Britain’s Financial Services Authority is calling for financial firms to adopt a stress test scenario that includes a deeper GDP drop and higher unemployment rates.

The FSA published its Financial Risk Outlook on Wednesday, which spells out the main risks and potential threats it sees in the financial markets. Its base case is for gradual economic recovery to occur throughout 2010, although it notes that there are a range of uncertainties around the possible outcomes for the economy, and the financial sector remains vulnerable to shocks.

With that threat in mind, it calls on firms to adopt a more severe stress test scenario. “Our new macroeconomic stress scenario models a further decline in GDP of 2.3% from the end of 2009 to the end of 2011, with gradual recovery thereafter. Alongside this fall in GDP, the scenario includes a rise in unemployment to a peak of 13.3% in 2012, and allows for a ‘doubledip’ in property prices, with house prices falling by 23% from current levels and commercial property by more than 34%,” it explains in the report.

Among the prudential and financial stability risks detailed in the report, it points to pressures on capital, liquidity and long-term funding and deficiencies in some firms’ risk management. “We are responding to these risks by delivering more effective intensive supervision,” it says, adding, “This will require firms to be far more proactive in their assessment of risks.”

Along with the new supervisory approach, the FSA says that it’s developing new policy frameworks to strengthen firms’ prudential positions, including new capital and liquidity regimes.

The market risks it sees include market fragmentation, the changing structure of the equity market, and market abuse. Market failures can also lead to the emergence of conduct risks, it says, which is also motivating changes in its approach to the retail segment of the industry.

In particular, it says it’s, “Developing a more consistent and intensive supervisory framework for conduct issues, including increased focus on emerging risks, environmental factors and firm-specific business model analysis to better understand firm strategies, profitability drivers and potential conduct implications.”

“We will continue our focus on ensuring that a firm’s culture and retail business strategy reflect a focus on treating customers fairly. We also want to do more to detect and prevent risks before they cause significant consumer detriment,” it says.

To that end, the FSA is strengthening its retail market analysis capabilities “to identify and analyse earlier the nature and potential sources of consumer detriment. This will allow earlier intervention to protect consumers and maintain market confidence.”

It’s also increasing the focus on firms’ product development and design activities, in addition to scrutinizing product marketing, distribution and post-sales handling. “We want to ensure that firms, at each step in the value chain, have the right incentives to provide products that address real consumer needs. We will intervene to change incentives and relationships if they result in poor consumer outcomes,” it says.

Already, the FSA is planning to outlaw embedded sales commissions (such as trailer commissions) by 2012, and, in the FRO, it stresses that advisors “should ensure that recommendations are in the best interests of clients and are not driven by commission incentives. We are actively looking for evidence of commission bias in the run up to the implementation of the [new commission policy] and will take enforcement action where we find inappropriate behaviour.”

It also points to firms’ complaint handling as an area of concern. “We are concerned that poor quality complaints handling may be leading to poor outcomes for complainants and ultimately to consumer detriment. Weak management control of complaints handling could lead to poor investigations, weak decision making, inadequate redress payments and delayed resolution. Firms need to ensure that they focus on improving standards of complaints handling and use complaint trends to prevent the rise of systemic issues,” it says, adding that this will remain a key area of FSA focus, and that new rules requiring firms to publish their own complaints data by August “will increase transparency in this area and should improve complaints handling standards”.

IE