Abstract

Despite the prohibitive cost of financial crises, an effective early warning system of such events remains a challenge. In this paper we develop a novel forward-looking indicator of near-crisis (FLEWS), based upon measures of financial stability and using a wide set of economic and financial indicators to forecast crises or periods of heightened financial fragility. Based on a Signal Extraction methodology which allows for the identification of dynamic thresholds, our results show that our indicator performs well. As early as 2004 we identify clear signals of financial sector fragility, significantly before the outbreak of the global financial crisis. We argue that it is possible to develop early warning indicators of near-crises and that their prior identification might be of more value than forecasts of crisis since it will give policy makers more time to respond.