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FSA publishes Prudential Risk Outlook

The Financial Services Authority (FSA) has today published its Prudential Risk Outlook (PRO), which sets out its assessment of macro-economic and financial trends as a context for its micro-prudential regulation and supervision of firms.

The analysis which lies behind the PRO helps inform how the FSA sets priorities and deploys its resources. The FSA’s Business Plan, due for publication next week, describes those priorities and the resulting resource requirements.

Over the past two years the capital and liquidity position of the UK banks has improved significantly, increasing resilience to shocks. But the PRO describes still important risks to financial stability. It highlights in particular:

>> Incomplete progress in deleveraging required to create a less vulnerable system.
>> Progress towards improved global capital and liquidity standards and the need, as that progress is achieved, to understand possible risk transfers and migrations to other parts of the financial system.
>> A number of important areas of credit risk, relating in particular to vulnerable eurozone countries, to commercial real estate, and potentially, in emerging markets facing rapid property price inflation.
>> The risks created by a sustained period of low interest rates which could crystallise as and when interest rates return to more normal levels.

Introducing the new publication, Adair Turner, FSA chairman said:

"In the face of these still important risks it is vital that banks focus on achieving further progress to sound funding positions, maintain high capital ratios and adequate provisions, and that banks, insurance companies and other financial institutions focus strongly on the specific risks to which their business mix exposes them."

The PRO is divided into four sections:

Macroeconomic context describes the global and UK economic environment and highlights the importance of further gradual deleveraging in over-extended parts of the UK household and corporate sectors.

The UK financial sector discusses the profitability, capital strength and funding position of the UK banking and insurance sectors and contains the updated FSA macroeconomic ‘anchor’ scenario for stress testing. Key messages to firms include:

>> To meet Basel III standards, some firms will need to strengthen capital positions further and should ensure that dividend and remuneration policies are consistent with the need to build up capital to meet these revised standards.
>> As firms strengthen capital positions, management and shareholders should review the appropriateness of target returns on equity. Too-high targets should not drive firms to imprudent risk-taking.
>> When market conditions allow, firms should take opportunities to get ahead of plans for issuance of medium and long-term debt in order to improve their liquidity positions, even if for the present short-term wholesale funding is cheaper.

Credit risks discusses five broad areas of credit risks to UK firms: country risks in the eurozone; UK household lending; UK commercial property; US residential and commercial property; and emerging markets. Key messages to firms include:

>> In their stress testing, firms should consider a range of policy options in the euro-zone peripheral countries, including a prolonged period of austerity and possible restructuring of bank and sovereign debt.
>> Lenders and their auditors should ensure that impairments on household lending are fully recorded, including forbearance cases, and that provisioning practices reflect realistic estimates of future cash flows.
>> Firms should have in place workable exit strategies for all of their loans to Commercial Real Estate (CRE) companies and ensure that decisions to extend loans or exercise forbearance are consistent with them, and reflect realistic assumptions on prospective loan repayments.
>> Firms should prioritise prudent credit risk management over expansion in markets experiencing rapid credit and asset price growth.

The interest rate environment section looks at the impact of low interest rates and risks that firms need to consider as interest rates return to more normal levels. Key messages to firms include:

>> In their stress testing of both banking and trading books, firms should prepare for a range of interest rate scenarios.
>> In their credit assessments, firms should assess the vulnerability of their customers to rising interest rates.

The publication follows Lord Turner’s speech to Cass Business School yesterday evening which signalled a more stringent approach to regulation of UK banks and interconnected financial institutions.

The Prudential Risk Outlook, together with the Retail Conduct Risk Outlook, which was published on 28 February, replaces the Financial Risk Outlook series.

The Financial Risk Outlook has been published since 2002. The FSA says it has now split them as it heads towards an increasingly distinct focus on prudential and conduct issues ahead of the restructuring of the FSA into the Prudential Regulatory Authority (PRA) and the Financial Conduct Authority (FCA). That restructuring also involves the creation of the Financial Policy Committee (FPC) which is specifically focussed on macro-prudential issues.

The FPC, which is already in place in interim form, and on which the FSA chairman and chief executive sit, will take responsibility for the content of the Bank of England’s Financial Stability Review (FSR), starting with the Review to be published this summer. In future years therefore the FSA will not produce a separate PRO: the functions of the FSA PRO and the Bank FSR will effectively be combined.