Financial Imbalances, Systemic Stress, and Macroprudential Implications

The effectiveness of macroprudential policy framework depends to a large extent on how the process of monitoring and assessing systemic risks and the calibration of macroprudential policy tools are operationalized in practice. This paper has two main contributions. First we propose an enhanced composite indicator, the Systemic Vulnerabilities Index (SVI), which captures the buildup of systemic vulnerabilities. The index is built on an innovative approach that uses optimal aggregation of subindices, and without imposing exogenous constraints. Specifically, making use of the Principal Component Analysis (PCA) for a broad set of relevant input variables, we determine their relative importance in contributing to the buildup of systemic vulnerabilities. Subsequent use of Monte Carlo simulation techniques allows us to select the optimal SVI that best predicts future credit losses. The proposed SVI captures both time and sectoral dimensions of the buildup of risks. We provide evidence showing a superior performance of the SVI, compared to the traditional credit-to-GDP gap in documenting risk accumulation. We investigate the relationship between our SVI and financial condition index and provide evidence of a negative correlation between the two, whereby a loosening of financial conditions is associated with more accumulation of imbalances. Second, we provide a framework that guides on how the SVI can be used for increasing Countercyclical Capital Buffer (CCyB) beyond its neutral level. Specifically, we propose a mapping that shows how the SVI can help determine the timing of setting a CCyB beyond the neutral rate as well as its magnitude.