Yesterday, the U.K. Financial Services Authority (FSA) published its annual Financial Risk Outlook (FRO) for 2010. The FRO outlines the main risks and issues present in the financial services industry in the U.K. The report is divided into four sections:

  • Section A. Macroeconomic background and outlook: Looks at how fiscal and monetary policy support has limited the scale and duration of the global recession and considers the future impact of its removal. The section focuses in particular on the challenges created by the need for some households and companies to deleverage from high pre-crisis levels of indebtedness.
  • Section B. Financial Stability and Prudential Risks and Issues: Highlights the importance of effectively managing prudential and financial stability risks for all stakeholders in the financial system and the main challenges that firms face in this area. The section also explores the new regulatory frameworks being developed to strengthen firms’ capital and liquidity management under stressed conditions and the FSA’s updated stress test. Among other things, the section sets out the new macroeconomic parameters that the FSA will be requiring firms to use to assess capital adequacy in the future. The new, more stringent stress tests will require financial firms to model a worst-case scenario in which the economy contracts an additional 2.3% from the end of 2009 and unemployment rises to 13.3%.
  • Section C. Market Risks and Issues: Explores risks derived directly from the crisis and other ongoing risks to which regulators and market participants need to respond. In this section, the agency briefly describes some of the cases where they have taken enforcement action against firms and individuals for market abuse. The agency notes that while major reforms such as to the over-the-counter (OTC) derivative markets are being introduced to reduce counterparty risks (through the creation of central counterparty (CCP) clearing systems), many of the risks with which the FSA is concerned are either ongoing (such as, the issue of market abuse) or reflect developments which are independent of the macroeconomic cycle (such as, the fragmentation of equity market liquidity through the development of new trading platforms, high frequency trading and OTC markets).
  • Section D. Retail Conduct Risks and Issues: Addresses retail conduct of business risks. Some of the risks that the FSA is focusing on have resulted from today’s specific economic circumstances such as, “[v]ery low interest rates…[which] can accentuate the danger that consumers may be susceptible to apparently yield-enhancing structured products whose risks they do not fully understand.” Many of the risks with which the FSA is concerned are, however, rooted in enduring features of retail financial services markets such as, “business models that cross-subsidize loss-making core products and very high margin products.” In this section, the FSA outlines policy initiatives that are being implemented to ensure fair outcomes are delivered to consumers in particular market segments including revised conduct strategy, which will enhance the FSA’s approach to identifying and addressing conduct risks.

The analysis done by the FSA to create the FRO will help inform how the FSA sets priorities and deploys resources in the coming year. The FSA also publishes, alongside the FRO, a series of Sector Digests which consider, in more detail, trends and risks in the following sectors: the banking sector, the insurance sector, the retail intermediaries sector and the asset management sector.