UK financial watchdog urges tougher stress tests

LONDON (Reuters) - Britain's financial regulator is concerned that the stress tests banks and financial institutions use to prepare for potential shocks are not severe enough.

Thomas Huertas, director of wholesale firms at the Financial Services Authority, said some of the tests applied an insufficient level of financial stress. He said, for example, that one scenario would not even have required a company to skip its dividend payment.

"We've written to firms to encourage them to include a significant level of stress," Huertas said at the Reuters Investment Banking Summit in London.

A recent review by the regulator of stress-testing practices at 10 large firms in the banking, building society and investment banking sectors found that only a small number of firms matched up fully to the FSA's criteria for effective stress testing, although most firms in the sample had practices that went some way to meeting them.

One of the FSA's priorities in terms of monitoring the risks to the financial system is to ensure that "firms be aware that the good times do not last forever", Huertas said.

"Less than four years ago there was a downturn," he said referring to the financial market downturn following the dot.com boom in 2000.

Financial markets are booming again now, with equity prices at five-year highs and merger and acquisition activity at record levels in Europe, driven by a flood of private equity deals.

He pointed to the FSA's discussion paper on private equity published last week, which warned that a default of a company that has been taken private by private equity firms via a leveraged buyout was "inevitable".

Huertas also said some of the stress testing the FSA is asking firms to look at is not covered by the "value at risk" systems banks use to measure market risk.

"These can be non-exotic (products) such as prepayment options on home mortgages," he said.