressure;

CONTACT Anuradha Guru

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2. EWS models: a literature review

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International Review of Applied Economics

3. Methodology steps in construction of an EWS

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International Review of Applied Economics

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SMSIt = (CMAXt CMAXt1 )CMAXt1

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4. EWS for India

International Review of Applied Economics

Table 1.Principal components analysis.

Proportion of total variance explained by respective components

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Figure 1.Movement of FSSI2 Series (April 2001 to December 2012).

Figures in the brackets are p-values.

ACF of squared FSSI

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Figure 2.Autocorrelation and partial autocorrelation functions of FSSI series.

*Denotes statistical significance at 1% level of significance.

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Figures in the brackets are standard errors of the estimates.

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Table 5.Logit regression with macroeconomic variables (Regression 1).

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Coefficient Std. error z-statistic

where X is the vector of explanatory variables and is the vector of coefficients.

where f is the density function corresponding to F. Thus, j is weighted by a factor f that

Table 6.Logit regression with external sector variables (Regression 2).

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Table 7.Logit regression with financial sector variables (Regression 3).

Coefficient Std. Error z-statistic p-value Marginal effects Odds-ratio

Total bank credit(12months lagged)

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Coefficient Std. error z-statistic

Marginal effects Odds-ratio

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Downloaded by [Central University of Tamil Nadu] at 03:20 27 July 2016

International Review of Applied Economics

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