Exploring the interplay between early warning systems' usefulness and Basel III regulation

We analyse the ability of credit gap measures to predict banking crises by estimating the usefulness measure conditionally on policymaker's preferences. The results show that the signals based on the credit gap indicators are most useful when the policymaker’s preferences regarding Type I and Type II errors are approximately equal. However, according to the current consensus, the preferences to avoid missing a crisis are higher than issuing a false signal. This means that the usefulness of the credit-gap-based early warning systems is likely to increase once the static Basel III regulative measures are implemented (assuming that their implementation results in lower financial crises’ costs).