Economic recovery will be slow, warns financial watchdog

The Financial Services Authority (FSA), which polices Europe's biggest money centre, said banks, building societies and insurers must not allow tough conditions to detract them from spotting and controlling risks better.

"Economic conditions and firm actions to manage default may mean that firms are underestimating the number of borrowers in financial difficulty," the FSA said in its annual Financial Risk Outlook.

However, on the overall outlook, it said: "Our central economic scenario is for gradual economic recovery throughout 2010."

The report outlines areas the watchdog is focussing on, flagging specific policy proposals it will unveil next week.

As Britain's special liquidity and credit guarantee schemes, used to shore up banks at the height of the financial crisis, are withdrawn, firms must plan to close the funding gap by the end of 2012.

"The FSA will be reviewing these plans in detail with the firms," the watchdog said.

Profitability at building societies or mortgage lenders will continue to be challenging due to low net margins and strong competition for retail funding.

"Funding and capital constraints will result in reduced capacity to lend, so society balance sheets are likely to shrink or grow only slowly," the FSA said.

Insurers also face a tough market.

"It is unlikely that the trading environment will quickly, if ever, allow firms to return to the levels of income and profitability experienced prior to the crisis, unless they make significant changes and this may present new risks," it said.

The watchdog signalled a stronger push to protect consumers by intervening earlier in product design and marketing rather than simply ensuring that people are properly compensated when things go wrong.

The FSA said new EU securities trading rules introduced in 2007, known as MiFID, have sparked competition in share trading.

"While competition in trading services is welcome, potential risks from the fragmentation of equity trading and data have resulted and need to be appropriately mitigated," the FSA said.

Trading venues could face pressure owing to the competition and they must ensure

that this does not detract from maintaining fair and orderly markets and proper surveillance.

The FSA also urged banks to improve publication of data on their off-exchange traded derivatives contracts