On March 17, 2011, the Financial Services Authority (FSA) published its first Prudential Risk Outlook (PRO), which sets out the regulator’s assessment of macro economic and financial trends, and sheds light on how the FSA sets priorities and deploys its resources.
The document is divided into four sections: macroeconomic context; UK financial sector; credit risks and interest rate environment.
In its first issue the PRO highlights important risks to financial stability, such as areas of credit risk relating to vulnerable euro-zone countries and risks created by a sustained period of low interest rates.
On the residential mortgage sector, the report mentions that arrears rose through early 2010 but that they have since come down. However, loan forbearance may disguise to some extend the scale of the problem, and the situation may worsen if interest rates increase. As expected, arrears are higher for borrowers with high loan-to-value loans, for borrowers with buy-to-let loans and for loans where income was self-certified, loans made by specialist lenders and to borrowers with an impaired credit history. The report warns of the potential of rising long term rates related to a steep yield curve and rising short-term rates, and the potential credit risk exposure for lenders when the predominantly adjustable rate mortgage portfolio will have to be re-priced. Another source of potential credit risk is the out-of-money credit swaps. The report urges lenders to include different interest rate scenarios in their stress testing.
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