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Macro-financial imbalances and cyclical systemic risk dynamics: understanding the factors driving the financial cycle in the presence of non-linearities

Published online by Cambridge University Press:  25 April 2024

Martin O’Brien  and
Sofia Velasco
Martin O’Brien
Affiliation:
Central Bank of Ireland, Dublin, Ireland
Sofia Velasco*
Affiliation:
European Central Bank, Frankfurt am Main, Germany Queen Mary University of London, London, UK
*
Corresponding author: Sofia Velasco; Email: s.m.velasco@qmul.ac.uk
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Abstract

This paper develops a multivariate filter based on an unobserved component model to estimate the financial cycle. Our model features: (1) a dynamic relationship between the financial cycle and key variables; (2) time-varying shock volatility for trend and cycle components. We demonstrate that our approach not only exhibits superior early warning properties for banking crises but also outperforms commonly used indicators in terms of data fit for decomposition exercises, as evidenced by the higher marginal likelihood. We document three important properties of the financial cycle. First, the sensitivity of the financial cycle to changes in real estate valuations increased during the post-90s period. Second, the sensitivity of the cycle to changes in financial conditions displays volatility and country specificities. Finally, our reduced form estimates suggest that the banking crisis of 1988 was preceded by positive contributions from the risk appetite shock, while the primary source of vulnerabilities emanated from the housing market in the run-up to the Global Financial Crisis.

Keywords

Cyclical systemic riskfinancial cyclemultivariate unobserved component modelsstochastic volatility
Type
Articles
Information
Macroeconomic Dynamics , Volume 29 , 2025 , e13
Copyright
© The Author(s), 2024. Published by Cambridge University Press

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