Credit-to-GDP gap as an early warning indicator of banking stress in Albania

• Author: Odeta Koçillari
• Position: Bank of Albania
• Pages: 148-159

Vol. 1 No. 1

January 2017

European Journal of Economics, Law and Social Sciences

IIPCCL Publishing, Graz-Austria

ISSN 2519-1284

Acces online at www.iipccl.org

148

Credit –to- GDP gap as an early warning indicator of banking stress in

Albania

Odeta Koçillari

Bank of Albania

Abstract

This paper investigates the performance of credit-to-GDP gap as a potential early warning

indicator of systemic banking distress in the case of Albania. Following the “signal extraction

approach” by Kaminsky and Reinhart (1999), we test the early warning abilities of indicators

of credit-to-GDP gap for total credit to private sector, credit to households and credit to fi rms,

computed using one sided HP fi lter with di erent smoothing parameters. These indicators

are tested upon various thresholds and time horizons. We fi nd that credit to GDP gap for total

credit to private sector, computed using HP fi lter 25000 or 400000 work best as EWI in terms of

our evaluation criteria and up to years ahead of a potential episode of distress or crisis.

Keywords: early warning indicators, credit-to-GDP gap, banking stress, signal extraction

approach.

Introduction

The high economic costs associated with the late fi nancial crisis (2007-2008)

highlighted the need for a careful monitoring of systemic risks threatening fi nancial

system in general and banking sector in particular. Many central banks have already

included in their tasks the monitoring and assessment of systemic risk on a regular

basis, in order to prevent future crises. These assessments can provide early signals

of vulnerabilities build-up, known as "macro - fi nancial imbalances", thus helping

in obtaining timely preventive measures to reduce such imbalances and maintain

fi nancial stability in the country. Despite the di erent methods and instruments

developed by various institutions and researchers on this ma er, the identifi cation

of a unifi ed set of reliable indicators that can serve as “early warning indicators” has

been quite challenging. This because the ability of such indicators to predict future

crisis is closely related to a number of factors that vary signifi cantly from one country

to another, such as: the structure of the economy and/or the fi nancial system, the

characteristics of the banking sector, crisis complexity, length and accuracy of the

data series etc. For this reason, an indicator that may result e cient in predicting

a particular crisis in a particular country may not result as such if these conditions

change. However, among various indicators investigated, most authors agree that

the indicators related to credit, especially credit-to-GDP gaps, are the most e cient

one and as history tend to repeat itself, they can be used to signal future episodes of

banking sector distress as well.

Taking guidance on the existing literature addressing this issue, this paper aims to

investigate the early warning properties of potential banking sector stress of the credit

–to-GDP gap, in the case of Albanian banking sector. Various transformations of this