While financial models and stress testing methodologies are some of the tools that help us in dealing with the issue, they are based on observable market parameters. Oftentimes, the problem arises through the so called “illusion of knowledge” (Barber and Odean / 2001) – tendency to make stronger inference than warranted by the data.
The difficulty comes when we have to overlay qualitative factors that have a bearing on financial stability. For instance we cannot always insist on empirical evidence to act upon an early warning. Even when early warning indicators are based on data, such indicators may be contradicting other financial indicators.