The Efficacy of Early Warning Systems Finance Essay

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This document examines the efficacy of early warning systems with respect to predicting incipient financial distress of banking institutions. Their practical use by policy makers is limited, even in the international financial institutions. This is a paradox since the changing nature of banking risks as more economies liberalise and develop their financial systems, as well as ongoing innovation, makes the use of EWS for informing policies aimed at preventing crises more necessary than ever. A model of banks with different of total assets (small, medium & large) is selected, financial and economic data for individual banks are collected, and EWSs that have been applied in banking studies are tested. During a period of few bank failures, the relevance of this bank failure model for surveillance depends to some extent on the accuracy of the model in predicting which banks will have their supervisory ratings downgraded to problem status in future periods. Rather than attempting to guess bank failure as in previous banking literature, we classify banks as capital adequate or capital inadequate and seek to predict inadequately capitalized banks one year prior to the initial decline of the capital ratio. The early warning systems models developed in this document could identify capital inadequate banks with a sufficient amount of accuracy. It is important to consider the policy maker’s objectives when designing predictive models and setting related thresholds since there is a sharp trade-off between correctly calling crises and false alarms.

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Introduction

Economic crisis caused a loss a lot of assets and hit banks and money markets and stock markets. Many experts put global and causes of the crisis and tried to put many of the solutions, in order not to repeat the crisis, with the yoke of crises frequently occur once in a while. Usually in a crisis Wallis rush to withdraw some or most of their money from banks, resulting in a smaller cache and entry into force of the banks as quickly lead to bankruptcy of the bank, or falling into financial hardship unless the state stepped quickly to support the bank or if the bank insured money of depositors. It has been said and will say a lot about how that occurred where the global economic crisis, which began in the precursors to the disclosure of the same several months ago. The world know this crisis with the emergence of the subprime mortgage crisis that took place in the United States to be followed by United kingdom after period, and peaked following the announcement of a number of institutions and banks in the forefront of the World famous “Leman Brothers” for bankruptcy, due to lack of liquidity, and the inability to meet the demands of customers, forcing some into bankruptcy, and caused the collapse of the market.

The causes of the crisis

The reasons for the current global financial crisis back to the year 2006 and the outbreak of the so-called “crisis of high-risk loans,” which introduced the banking sector and U.S. banking in the spiral of losses and disorders, and claimed the lives of hundreds of thousands of American citizens. The crisis erupted high-risk loans because of the feet of many of the authorized banks in real estate loans to hundreds of thousands of citizens with limited income, ignoring the rule of caution and risk assessment. And adopted the banks of this approach is characterized by unprecedented growth of the real estate sector and a significant reduction of interest rates in place, which resulted in significant numbers of Americans to the conviction that the highly favorable opportunity to buy a house. 

With the sudden increase of interest rates in the banking markets of America, a large number of Americans have been unable to repay their loans, and the numbers have increased over the months to create an atmosphere of panic in financial markets and among investors in the real estate sector. Banks have been affected in the relevant high-risk loans more than other because of high interest rates, and their impact on the situation of borrowers with modest incomes. As soon as the first disturbance, accelerated banks to the confiscation of homes who are unable to repay the loans and sell them on the back of a sudden and severe crisis for the real estate sector is a result of declining prices by much. The series deal with the repercussions of the financial crisis since the outbreak of the credit crunch, high-risk, the central banks in the United States, Europe and Asia are being forced to move, leaving her only the choice between changing interest rates, pumping money into banks affected. The U.S. Federal Reserve deliberately approaches the first option, which took the initiative in many times to reduce the rate fell from 5.25 percent in June 2006 to 2 percent in April 2008.Not only has the U.S. government take this action, but has chosen to go away in their quest to prevent the spread of the crisis, which decided to nationalize the three big banks.

Manifestations of this crisis

  • Rush to withdraw deposits from the banks; because “capital is coward,” and this as stated by the mass media. – The fact that many financial institutions to freeze loans to companies and individuals for fear of the difficulty of recovery. – Lack of cash in circulation of individuals, companies and financial institutions, and this led to a sharp contraction in economic activity and all aspects of life; which led to the suspension of the borrowers to repay their faith.
  • Low level of transactions in the financial markets, and this caused confusion and disruption in the indicators of ups and downs. 
  • Low level of energy used by the companies due to lack of liquidity and a freeze on access to loans from financial institutions, but interest rates are very high and difficult guarantees. 
  • Lower sales, especially in real estate, cars, etc.; because of poor liquidity.
  • Increasing rate of unemployment due to the bankruptcy and liquidation, and every employee and worker threatened with dismissal. 
  •  Increased demand for social subsidies from governments.
  •  Low rates of consumption and spending, saving and investment, and this has led to more: recession, unemployment, and slower, stop, and liquidation and bankruptcy.

 Banking is one of the more closely supervised industries in the United States, reflecting the view that bank failures have stronger adverse effects on economic activity than other business failures. Capital adequacy is central to regulatory oversight of security, safety and reliability in the U.S. banking system. From a regulatory point of view, inadequate capital reflects financial distress that often leads to failure and crash. Regulators’ ability to predict bank capital shortage would really improve the success of the supervisory process, thereby affording regulators extra time to closely watch potential crisis banks and force sanctions (on dividend payments, asset increase, new business activities, salaries, deposit rates, etc.) to facilitate institutional recovery. Because inadequate capitalization is a pre-condition to bank failure, it has been the focus of widespread study. 

It is well documented in the literature that financial distress is a prolonged process that in general takes place over an extended period of time. Previous work on financial distress attempts to predict bank failure or closure by regulatory authorities. These studies observe the endpoint in the timeline of financial distress, which extends from the early phase of inability to earn competitive profits to a period of financial turmoil and ultimate failure. Consistent with this judgment, Gilbert, Meyer, and Vaughn (1999) attempt to predict banks that are likely to develop financial problems in the near future – predicting a CAMELS downgrade from a safe level (rated 1 or 2) to a watch list level (rated 3, 4, or 5).4 Using a logit analysis, found a simple equity to asset ratio to be one of the important predictors for a CAMELS downgrade. This article describes the process of developing an early warning system for banks to predict financial crises in the God of the bank’s capital significantly. We apply both logit analysis as well as trait recognition analysis (TRA), a neural network-like method, to the financial and economic data for the period 1988 to 1990.

Literature on Predicting Financial Distress

Several studies have examined financial distress, which is a pre-condition to firm’s failure. In general, these studies have found that accounting information can detect incipient financial distress of nonfinancial firms, and that different firm states on the financial distress continuum appear to be independent of one another. There are two branches of literature on financial distress – the multinomial choice approach and the survival time approach.

Multinomial choice models

In multinomial choice models a number of states of the firm are hypothesized to exist. For example, some studies define five possible states – financial stability, omitting or reducing dividend payments, default on loan payments protection from the Bankruptcy Act, and bankruptcy and liquidation. Some studies define a continuum of financial distress. Others collapse these five states into non bankrupt, financially weak, and bankrupt firms. In most of these studies, an ordinal logistic regression (OLGR) technique is employed, where the response variable is multinomial (as opposed to binomial), and explanatory variables are used to approximation the cumulative probability that a firm is a member of the response states. An additional branch of financial distress, survival time research, these techniques were primarily developed in the medical and biological sciences, but they are also widely used in the social and economic sciences, as well as in engineering, censored observations arise whenever the dependent variable of interest represents the time to a terminal event, and the duration of the study is limited in time. Censored observations may occur in a number of different areas of research. For example, in economics we may study the “survival” of new businesses or the “survival” times of products such as automobiles.

Survival time research

Survival time research, Predicts the probable time to failure using financial, economic, managerial, and regulatory factors. Using Cox proportional hazards models, as well as split-population survival time models, earlier studies compute survival time relative to bank closure or failure. In general, the empirical results support the notion that financial distress is a dynamic process that can be predicted using financial, economic, and other explanatory variables. We applied a survival time model with time-varying predictors to savings and loan (S&L) institutions. Interestingly, the authors noted that, among numerous studies attempting to predict S&L failure, only one variable was significant in all such studies – the equity capital ratio. Our study attempts to shut this gap in the literature by using the equity capital ratio as the dependent variable to reflect an early stage of financial distress. Our aim is to build up a model that predicts one of two states – capital-adequate versus capital-inadequate – where the latter state represents incipient financial distress to be predicted by bank supervisors.

The Methodology — EWS Models

Use the EWS Survey, to measure the amount of knowledge of individuals about the early warning system in financial institutions and its relationship to economic crises that occur in the world.

Objectives of the study

Identify the current situation on the economic crisis Measure the individual information about the early warning system

Building Study Tool

We designed a Questionnaire to measure the amount of knowledge of individual on the economic crisis(Appendix 1) The Questionnaire consists of public statements and two area: 

  1. The first area about the economic crisis 
  2. The second area about the early warning system

Applying the Tool study

  • The questioner was distributed to different ministries, institutions, some branches of the Bank and the training institutes
  • Survey was sent to many groups of individuals on 14-12-2009 via fax, e-mail and by hand.
  • Data was collected through 17-12-2009.
  • 83 responses were received from 100 surveys.

Programming Study Tool

The questionnaire data was insert and analyze using Microsoft spreadsheets .

Data and Empirical Results

Survey Results from the viewpoint of individual

The public question results : Notice here that the sample almost equally between males and females. It is noted that a large proportion of respondents said their incomes less than a thousand Kuwaiti Dinars ($ 3000) and they represent a large segment of workers in the community. These individuals are most affected by any economic crisis It is noted that one-third of respondents working in the business sector and the rest spread over other sectors. It is noted that a large proportion of respondents dealing with one bank and a significant proportion of individuals dealing with two banks and a few deals with three banks Results of the study are divided into two parts: 1-The first part about the economic crisis 2-The second part about the early warning system 

Part1 : Economic crisis have you heard about the Economic crisis that occurred recently? Yes No I don’t know Q1 81 2 0 Table 6 It is noted that most of the respondents (97.5%) had heard about the economic crisis, either through television or radio or newspapers or friends or seminars. figure 6 Did you expect the economic crisis?

Yes No I don’t know Q2 34 47 2 Table 7 There are convergent between the percentage who predicted the crisis and among those who did not. figure 7 Is the economic crisis affected your ability purchasing?

Yes No I don’t know Q3 48 35 0 Table 8 A percentage of its purchasing power was affected (57.8%) more than those who did not(42.1%), either because of lack of their incomes or because of their expulsion from their jobs or reduce their salaries or high prices of some goods. figure 8 Is the economic crisis affected the number of your trips?

Yes No I don’t know Q4 34 46 3 Table 9 Proportions of those not affected by its ability to travel (55.4%)more than those who affected(40.9%), because of the decline in oil prices, which led to lower fuel prices, which in turn lower prices of air tickets. figure 9 Is the economic crisis affected your Bank?

Yes No I don’t know Q5 34 39 10 Table 10 figure 10 Do you take a loan from the bank because of the economic crisis?

Yes No I don’t know Q6 15 67 1 Table 11 We note here that most of the respondents (80.7%)did not take loans because of the crisis and that back to either they take loans in the past and they cannot take again, or because they don’t need loan. figure 11 Do you feel that the economic crisis affected your behavior in dealing with banks?

Yes No I don’t know Q7 29 54 0 Table 12 We note here that some members of the sample (34.9%)affected by their dealings with the bank this may be due to the presence of installment or obligations of the bank they could not meet them. figure 12 Have you taken your actions for fear of another economic crisis?

Yes No I don’t know Q8 43 39 1 Table 13 We note here that some members of the sample (51.8%)taken precautions for fear of another crisis, because they hurting of the current crisis, we find some of them shift from work in the private sector to the government sector. figure 13 Do you expect another economic crisis?

Yes No I don’t know Q9 53 17 13 Table 14 We note here that most of the respondents (63.8%) do not expect a repeat of the crisis once again. figure 14 Part 2: Early Warning system Have you heard about the Early Warning System?

Yes No I don’t know Q10 16 67 0 Table 15 We note here that most of the respondents (80.7%) had not heard of early warning systems, due to a lack of informing, or because of lack of attention because of government-sponsored banks and guarantee deposits figure 15 Do you deposit your money in banks that rely on early warning system?

Yes No I don’t know Q11 10 5 1 Table 16 We note here that most of the respondents deposit their money in bank that rely on EWS because of government-sponsored banks and guarantee deposits. figure 16 Do you feel the importance of the existence of early warning system?

Yes No I don’t know Q12 14 2 0 Table 17 We note here that most of the respondents who had heard about the early warning system believe the importance of having early warning systems in the bank. figure 17 Do you agree with the need to adopt financial institutions and economic of early warning system?

Yes No I don’t know Q13 13 2 1 Table 18 We note here that most of the respondents who had heard about the early warning system agree with the need to adopt financial institutions and economic of early warning system. figure 18 Do you agree that the early warning system reduces the incidence of economic crises?

Yes No I don’t know Q14 13 2 1 Table 19 We note here that most of the respondents who had heard about the early warning system agree that the early warning system reduces the incidence of economic crises. figure 19

Summary and Conclusions

This paper has sought to empirically test the efficacy of EWS models as prediction tools in identifying incipient capital inadequacy in U.S. commercial banks. Our results demonstrate that capital deficient banks are much different from other banks in terms of their financial health. We find that capital adequacy is a broad concept that requires review of a wide array of different kinds of financial and economic variables. In addition, the TRA results highlight the importance of complex interaction variables in identifying banks with deficient capital. Our EWS models could detect the early onset of financial distress in commercial banks one year in advance with a reasonable degree of accuracy. By implication, the EWS models can be used to provide a timely signal of impending bank problems to supervisory agencies. Our group belief, international financial institutions do not employ an EWS specifically for banking crisis. However, given the ongoing liberalization of emerging market financial sectors as well as the changing nature of banking risks as more economies move into market and securitized banking phases, the use of EWS for crisis prevention is more necessary than ever. It is important to consider the policy maker objectives when designing predictive models since there is a trade of between correctly calling crises and false alarms. In this sense our study confirms that EWS for banking crises are a necessary but not sufficient tool for predicting further crisis episodes, since a generalized global model cannot be a substitute for country-specific prudential surveillance.

Group Recommendation of Some solution of the problem:

Adaptation of this crisis as the financial crisis on financial institutions is to adapt away from the fact that the crisis has, in fact, is a crisis of the capitalist system in its foundation underlying mechanisms and in terms of work and in terms of ethics in his dealings and explained as follows: in its foundation, the system of modern capitalist embrace to say the following: (a more efficient economic role of the state not to have a role in it), we believe that this is a real reason for the crisis and the President of the capitalist system. Here we say that Islamic economics does not is left to the entire economy with the decisions of individuals, but there are individuals in the state with economic decision. Islamic jurisprudence by the richness and wide on the role of the state and nature of the tools and understanding of the evolution. 

So, we say that the treatment of the entrances to this crisis was the introduction of Islam to the decision on the management of economic partnership between both the State and individuals. B- in terms of the mechanisms of the capitalist system: multiple of these mechanisms, but we refer only to the interest system which is managed by the capitalist economy, and we remember that the system of interest with his control in the capitalist system, but criticized by economists and capitalists permanent link system crisis in the interest of many of their writings here provide a solution to the mechanism of action of the Islamic economic system with reference only to the subject of the basis upon which the funding mechanism, a system of participation, this system has no system of co-effectiveness and economic efficiency is not economic when the Islamists alone, but when the economists who have studied this system objectively and impartially. Under the impact of financial crisis offers contemporary Muslims as the Islam of the system of participation to be the mechanism governing the work of financial institutions. This system of legislation of the Almighty God believes in achieving economic stability and this alternative courses and violent fluctuations caused by the system of interest. In terms of micro and macro view of the economy, the financial crisis of contemporary adaptations of partial adjustment is said it is a crisis at banks or at the level of the stock market, and this adaptation as a minor part of this crisis is now hitting all sectors of the economy. Here we come to the Islamic economy; Islam does not deal with the economy separate intervals, but the entire economy is taking his view to accommodate a total of all sectors of the economy and its branches. Islam, when funding be organized, for example, it takes all matters of economy in terms of equal distribution of incomes, where the interests of society and in terms of interest and not that which is known in the organization of Islam to the economy.

 In summary, Islam takes all matters of the economy as a complex and interactive, this adaptation of the true economic reality leads to the proper management of the economy. . Economy of the Islamic moral economy: the phrase start by talking on the economy, ethics and this is highly complex in spite of the economy, some economists have warned against the danger to separate economy from ethics, however, the reality of modern capitalist economy no uncertain terms that the role of ethics in the economy and this command from the clarity in the contemporary economic reality, does not need to prove it. Hence the one of the largest Islamic contributions in the economy. Economics of Islam is linked firmly to ethics in all aspects of the economy and the production sector, for example, is governed by specific ethical disciplines of Islam, and the area of finance at the same level, even in consumption is governed by specific ethical controls. 

So, we say that Islam addresses the economy with moral links secured setbacks arise because of a lack of ethics … Here we refer to what is said about the current financial crisis and the reasons that led to and including those related to the lack of morality when some managers financial institutions in capitalist societies. The application of control systems of banks and early warning to financial institutions, and provides the prediction of the expected losses to banks by estimating the potential future losses. Statistical early warning models are useful models to predict the banks that may face problems in the future, and thus the banks that need more intensive monitoring. But to ensure this benefit must be to continue the development of such models in terms of accuracy and reliability, studies have shown that the introduction of some economic variables in these models, such as unemployment and economic growth rate and growth rate of per capital income, increases the ability of these models to predict, as studies have shown the need to use these models in the analysis of scenarios. Educate people about the crises and early warning systems and the need for these systems in all banks and financial institutions.

Discussion:

  1. First: the spread of moral corruption, economic, such as: exploitation, lies and malicious rumors, fraud, fraud, monopoly and illusory, and these vices lead to injustice, which leads to the oppressed people complained when they could not afford it, and thereby lead to disgruntled civilians and social revolutions occur when non-payment of debts and loans. 
  2. Secondly: One of causes of the crisis as well as the article is becoming a weapon of tyranny and tyrants, and control over policy and decision-making sovereign in the world, and money is the god materialists 
  3. Third: The interest-based banking system on a system of interest taking and giving, and works within the system, debt trading and buying and selling broker, the higher the interest rate on deposits, the higher the interest rate on loans to individuals and companies and the beneficiary is the banks and financial intermediaries, the burden and injustice is that borrowers who receive on loans, whether for consumption or for production purposes. Some economists have argued that real development cannot be achieved and the rational use of factors of production only if the interest rate is zero, because it would bring stability and security, also said that the system of interest leads to a concentration of funds in the hands of a few will control the wealth.
  4.  Forth: The financial system and the traditional banking system debt at higher interest rates, or replace the loan due and payable loan new interest rate is high, and this places additional burdens on the borrower’s inability to pay the first loan; because of the higher interest rate. 
  5. Fifth: The bad manners of financial intermediation institutions which are based on loans and induce people to them and lure them with fraud, and deceit, and ignorance to take loans from financial institutions, high commissions and ask if there is risk, and who bears the risk of all is the borrower who does not about him or force, and this is what actually happened, which ultimately leads to the crisis. 
  6. Sixth: The over-expansion and the introduction of credit cards without balance (overdraft), which carry high costs and the owner of the causes of this crisis, and when the cardholder is unable to pay off its debt, has increased the interest rate, and so on until the inquiries by the or under his car or his house, and this is what actually happened to many holders of these cards and led to an imbalance in the House budget and the cause of the crisis in some of the riba-based banks.

References:

  1. Coats, P. K. and L. F. Fant. 1993. Recognizing financial distress patterns using a neural network tool. Financial Management 22: 142-155. Whalen, G. and J. B. Thomson. 1988. Using financial data to identify changes in bank Condition. Economic Review, Federal Reserve Bank of Cleveland: 17-26. James B Thomson – Predicting Bank Failures in 1980s – Federal Reserve Bank of Cleveland Economic Review, 1991, Quarter 1 – pages 9-20. 
  2. Alejandro Gaytán and Christian A. Johnson – Octubre 2002 , A REVIEW OF THE LITERATURE ON EARLY WARNING SYSTEMS FOR BANKING CRISES, Central Bank of Chile, Working Papers James Kolari, Dennis Glennon, Hwan Shin and Michele Caputo – Predicting Large US Commercial Bank Failures – Economic and Policy Analysis Working Paper 2000-1, January 2000, Office of the Comptroller of the Currency. E Philip Davis and Dilruba Karim1,(2007), COMPARING EARLY WARNING SYSTEMS FOR BANKING CRISES, A case study, Brunel University and NIESR West London, pp1-26 Kolari, J., D. Glennon, H. Shin, and M. Caputo. 2000. Predicting large U.S. commercial bank failures. 
  3. Working Paper No. 2000-1, U.S. Comptroller of the Currency (Washington, D.C.). Whalen, G. and J. B. Thomson. 1988. Using financial data to identify changes in bank Condition. Economic Review, Federal Reserve Bank of Cleveland: 17-26. Spong, K. 1985. Banking Regulation: Its Purposes, Implementation, and Effects. Second Edition. Federal Reserve Bank of Kansas City, Division of Bank Supervision and Structure R. Alton Gilbert, Andrew P. Meyer and Mark D.Vaughan,(2000), The Role of a CAMEL Downgrade Model in Bank Surveillance, https://research.stlouisfed.org/wp/2000/2000-021.pdf ,octobor 2009 Ranjana Sahajwala and Paul Van den Bergh,( December 2000) , BASEL COMMITTEE ON BANKING SUPERVISION, https://www.bis.org/publ/bcbs_wp4.pdf , October 2009 Richard C. Cook, (November 29, 2009), 
  4. The Economic Crisis and What Must be Done, https://www.prisonplanet.com/the-economic-crisis-and-what-must-be-done.html , December 2009 Mark Thoma on Saturday, (October 4, 2008), What Caused the Financial Crisis?, https://economistsview.typepad.com/economistsview/2008/10/what-caused-the.html , December 2009 By Mustaq Koya, Idialogue Magazine (Australia) January 2009 Edition, “Global Economic Crisis, An Islamic Perspective”, https://islamicsystem.blogspot.com/2009/01/global-economic-crisis-islamic.html , December 2009 Kabir Hassan,(Novembar 17,2009), “The Global financial crisis and the Islamic finance solution”, https://www.sesrtcic.org/imgs/news/image/Presentation-FinCrisisAndIFSolution.pdf , December 2009
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