FSA 2006 Financial Risk Outlook

Amanda Jarvis

January 26, 2006

It highlights the risks that the FSA believes will be most important in the next eighteen months and how these could affect its ability to achieve its statutory objectives and strategic aims.  The Financial Risk Outlook therefore provides the background against which the FSA sets its priorities for the year. 

Callum McCarthy, Chairman of the FSA, said:
“The Financial Risk Outlook is designed to raise awareness of the key risks which the FSA believes it, and both providers and users of financial services, should consider.

“Despite a year of growth and stability in 2005, and the prospect for broadly comparable conditions in 2006, there are risks and uncertainties which need to receive greater attention.  The risks to macroeconomic stability and growth are more weighted to the downside in 2006 than in 2005: it is easy to identify an increasing number of severe risks which, although of low probability, would have high impact if they were to materialise. 

“In these circumstances it is important that senior managers in financial services firms do not rely on the continuation of the low volatilities and stability of recent years, but instead identify, analyse and test the impact on their firms of differing assumptions, by carrying out effective stress tests, and learning from them.”

The FSA’s central assumption for macroeconomic conditions for the next 12-18 months is that the relatively benign conditions experienced in 2005 will continue: that there will continue to be strong world economic growth, without substantial change to the economic and financial stability which characterised 2005.  This assumption is in line with consensus forecasts.  But these relatively benign conditions are accompanied by large and growing imbalances which are in the long term unsustainable, and whose correction, if it were to occur in a rapid or disorderly manner, would pose risks to both providers and users of financial services.   The Financial Risk Outlook examines in particular three possible sources of instability which could affect firms, markets, consumers and the FSA’s own work.  These are:

-a significant and sustained rise in oil prices;
-a slow-down in global consumption; and
-a large and disorderly depreciation of the US dollar.

The Financial Risk Outlook also identifies and discusses a number of particular risks which would adversely affect the FSA’s ability to discharge its statutory responsibilities if they were to materialise.  Many would also affect financial markets.  Some of these risks are events, others trends.  The risks identified are:

-It is important for firms to evaluate how they would respond to extreme risk scenarios, such as a global pandemic or a major corporate bankruptcy, despite the current period of relatively low market volatility.

-The threat of terrorism poses a range of financial-crime, operational and insurance risks.

– Valuation problems with illiquid financial instruments, such as complex derivatives and structured products, raise operational and conflicts-of-interest risks.

– The level of outstanding credit-derivative trade confirmations presents operational and legal risks for firms; due to the rapid growth in the credit-derivatives markets, a backlog in unconfirmed credit-derivatives transactions has built up.

-The risk of financial fraud is increasing.

-The volume of international regulatory reform creates challenges for the financial-services industry.

-High levels of consumer borrowing may create financial problems for a significant minority of consumers.

-Increasingly complex financial decisions will pose a challenge for many consumers.

-Consumers are being required to take more responsibility for financing their retirement.

The Financial Risk Outlook emphasises the need for the senior managers of financial service firms to carry out stress tests to identify how their firms would respond to these and other risks materialising, and the adverse conditions, including a sudden drying up of liquidity, that they might cause.  The FSA is encouraging firms to fully embed stress testing into their day-to-day management processes. The ability to aggregate risks in stress testing will give firms a more complete sense of the risks they face, including hidden correlations across portfolios. Evidence suggests that this remains a key challenge for many firms that, if it is not addressed, leaves them vulnerable to sudden events.

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