Banks face toughest conditions since '90s

The sign of the Northern Rock bank is seen outside a branch in central London September 14, 2007. Banks are navigating their choppiest waters since the early 1990s and face growing risks including a loss of public confidence, escalating consumer defaults and a rise in financial crime, the regulator warned. The banking sector was rocked last September by the near-collapse of Northern Rock.

LONDON (Reuters) - Banks are navigating their choppiest waters since the early 1990s and face growing risks including a loss of public confidence, escalating consumer defaults and a rise in financial crime, the regulator warned.

In its annual review of top risks for the year ahead for the financial sector, the Financial Services Authority (FSA) warned that some banks could find their business models under strain if wholesale funding markets remain constricted, forcing them to pull back on lending.

That, it said, would add to already heavy pressures on indebted consumers.

The regulator said on Tuesday that a third of UK mortgages written between April 2005 and September 2007 were considered to be high risk, including high loan-to-income ratios, high loan-to-value ratios and long terms.

The FSA, which said the focus had shifted away from unsecured debt this year, warned last year that at least 1.4 million short-term fixed-rate mortgages would be reset in 2008, in a context of weaker property prices.

"The spectre of consumers having debt that exceeds the value of their property is not something that has materialised yet but it is certainly a risk we have to take seriously," said Sarah Carlson, head of global risk and risk aggregation at the FSA.

"We are also concerned that consumers are ill-prepared for a deterioration in economic conditions and may have placed too much reliance on their ability to obtain cheap credit and housing wealth to sustain their consumption levels."

She said the market was expecting the Bank of England to cut rates, but said higher borrowing costs could make it harder for lenders to pass on that reduction to mortgage clients.

The banking sector was rocked last September by the near-collapse of Northern Rock NRK.L and a run on its deposits after the credit crunch forced the country's fifth-largest mortgage lender to turn to the Bank of England for funds.

The FSA, which has come under fire for its role in the Northern Rock saga, said banks could not ignore risks associated with consumer confidence and the increasing fickleness of depositors, who can easily pull cash from Internet accounts.

"WAKE UP CALL"

Speaking less than a week after a rogue trader scandal at France's Societe Generale (SOGN.PA), the FSA said increased pressure on firms and employees to generate returns in a tough environment meant there could be a rise in high-risk activities taking place without full assessments -- and a subsequent increase in financial crime.

The FSA said crimes could range from "mismarking" -- when traders record fake prices -- to identity fraud and phishing, a type of Internet financial fraud.

The FSA has been criticised for being too soft on crime, particularly compared with its U.S. counterpart, but the regulator said it had beefed up its financial crime unit.

"We are strong enough to enforce it," Lyndon Nelson, the FSA's head of global risk, said, adding the FSA saw the Societe Generale unauthorised stock trading as a "wake-up call".

In last year's outlook, when the economy still looked set for a fifth straight year of growth, the FSA, among other priorities, told firms to test "extreme risk scenarios" and alerted the market to the danger of illiquid financial instruments -- both borne out in the last 12 months.

** For a full version of the report, click on: here

(Additional reporting by Steve Slater; Editing by David Cowell)