The Financial Services Authority (FSA) today published its Financial Risk Outlook (FRO) outlining the main risks and issues present in its operating environment, affecting firms, markets and consumers. 

This year’s FRO is divided into four sections:

• Macroeconomic background and outlook looks at how fiscal and monetary policy support has limited the scale and duration of the global recession, and the future impact of its removal;

• 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.  The chapter explores the new regulatory frameworks being developed to strengthen firms’ capital and liquidity management under stressed conditions and the FSA’s updated stress test;

• Market Risks and Issues explores risks derived directly from the crisis and other ongoing risks to which regulators and market participants need to respond;

• Retail Conduct Risks and Issues identifies retail conduct of business risks, some of which have resulted from today’s specific economic circumstances but many of which are rooted in enduring features of retail financial services markets: such as business models that cross subsidise loss-making core products and very high margin products.

"Since the publication of last year’s Financial Risk Outlook, the immediate financial crisis has subsided, equity and credit market prices have recovered, and most major economies came out of recession in the last quarter of 2009. But this stabilisation and recovery was only possible because of the public policy response to the crisis – bank recapitalisations, public debt guarantees, exceptional central bank liquidity support, quantitative easing and the reduction of policy interest rates to historically low levels. Moreover, despite these measures, most developed economies including the UK suffered a severe recession in 2009; recovery is only gradual, and vulnerabilities created by the build up of leverage in the pre-crisis years still remain."

"Deficiencies in some firms’ risk management, including shortcomings in systems and controls, and governance and culture, have been exacerbated by the financial crisis as firms’ senior management has been stretched to deal with immediate prudential issues."

"The financial crisis resulted from a combination of asset losses, extreme uncertainty about the eventual scale of those losses, and the collapse in funding liquidity. In response, the authorities took unprecedented measures to recapitalise the banking sector and provide large-scale liquidity support. In addition, monetary policy was dramatically loosened to offset demand deflation, with the Base Rate cut to a historically low 0.5% and quantitative easing executed. Looking forward, a new regulatory regime for both capital and liquidity is being designed, which will ensure a more stable banking system in the future. The transition to this new regime, combined with the withdrawal of exceptional liquidity support will, however, create major challenges which will need to be addressed:

• Capital adequacy, stress tests and the transition to a new capital regime;
• Funding challenges as exceptional support is withdrawn and new liquidity requirements introduced; and
• Margin challenges created by low interest rates, especially for building societies."

The report: Financial Risk Outlook 2010