Financial crisis triggers first stress test

By Natalie Harrison

LONDON (Reuters) - The recent financial market turmoil, sparked by losses related to U.S. subprime mortgage securities, has imposed the first major stress test on the modern financial market system, Moody's Investors Service said.

A long overdue re-pricing of risk -- following five years of bullish sentiment and historically low credit spreads -- turned into financial panic due to untested financial innovation and a presumption of liquidity, which drives the highly leveraged system, the rating agency said in a report on Wednesday.

"The modern financial system over-relies on the presumption of liquidity; risk is increasingly difficult to localize; asset correlations increase in times of stress; and leverage changes the scale of market dynamics," Moody's said.

The 'weakest link' in the modern global financial system is that of confidence, with lessons to be learned from the latest financial crisis similar to those thrown up after the bailout of hedge fund Long-Term Capital Management in 1998, Moody's said.

Market psychology can change overnight, the agency warned.

Although central banks are able to help stabilize markets by injecting liquidity into the financial system, this summer's crisis has shown that it is far harder to buttress confidence in the broader non-bank financial system, it said.

The agency said one reason for that is that credit relationships are now more at arm's length.

Central banks are less able to influence the behaviour of significant market participants such as hedge funds, making it more difficult to reintroduce stability.