A1025
Title: Beyond financial markets: High-dimensional country risk assessment using latent factor models
Authors: Elias Wolf - European Stability Mechanism (Luxembourg) [presenting]
Robert Blotevogel - European Stability Mechanism (Luxembourg)
Abstract: In today's global economy, risks to financial stability are increasingly broad-based and not limited to developments in financial markets alone. Assessing country risk, therefore, requires a comprehensive approach that incorporates classic economic vulnerabilities across sectors, e.g., households, financial institutions, and corporates, as well as unexpected and external shocks that may arise from structural economic trends, political and institutional developments, or climate events and geopolitical tensions. Additionally, these risks might not be idiosyncratic but often interact in complex ways and propagate across time and space. Even countries with strong fundamentals may face financial stability risks if macroeconomic outcomes deviate from expectations due to adverse geopolitical shocks. Therefore, a new indicator is constructed, pooling information from a comprehensive high-dimensional set of individual risk sources to quantify and track multidimensional risks for different European countries. Following methodologies similar to the NFCI and CISS index, the strength of dynamic factor models is leveraged to handle big data sets with different sampling frequencies to identify latent risk factors. Simultaneously, it is investigated how the different sources contribute to the overall country risk over time. This approach aims to improve risk monitoring in the Euro area, where existing individual financial or economic indicators may underestimate emerging vulnerabilities.
