The UK’s Financial Services Authority called on firms to improve the stress testing of their businesses after its financial risk report highlighted the greater impact a shock could have were it to happen in the next 18 months.

The FSA’s Financial Risk Outlook 2007, published today, is designed to raise awareness of the priority risks which the FSA believes it, along with providers and users of financial services, should consider.

While the FSA’s overall outlook for the global economy continues to be benign, the FRO identifies an increasing risk that it will become more unsettled. Key factors include the increasing geopolitical risks, which escalate the probability of an ‘event risk’ materialising; 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. These trends mean that the impact of a shock to the financial system would be much greater now than two or three years ago.

A recent FSA review on stress testing found that, while good work was being done, some firms could be underestimating the probability of severe events. Firms should not overestimate their ability to take action in an effective and timely manner, it cautioned.

“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.

“I would encourage all firms to consider the risks outlined in the FRO and to plan accordingly. Stress testing and scenario analysis enable 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 still need to do more to develop their stress testing and to use more challenging scenarios,” McCarthy added. “Similarly, consumers should consider how they would manage their existing debt in the event of any disturbance to the present favourable economic circumstances.”

In the FRO, the FSA states that a significant minority of consumers could experience financial problems because of high levels of borrowing. In spite of the benign environment, there are growing signs of consumer distress, such as record levels of insolvencies, late payments on credit cards and a rise in mortgage-possession orders, it found.

These are high debt levels are not seen as a financial stability problem, but the possible increase, and subsequent impact, of interest rates and unemployment is something consumers and industry should prepare for, the FSA said.

Also examined in the FRO is the likely impact three ‘plausible alternative scenarios’ could have on firms, market and consumers. They are: a human influenza pandemic that could cause widespread disruption to the financial system; the impact of a global reappraisal of risk, which involves a widening in risk premia amongst all asset classes, but particularly affecting emerging markets and high-yield assets; and, a deterioration in consumer credit quality.

This year, for the first time, the FRO has identified the considerable risks and challenges that climate change poses to the financial sector. These include greater costs to firms through extreme events and possible equity market volatility arising from these costs.