Back offices must be reformed to reduce risk, says FSA

The Financial Services Authority (FSA), the UK’s financial markets regulator, has said that it is still concerned about backlogs in the credit derivatives market despite improvements, and has warned that banks need to further develop the robustness of their back-offices.

Following a market-wide initiative to reduce backlogs last September, the number of outstanding confirmations has fallen dramatically from record highs last year. According to figures in the FSA’s Financial Risk Outlook 2006 report, the credit derivatives market grew by 6.85% in September and October 2005, but the average outstanding trade confirmations fell by 4.25%.

However, the FSA warned that unsigned confirmations could still pose serious problems if a default event were to occur, exposing both parties to unnecessary legal risk. An expected rise in the number of defaults could also pose serious cash settlement problems, it said.

The regulator also warned that the industry needs to do more to understand the impact of low probability events on new products and markets. In particular, it said firms were vulnerable to disruptive economic events such as a possible avian flu pandemic, for which banks had little data to input into their models.

“The recent benign economic environment and low volatility in both equity and credit markets allowed investment banks to weather the impact of adverse events in 2005,” said the report. “However, one potential consequence of the long period of low volatility is that new products and markets can develop without their effectiveness in stressed scenarios being tested.”