Commercial property may cause new crisis, says FSA

Tougher stress tests call on banks to show they can handle 8 per cent GDP fall

The City watchdog has sounded alarm about the prospect of a meltdown in commercial property. Announcing much tougher stress tests for banks, the Financial Services Authority raised concerns that they are not setting aside enough to cover losses on the sector.

In its overview of the financial risks facing Britain this year, the FSA said about £160bn of UK commercial property debt would mature over the next five years. During the recession, many commercial property companies were supported by forbearance from banks, which often waived conditions attached to loans, it added.

However, banks could decide not to renew loans after their terms expire. "This could force liquidations and release commercial properties on to the market, possibly triggering further price falls. Leveraged loans to UK companies that were subject to buyouts also face a maturity hump and present similar refinancing changes to the banks in this sector," the rgulator's report warned.

There have been tentative signs of improvement in the market, but at its recent results Hammerson said that while the company is returning to investment, it will focus on France because the UK market is still too choppy. A rush of defaults in the sector – which is typically heavily financed by borrowings – could raise the pressure on banks' bad debts despite some recent improvement.

The FSA's new stress tests demand that banks hold enough capital to withstand a peak-to-trough fall in commercial property values of 60 per cent, the same as in 2009. However, this year's tests will require banks to show that they can handle a fall in GDP of minus 8.1 per cent by 2014 and an unemployment rate of 13.3 per cent. Those scenarios are much tougher than the 2009 tests, when the watchdog demanded that banks have enough capital to weather a fall of 6.9 per cent and unemployment of 12.5 per cent. Passing the last test enabled Lloyds to evade the Government's toxic insurance scheme.

Revised figures for Britain's economy showed a 6.2 per cent decline, making the recent recession the most severe since records began. The FSA said it concurs with the Bank of England's forecasts of a return to growth this year.

The watchdog, however, said a "careful balance" needed to be struck between the withdrawal of measures such as the Bank of England "special liquidity scheme" to help banks with financing at a time when the FSA is demanding that they hold more capital.

The FSA also warned that continuing low interest rates could force building societies to the wall. Just this week it emerged that Stroud & Swindon is holding merger talks with Coventry Building Society. Low interest rates squeeze building societies' margins when most do not have other businesses lines to cushion them. Lord Turner, the chairman, accepted that very "narrow" banks could therefore not be the panacea some have suggested.

He also sharply criticised the financial services industry's treatment of consumers: "Every two or three years we have what is perceived to be a major misselling scandal, at the end of which firms pay out really quite large amounts to consumers in redress. This is not a sensible way of running a business."

He said while the FSA could not conduct "trials" of products like the drug industry it was looking carefully at tighter regulation. New proposals are due on Friday.

David Kenmir, financial services partner at PricewaterhouseCoopers, said: "This [the stress tests] will increase the pressure from the FSA and markets on those firms that are perceived to be relatively short of capital. The FSA's revised strategy for conduct regulation, which plans to focus more on the whole product life cycle, from development and design to post sales handling, is likely to prove challenging to many firms in the retail market."