Predicting banking and sovereign distress in the Eurozone: An econometric early warning system approach
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The financial crisis that plagued the European economy during 2008-2013 was one of the most severe on record among advanced economies. The crisis followed a decade of reasonable growth and financial stability since the creation of the Euro in 1999. In that period several peripheral Eurozone Member States experienced very rapid growth and convergence of living standards to European averages. When the crisis hit, borrowing costs on money markets for some governments rose to unsustainable levels, banking systems became stressed, and economies fell into deep recession. Prevailing models largely failed to predict the financial crisis. This thesis seeks to build Early Warning System (EWS) econometric models for the prediction of banking and sovereign crises in the Eurozone. These models stress the interactions between sovereign debt markets, banking systems, and the real economy. We find that banking, macroeconomic and financial indicators are required in EWS models to predict distress in banking systems and sovereign markets. We find that the models developed in this thesis have strong predictability power, and can predict banking and sovereign stress up to three years in advance, allowing policy-makers time to take corrective actions to guard against financial and sovereign distress.