The Bank of England gave the UK banking industry a stark warning today to improve stress-testing systems to avoid being dangerously exposed if there is a 'severe shock' to the financial system. The UK’s central bank made the comments in its twice-yearly Financial Stability Report, which found that risk models used by banks are better at capturing certain types of risk such as credit risk rather than liquidity risk.Banks’ risk management systems are also failing to keep up with the pace of evolution in financial markets and the growing popularity of financial instruments such as collateralised debt obligations (CDOs) and complex structured products, which may prove to be illiquid in stressed market conditions, the report said. The Bank of England added that counterparty credit and interest rate risks, which are increasing as banks lend to each other and to other financial institutions, also need to be stress-tested more vigorously. Banks’ increasing appetite for risk was found to be exacerbating their vulnerability to a ‘severe shock’ to the financial system. The report said this year had witnessed “an extension of risk-taking activities by banks, despite a widely held belief that the price of certain assets had become too high and the premium for taking risk too low”. A focus on short-term profitability, fear of losing market-share and the risks associated with failing to establish a foothold in a rapidly expanding market all contributed to banks taking on more risk, the report said. However, Aaron Brown, head of credit risk architecture at Morgan Stanley, said both investment and commercial banks were not neglecting the stress-testing of market or liquidity risk. “Stress testing seems to be the main practical challenge for risk managers, and there has been tremendous improvement over the past three years,” he said. “People should know that market and liquidity risk are equally as important as credit risk. With operational risk it is more a case that we do not have a consensus on an everyday distribution. There has been a lot of work on extreme cases, with the emphasis all been on avoiding the big ones.” Sir John Gieve, deputy governor for Financial Stability at the Bank of England, said dealers needed to continue to improve their stress testing against less favourable conditions. “We are working with the FSA [Financial Services Authority] and Treasury and authorities abroad to mitigate the risks and improve contingency planning," he said. The UK’s Financial Services Authority is currently surveying banks’ stress-testing systems to ensure best practice in the industry.
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