Banking soundness and financial crises' predictability: A case study of Turkey

This paper develops an Early Warning System (EWS) based on third-generation mechanism of financial crises using the Markov switching model and a new twin-crisis index. We apply the EWS to Turkey using monthly data ranging between February 1992 and December 2007. We show that the model captures the two major Turkish financial crises of April 1994 and November 2000/February 2001, and identifies the second one as a twin-crisis. Besides, the model reveals that the financial vulnerability of the Turkish banking system is significant in explaining the triggering of the two financial crises. Furthermore, we show that higher share of banks' assets receivable from the public sector and the interest rate mismatch have the best predictability ability of the twin-crisis over the horizon of 1 month.