The UK’s Financial Services Authority published its Financial Risk Outlook report today, highlighting oil prices, the U.S. dollar and global demand as the biggest macro risks it sees, but the financial industry faces a slew of specific risks of its own, too.

The FSA’s central assumption for macroeconomic conditions for the next 12-18 months is that the relatively benign conditions experienced in 2005 will continue. It expects that there will continue to be strong world economic growth, without substantial change to the economic and financial stability which characterised 2005.

However, it allows that these relatively benign conditions are accompanied by large and growing imbalances which are in the long term unsustainable, and whose correction, if it were to occur in a rapid or disorderly manner, would pose risks to both providers and users of financial services.

The report examines three possible sources of instability which could affect firms, markets, consumers and the FSA: a significant and sustained rise in oil prices; a slow-down in global consumption; and, a large and disorderly depreciation of the US dollar.

It also identifies particular risks which would adversely affect the FSA’s ability to discharge its statutory responsibilities. These risks are: firms ability to deal with extreme scenarios, such as a global pandemic or a major corporate bankruptcy; the operational and insurance risks associated with terrorism and financial crime; valuation problems with illiquid financial instruments, such as complex derivatives and structured products; the backlog in unconfirmed credit-derivatives transactions; the increasing risk of financial fraud; the volume of international regulatory reform; high levels of consumer borrowing; increasingly complex financial decisions will pose a challenge for many consumers, as they are being required to take more responsibility for financing their retirement.

The Financial Risk Outlook emphasises the need for the senior managers of financial service firms to carry out stress tests to identify how their firms would respond to these and other risks materialising, and the adverse conditions, including a sudden drying up of liquidity, that they might cause. The FSA is encouraging firms to fully embed stress testing into their day-to-day management processes.

It says that the ability to aggregate risks in stress testing will give firms a more complete sense of the risks they face, including hidden correlations across portfolios. Evidence suggests that this remains a key challenge for many firms that, if it is not addressed, leaves them vulnerable to sudden events.

“Despite a year of growth and stability in 2005, and the prospect for broadly comparable conditions in 2006, there are risks and uncertainties which need to receive greater attention. The risks to macroeconomic stability and growth are more weighted to the downside in 2006 than in 2005: it is easy to identify an increasing number of severe risks which, although of low probability, would have high impact if they were to materialise,” said Callum McCarthy, chairman of the FSA.

“In these circumstances it is important that senior managers in financial services firms do not rely on the continuation of the low volatilities and stability of recent years, but instead identify, analyse and test the impact on their firms of differing assumptions, by carrying out effective stress tests, and learning from them.”