A Leading Indicator Model of Banking Distress ¡V Developing an Early Warning System for Hong Kong and Other EMEAP Economies

This study develops a probit econometric model to identify a set of leading indicators of banking distress and estimate banking distress probability for Hong Kong and other EMEAP economies. Macroeconomic fundamentals, currency crisis vulnerability, credit risk of banks and companies, asset price bubbles, credit growth, and the occurrence of distress of other economies in the region are found to be important leading indicators of banking distress in the home economy. The predictive power of the model is reasonably good. A case study of Hong Kong based on the latest estimate of banking distress probability and stress testing results shows that currently the banking sector in Hong Kong is healthy and should be able to withstand well certain possible adverse shocks. Under some extreme shocks originating from real GDP growth and property prices such as those that occurred during the Asian financial crisis, the model indicates a non-negligible risk of an occurrence of banking distress in Hong Kong. However, the chances of the occurrence of such severe events are extremely low. Simulation results also suggest that compared to the period before the Asian financial crisis, the local banking sector is currently more capable of withstanding shocks similar to those that occurred during that crisis. The study also finds that banking distress is contagious, suggesting that to be effective in monitoring banking distress, close cooperation between central banks should be in place.