Designing an early warning system for the financial crisis in Iran through introducing a new index

One of the stylized facts of economics is the spread of the financial crisis to various sectors and the ensuing downturn. Thus, observing the financial sector and predicting its crises is an attractive topic among economists, policymakers and investors. For this purpose, financial condition indexes are used. In this regard, the present study develops a new index for the financial condition by using the principal component analysis (PCA) and combining eight financial variables. Then, using the constructed index and applying Markov Switching approach, the financial sector is divided into three situations of crisis, stability and boom over the period 1990:2 - 2017:1. Then, the probability of exposure to these situations in financial sector is calculated. The results show that the critical situation in the financial sector has a relatively low stability, so, with probability 0.93, the financial sector becomes stable in the next period. According to calculations, it is impossible to move from critical and volatile situation to boom. The boom in the financial sector has low stability as well. If the financial sector is in boom at period t, it will remain in the same position with probability 0.27 in the next period. With probability 0.59, the financial sector will experience stability, and with probability 0.14, it will be in crisis condition.