The UK’s Financial Services Authority has published the latest version of its Financial Risk Outlook, indicating that economic deleveraging, and the negative feedback loops that could result, remains one of the chief risks facing the financial system.

The report, which was released Monday, outlines the main risks facing firms, consumers and the regulatory system in the economic downturn, in particular the challenges created by deleveraging in both the banking sector and the real economy. “These challenges include banks adjusting their business models to operate successfully in difficult conditions in financial markets and in the real economy,” it says.

“Firms are also reminded of the importance of treating customers facing difficulties with fairness. Consumers will need to be able to identify warning signs that might suggest they are getting into financial difficulty, should be cautious of financial deals which seem too good to be true and know where to go for impartial finance advice,” it counsels.

The report spells out three changes that are likely to have implications for financial firms in the year ahead: new capital adequacy rules, liquidity rules and institutional regulation. “There is an emerging international consensus that rules on capital adequacy need to be revised to increase the capital held against trading books and market risk, and to introduce a counter-cyclical element to bank capital requirements,” it notes, adding that, “a new counter-cyclical regime is required to restrain over-rapid growth in the future with implications for firms’ strategies.”

Liquidity regulation also needs to be reviewed, the FSA says. “New more effective regulations, supervisory processes, reporting requirements and internal risk management approaches are required,” it says.

Also, in the future the institutional coverage of regulation needs to be driven by economic substance, not legal form, the FSA notes. “The growth of complex investment banks, SIVs, conduits, mutual funds and hedge funds created risks which were inadequately covered by current regulation and supervision. There is increasing international consensus in favour of a regulatory approach, which will not allow this to occur in the future and bank and investment bank practices are likely to be significantly affected as a result,” it says. “

This approach will probably also entail the gathering of more extensive information from those firms whose activities do not require prudential regulation today. The aggregate of such activities may have systemically important effects and in some cases, individual firms engaged in such activities may themselves become systemically important. At such a point, prudential regulation may be necessary,” the FSA adds.

On the economic front, the FSA reports that consensus forecasts suggest that the total global economy will be close to zero growth in 2009. “Developed countries will suffer recessions, and developing countries significantly lower growth than in 2008. However, absolute growth figures for some developing countries are expected to remain robust and growth in these economies should aid the global economic recovery. The consensus forecast suggests a recovery in 2010, with global growth at 2.0%,” it says.

Still, the regulator notes that, “There is still considerable uncertainty over the forecasts and the global recession could be more prolonged than expected.”

A crucial issue in determining the trajectory of the global economy is how far the process of deleveraging within the financial sector has already progressed, and how much more is likely to occur. It finds that this process is likely still in the early stages, “While it is not possible to be definitive, it therefore seems likely that deleveraging within the financial system is proceeding at a pace which by the middle of 2009 should have markedly reduced the leverage from previous levels.”

And, it notes that some deleveraging of the household sector and some parts of the corporate sector is needed to reduce long-term financial risks. “However, this deleveraging cannot occur rapidly in a period of low growth and low inflation. As property prices fall, asset leverage will increase, and if corporate and household incomes are depressed, income leverage may also rise,” it observes. “Therefore, attempts by households and corporates to rapidly reduce their leverage through increasing savings, cutting household consumption and business investment, could prove ineffective. At the aggregate level, this could also be self defeating, as reduced household consumption cuts business revenues, and reduced household borrowing depresses property prices.”

These sorts of self-reinforcing relationships could deepen and prolong the recession, the FSA warns. “These self-reinforcing cycles exist in any economic downturn, but the crucial danger in the current crisis is that weakness in the banking system could stimulate and reinforce them. This could become even more serious if price deflation resulted in a rise in the real value of existing debt.”

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