In 2013 all ECB publications feature a motif taken from the €5 banknote.note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. All rights reserved. ISSN 1725-2806 (online) EU Catalogue NoQB-AR-13-094-EN-N (online)Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the authors. The refereeing process of this paper has been coordinated by a team composed of Gerhard Rünstler, Kalin Nikolov and Bernd Schwaab (all ECB).The paper is released in order to make the research of MaRs generally available, in preliminary form, to encourage comments and suggestions prior to final publication. The views expressed in the paper are the ones of the author(s) and do not necessarily reflect those of the ECB or of the ESCB. AcknowledgementsThe authors want to thank Riina Vesanen for excellent research assistance and colleagues at the ECB, Non-technical summaryThe global financial crisis has had a significant impact on the health of the European banking system and on the soundness of individual banks. Beyond the direct bailout costs and output losses, the interplay of fiscally strained sovereigns and weak banking systems that characterize the ongoing sovereign debt crisis show the importance of the euro area banking sector for the stability of the entire European Monetary Union. The motivation for an early-warning model for European banks is thus clear.To derive an early-warning model for European banks, this paper introduces a novel dataset of bank distress events. As bank defaults are rare in Europe, the data set complements bankruptcies, liquidations and defaults by also taking into account state interventions, and mergers in distress. State interventions comprise capital injections and asset reliefs (asset protection and guarantees). A distressed merger occurs if (i) a parent receives state aid within 12 months after the merger or (ii) if a merged entity has a coverage ratio (capital equity and loan reserves minus non-performing loans to total assets) smaller than 0 within 12 months before the merger.The outbreak of a financial crisis is known to be difficult to predict (e.g. Rose and Spiegel, 2011). Recently, the early-warning literature has therefore focused on detecting underlying vulnerabilities, and finding common patterns preceding financial crises (e.g. Reinhart and Rogoff, The models are estimated to derive probabilities of banks being in vulnerable states, but a policy maker needs to know when to act. Following Sarlin (2013), the signals of the model are evaluated taking into account the policymaker's preferences between type I and type II errors, the uneven frequency of tranquil and distress events, and the systemic relevance of each bank.This paper presents the first application of the evaluation framework t...

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We investigate the effectiveness of the euro area’s single supervisory mechanism’s capital relief measures in response to the outbreak of the coronavirus pandemic, in terms of large non-financial corporations’ lending outcomes. Using a granular borrower level dataset and controlling for the policies of other euro area authorities, bank characteristics and demand effects, we find that the lifting of the pillar 2 guidance (P2G) capital recommendation had a considerable statistically significant impact in supporting bank credit supply. The results are attributed to both, the capital made available and announcement effects. The latter are generated by the communication of supervisory plans and the fact the P2G was not designed to be ex ante “releasable”. The announcement of granted supervisory flexibility seems to have reduced uncertainty surrounding forthcoming regulatory responses in the beginning of the pandemic and acted as a de facto “supervisory forward guidance” in support of bank business decisions. Going forward we propose the creation of a formal supervisory forward guidance strategy, to complement the existing communication channels, to the benefit of banks’ and market participants’ decision making during both normal and crisis times. Our work therefore contributes to the literature threefold: (i) it introduces a novel granular supervisory dataset at the borrower level, (ii) it is one of the first papers to take a euro area supervisory perspective in analysing the effectiveness of capital relief measures at the onset of the Covid-19 pandemic, and (iii) it proposes a new supervisory policy instrument, the “supervisory forward guidance” with the goal of informing and steering banks’ and market participants’ expectations in order to prevent distress episodes.

Early Warning Models (EWMs) are back on the policy agenda. In particular, accurate models are increasingly needed for financial stability and macro-prudential policy purposes. However, owing to the alleged poor out-of-sample performance of the first generation of EWMs developed in the 90's, the economic profession remains largely unconvinced about the ability of EWMs to play any important role in the prediction of future financial crises. The authors argue that a lot of progress has been made recently in the literature and that one key factor behind the prevailing skepticism relates to the basic evaluation metrics (e.g. the noise-to-signal ratio) traditionally used to evaluate the predictive performance of EWMs, and in turn to select benchmark models. This chapter provides an overview of methodologies (e.g. the (partial) Area Under the Receiver Operating Characteristic curve and the (standardized) Usefulness measure) better suitable for measuring the goodness of EWMs and constructing optimal monitoring tools.