Title: Use of unit root methods in early warning of financial crises
Authors: Eero Tolo - Bank of Finland (Finland) [presenting]
Matti Viren - University of Turku (Finland)
Timo Virtanen - University of Turku (Finland)
Katja Taipalus - Bank of Finland (Finland)
Abstract: Unit-root based methods have for long been used to study the existence of financial bubbles in asset prices. The basic idea is that certain fundamental changes in the autocorrelation structure of relevant time series imply the presence of a rational price bubble. We provide cross-country evidence for performance of unit-root based early warning systems in ex-ante prediction of financial crises in 15 EU countries in the past 3 decades. The early warning signals have quite high relative usefulness. To further improve the crisis prediction, the signals from multiple time series can be combined into a composite indicator. It is also possible to use a mix of data with different frequencies, which can be useful for providing more timely warning signals. The results suggest that this approach has a place in the toolkit of financial stability supervision.