FSA cautions higher correlation may increase risk

Increasing correlation across asset classes and geographies has heightened the risk of a rapid widening of spreads and a decline in some asset classes, according to the UK’s Financial Services Authority (FSA).

The FSA named rising correlation, as well as greater geopolitical risk, event risk and the complexity of the financial markets, as key factors in increasing overall risk.

In its “Financial Risk Outlook 2007” released on January 31, it said: “Instruments that have been traditionally used to balance portfolios due to their low or negative correlation may no longer necessarily fulfil this role as effectively.”

Over the last year, riskier asset classes such as commodity and emerging market assets have become increasingly exposed to a potential rapid widening of spreads and decline in prices, the FSA warned. The regulator also noted an increase in capital invested in alternative asset classes and structured products, which may be illiquid and difficult to value.

It stressed a continuing obligation for those involved in trading and pricing these assets to “consider their inherent conflicts of interest”, particularly where incentives are awarded based on portfolio performance. For banks trading in the over-the-counter markets, the growth of risk over the past few years “underlines the importance of prudent collateral management”, according to the FSA. Within prime brokerage, it raises concerns that competition for business among banks may lead to the erosion of suitable margin and collateral requirements for hedge funds.

The regulator reiterated worries about insider information affecting trading in the corporate bond and credit default swap markets, and the level of confirmation delays in the equity derivatives market. The FSA also repeated a call for banks to improve their stress testing. See also: FSA warns of complacency in stress testing