The Financial Services Authority has called on firms to improve the stress testing of their businesses after its financial risk report highlighted the greater impact a shock could have were it to happen in the next 18 months.
The FSA’s Financial Risk Outlook 2007 is designed to raise awareness of the priority risks which the FSA believes providers and users of financial services should consider.
While the FSA’s overall outlook for the global economy continues to be benign, the report identifies an increasing risk that it will become more unsettled.
Key factors include the increasing geopolitical risks, which escalate the probability of an event risk happening, event risk meaning the likelihood of a repeat of either 9/11 or 7/7.
Also increasingly complex financial markets and the combination of low volatility of asset prices, a low market pricing of risk and stronger correlations between the prices of different classes of asset are risks that firms should be taking into account.
These trends mean that the impact of a shock to the financial system would be much greater now than two or three years ago.
Also examined in the report is the likely impact of three plausible alternative scenarios could have on firms, market and consumers.
They were a human influenza pandemic, the impact of a global reappraisal of risk, which involves a widening in risk premia amongst all asset classes, and a deterioration in consumer credit quality, which considers the impact of continued high growth in personal debt on the financial services sector in the UK.
Callum McCarthy, chairman of the FSA says: “While the central case is one of continued economic and financial stability, the various trends in place now mean that were something to go wrong it would have a much bigger impact than two or three years ago.
“This has implications for both providers and consumers of financial services.
“Stress testing and scenario analysis enable firms to assess and mitigate the risks that face them. It is important that firms use this period of relative stability to identify risks that could arise in less benign times.
“Our work shows that many firms still need to do more to develop their stress testing and to use more challenging scenarios.