Model-based indicators for the identification of cyclical systemic risk

The credit-to-GDP gap, as proposed by the Basel methodology, is the reference measure for the activation of the Countercyclical Capital Buffer. However, most of the countries implementing this instrument in recent years are not following its signals due to the large downward biases that it is presenting after the last financial crisis that do not reflect properly the current macrofinancial environment. In this context, credit gap measures that incorporate economic fundamentals may provide more accurate signals of cyclical systemic risk. We propose two alternative model-based indicators that account for these factors. We assess their performance using time series data from the 1970s for six European countries and compare them to the Basel gap. We find that our proposed models provide more accurate early warning signals of the build-up of cyclical systemic risk than the Basel gap, as well as lower biases after rapid changes in fundamentals. Furthermore, we identify the model specifications that are optimal for each of the countries considered. Our flexible approach can easily accommodate national specificities, which are key to maximize the performance of the models.