FSA Financial Risk Outlook 2006 Product Providers

February 2006

The Financial Services Authority Financial Risk Outlook 2006, published on the 25th January 2006, 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 strategic aims and statutory objectives. As such the Financial Risk Outlook provides the background against which the FSA sets its priorities for the year.

Essentially, the FSA's Outlook is one of continued economic and financial stability although uncertainties surrounding this forecast which could affect firms, markets, consumers and the FSA's own work arise from the trend for increases in oil prices, the general slow down in global consumption and increasing global imbalances.

In addition, the Financial Risk Outlook identifies and discusses a number of particular risks, the FSA's priority risks, which would adversely affect the FSA's ability to discharge its statutory responsibilities if they were to materialise. Many of these risks could also have an effect on the financial markets. Some are events for which contingency planning should be considered; others are trends which will require action to reverse the trend and/or to reduce the ongoing effects. The Priority Risks identified in the 2006 Financial Risk Outlook include:

Challenges posed for many consumers as a result of the increasingly complex financial decisions they are being required to make
The shift in responsibility to consumers, from Employers and the Government, to take responsibility for financial matters, coupled with increased choice for consumers in financial services and increased complexity of the products available to them gives rise to the risk that consumers buy products that are not suitable for them or appropriate for their needs. Firms need to help consumers by providing them with clear explanations of the products they are selling together with all associated risks, costs and benefits.

Concerns over credit-derivative trade
This concern was first raised in the Financial Risk Outlook 2005, and results from rapid growth in the market resulting in a backlog of unconfirmed transactions. Such a backlog leaves exposure to legal and financial uncertainty where a credit event occurs prior to the issue of the confirmation, potentially creating liquidity problems and accelerating a financial crisis. Whilst the backlog is now acknowledged to be falling the FSA remains concerned, and firms need to ensure that the backlog continues to fall to reduce these potential uncertainties.

The challenges created by the volume of international regulatory material which will require implementation
The FSA remains concerned about the volume of EU legislation that firms will be required to comply with. Firms are being warned to ensure that adequate resources are set aside to deal with the necessary implementation to avoid incurring significant last minute costs and additional compliance risk.

Need for consumers to take more responsibility for financing retirement
Concerns result not only from the problem of understanding the array of products available, but also from a reluctance on the part of consumers to focus on such provision rather than on more immediate needs. In addition, concerns are raised over how consumers handling the decisions required at drawdown will be dealt with given the wide range of vehicles currently used for saving. The FSA also warns of the importance of consumers' understanding the costs, terms and conditions and associated risks of the products they buy on drawdown.

Extreme risk scenarios, such as a global pandemic or a major corporate bankruptcy, despite the current period of relatively low market volatility
Whilst many firms have imbedded stress testing for market risk, testing in other areas is less well developed. Fully embedding adequate stress testing into a firm's risk management process remains a challenge for many firms which needs to be addressed. Firms are also reminded of the need to use aggregated risks in their testing scenarios.

Terrorist Activity
Not only does this present an operational risk for firms, but it is also a potential source of market disruption. Terrorist finance is also noted as a potential risk for the damage it could cause to the reputation of the UK financial markets. The exposure of the UK insurance industry to terrorist events is also noted.

Valuation problems with illiquid financial instruments
As the public's appetite for investments such as complex derivatives and structured products has increased the FSA has included the risk presented over valuations of the products in its list. Valuation problems are considered to be a potential concern due to systems inadequacies, where systems are not originally set up to deal with the valuation of illiquid products, and lack of expertise resulting from the relatively small number of such valuations that are required to be undertaken.

Financial problems resulting from high levels of consumer borrowing
Levels of consumer borrowing continue to rise in spite of a general slowdown in the housing market and consumer spending. Whilst current high levels of employment coupled with low interest rates ensure that the level of debt taken on is able to be serviced for the time being, the concern is that if either of these variables were to change the consequent inability, of many, to pay would result in reputational damage and potentially mortgage mis-selling claims.

The general increase in financial fraud
The increasing use of the internet to conduct transactions increases susceptibility to financial fraud. In addition, disincentives to commit such fraud are seen to be falling when compared with the potential reward. To mitigate this risk the best courses are considered to be collaboration within the industry to reduce the occurrence of prolific frauds and have an impact on more sophisticated crime. In the longer term the Fraud Bill together with the Government's wide ranging review of fraud and the creation of the Serious and Organised Crime Agency will all hopefully create further disincentives to the crime.

We would urge firms to note the priority risks identified and ensure action is taken in mitigation of the risks so far as possible.

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