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FSA calls for more stress testing

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LONDON—Economic and financial stability is set to continue in the global economy in 2007, but if something were to go wrong, the impact would be far greater than only two or three years ago, according to the U.K. regulator—the Financial Services Authority.

The FSA published its analysis of the global risk landscape in its annual "Financial Risk Outlook" report.

This document is to designed to raise awareness of the priority risks which it believes it—and the users and providers of financial services—need to focus upon.

The FSA said that its findings meant that firms need to improve their stress testing because of the apparent rise in impact that a shock could have upon the financial sector, were it to happen in the next 18 months.

"While the central case is one of continued economic and financial stability, the various trends in place now mean that were something to go wrong, it would have a much bigger impact than two or three years ago. This has implications for both providers and consumers of financial services," said Callum McCarthy, chairman of the FSA.

"Stress testing and scenario analysis enables firms to assess and mitigate the risks that face them. It is important that firms use this period of relative stability to identify risks that could arise in less benign times. Our work shows that many firms need to do more to develop their stress testing and to use more challenging scenarios," continued Mr. McCarthy.

The FSA also said that it believes there is an increased risk that the global risk will be more unsettled.

The main reasons for this are increasing geopolitical risks that escalate the probability of an "event risk" materializing; increasingly complex financial markets and the combination of low volatility of asset prices, a low market pricing of risk and stronger correlations between the prices of different classes of asset, according to the regulator.

Alex Hindson, associate director of Aon Global Risk Consulting, reacted to the FSA's report by stating that it reinforces the argument for enterprise risk management.

"In effect, ERM is supporting the solvency objectives of individual capital adequacy standards, by identifying possible operational and market risks. This is a good discipline for ensuring the organization is prepared to respond, both in terms of capital allocation, but also risk mitigation strategies," he said.

"Identifying a pandemic as a 'plausible alternative scenario' drives the logical next step of understanding just how damaging the impact can be—especially for life insurers—through financial modeling. Such financial modeling enables companies to plan an effective business continuity process. Companies now need to go back to their business continuity plans and ensure they take account of the challenges of a pandemic scenario, with the consequences on staff and employee relations," continued Mr. Hindson.