FSA published its Financial Risk Outlook (FRO) for 2010 on 10 March. As usual, the FRO was the forerunner of FSA’s Annual Plan and sets out FSA’s views of the country’s economic background and outlook and the challenges firms will face. In this article, Emma Radmore of Denton Wilde Sapte looks at the main priorities FSA identifies.

Different firms, different challenges

As usual, this year’s FRO includes FSA’s usual assessment of the financial markets generally, and the macroeconomic circumstances created outside the financial markets but having an impact on the markets. It also highlights how the main challenges for some sectors of the market are prudentially driven, whereas for others they stem from market structure and, for the retail sector, in conduct of business dangers. To get this message home, FSA has published four sectoral digests highlighting the key messages for different types of firm.  

The overall picture

FSA’s initial analysis of the macroeconomic background and outlook gives a mixed picture. On the one hand, there have been clear signs that the measures taken to halt, limit or mitigate the effects of the financial crisis both globally and domestically have worked. In the UK, the main uncertainty for the immediate future stems from high leverage in the household and corporate non-financial sectors. How quickly these sectors deleverage will affect the economic outlook and therefore the pressures on the financial sector. FSA says, if UK economic growth accelerates steadily and puts the UK economy on a “V”-shaped growth path, then it should be possible to combine economic recovery with fiscal consolidation and gradual deleveraging by the nonfinancial sectors. But it warns high leveraging will still leave these sectors vulnerable to economic shocks and this will in turn mean continued high risks for financial firms. FSA has also looked at the implications for firms of three possible alternative scenarios:

  • if there is a strong economic recovery with quick abatement of disflationary pressures, then firms must be aware of the possibility of new asset bubbles. They should ensure they have strong risk management processes to protect against subsequent price volatility. Banks and building societies will also need to assess where risks arise in highly leveraged customers when interest rates increase;  
  • if the global economic recovery falters and UK growth is slower than expected, then asset prices will fall, which will lead to pressure on insurers and asset managers, while credit institutions find their interest margins squeezed; or  
  • if the UK falls behind the general global recovery, then there will be an increase in defaults and interest rates, which will crystallise losses on loans. In turn, falling asset prices will magnify losses and higher funding costs will squeeze profitability.  

Prudential challenges

Prudential challenges present the most obviously burdensome changes and risk management issues. FSA looks at the transition to a new capital regime for banks and building societies, stress testing, funding challenges and the new liquidity requirements. It also addresses margin challenges brought by low interest rates. The section also looks at prudential risks and issues for insurers, including highlighting concerns of an unstable claims environment in general insurance. Finally the section covers risk management practices in financial firms and assesses how the crisis has heightened certain risks and highlighted certain deficiencies.  

Market challenges

This section covers changes in the markets, particularly transparency in OTC derivatives markets and the greater use of centralised clearing and settlement leading to greater systemic importance of central systems. However, it stresses the importance of robust bilateral counterparty risk management arrangements where products are not suitable for clearing. It moves on to look at the changing structure of equity markets and trading platforms. FSA wants firms and their clients to understand that different trading venue models pose different risks. It also notes its concerns about market abuse and the possibility of product innovation again leading to excessive risk-taking. Firms should have strong anti-market abuse systems and remember to report suspicious transactions. Finally, FSA notes the impact on firms of the Credit Rating Agencies Regulation.  

Conduct of business challenges

The final section looks at the conduct risks that arose from the crisis and how customer behaviour has adversely impacted on some firms. It looks at how the crisis has highlighted deficiencies and identifies areas of challenge. Depending on the business in question, these challenges may arise from the need to increase margins, but not to the detriment of consumers and bearing in mind which products will not be suitable for many consumers. FSA specifically addresses platforms, which it believes will grow but which entail certain risks, such as transparency, suitability and transfer between platforms. It also notes the market for structured products is continuing to grow but cautions about the risks of mis-selling, which was revealed in connection with Lehman-backed products but which could extend to similar products. PPI concerns continue, with addressing complaints and compensating customers still under way, and FSA is increasingly concerned about share fraud.

Challenges by sector

In its sectoral digests, FSA relates the challenges to four sectors:  

Asset management

The asset management digest looks at how the model for asset management services changed in the past year. FSA noted that rising volumes, particularly in retail markets, and more complex strategies and products had exposed weaknesses in systems and controls. Its key message to the sector is that firms must:  

  • design, characterise and communicate products in a manner appropriate for the end client;  
  • ensure their systems, controls and capital are suitable for the strategies they offer; and  
  • assess the impact of the Alternative Investment Fund Managers Directive on them and raise concerns with policy makers.

FSA is concerned the sector, like other sectors, risks developing products it does not fully understand to meet changing investor needs. But if firms do not understand the products, the risks of mis-selling and inappropriate risk management are high. So firms must be sure they have the expertise and understanding to assess and manage the risks at all levels. FSA identified particular concerns as:  

  • controls over client money and assets;  
  • valuation of assets in funds including firms having the expertise to “sense check” valuations;  
  • the AIFMD and the need to continue to engage with policy makers;  
  • platforms, by ensuring each business unit is properly capitalised, including the cost of winding down operations if necessary;  
  • product design and characterisation;  
  • consumer awareness;
  • fund liquidity, so that managers manage liquidity appropriately to the instruments they use and the expectations they would have given investors when marketing the fund;  
  • capacity of manager to manages complex investment strategies; and  
  • growth in UCITS funds: FSA wants managers to make sure a fund is inherently suitable for retail investors, and not just rely on the fact it is a UCITS.  

Banking  

The failings of the banking sector became very clear during the crisis. The challenges now include ensuring institutions can generate sufficient stable profits to weather economic and market shocks, and institutions moving to liabilitydriven growth strategies. FSA feels banks and building societies that survived the crisis are now better capitalised than before but now need to ensure their business models are sustainable. The supplement looks at how new and developing structural constraints are driving adjustments to business models. FSA’s supervision strategy will focus on flagging early-warning indicators. FSA will be looking at other factors as well, such as:  

  • diversification strategies;  
  • risk appetite;  
  • asset mix and quality;  
  • funding and liquidity patterns;  
  • quality and level of capital; and  
  • conduct risk issues, especially where customers move between institutions that have consolidated or broken up during the crisis.  

The supplement discusses how FSA expects business models of retail and commercial banks to change, although not to the same extent as wholesale and investment banks. It also looks at the specific challenges building societies face, including how the covered bond market might develop as a funding avenue.

Insurance

FSA identified a number of risks to the insurance sector and its clients. The main consumer risk is posed by the likelihood of M&A activity in the life sector. FSA is concerned about how deals will be financed and whether they might complete too hastily. There is also a risk firms might try to maximise short-term business gains at the expense of core infrastructure investments. In the pensions and investment markets, the reforms of pension law will have a widespread effect. General insurers may suffer because of claims inflation. FSA’s concerns over compliance with client money protection requirements extend to wholesale insurance intermediaries. The insurance sector – both insurers and intermediaries – must focus on:  

  • robust capital management, although the sector has on the whole stood up well to the stressed conditions. Reserving adequacy has become an issue for general insurers;  
  • regular stress testing;  
  • making sure firms understand the risk management implications of the products they sell, and that the products are clearly described and offer real benefits to customers;  
  • assessing the impact Solvency II will have on their capital and tax positions and the demands on human and other resources of implementing it; and  
  • the effects of other relevant legislative changes.  

Retail intermediaries

Retail intermediaries in investment, insurance and mortgage businesses face continuing challenges. While the sector is used to evolving to meet change, FSA is concerned about sustainability of business models, quality of advice and standards of management and control. The key messages for the sector include planning for implementation of stages of the Retail Distribution Review and ensuring compliance with client money requirements.

What next?

The FRO gives some good clues as to where FSA will focus its supervisory efforts over the next year. The breakdown of the FRO indicates an appreciation of the split between prudential and conduct challenges and the weighting of challenges between sectors. The recurring themes are predictable – good quality, resilient capital, strong risk management demonstrating understanding of the business and optimal protection for consumers, through appropriate products, good advice and proper client money controls. Add to this the need for many firms to adapt to new legislation over the next year or so, and this leaves many challenges for firms in all sectors.