In its annual report published yesterday, the SFA said that with markets buoyant there was "a definite risk of speculative over-reach, which could reverse at any time".
The report used the copper market, where the price collapsed by 30 per cent in a few days last summer, as an example of what can occur. It warned that many City workers had only experienced a bull market and so might not know how to react in the event of a correction.
Nicholas Durlacher, SFA chairman, said: "What we are looking at is a stock market that is very high but also pretty volatile. We can't tell people how to cope but we can prod them to think about it. You have to go back to 1987 for the last correction. A lot of young traders haven't seen a market like that before."
Mr Durlacher described the SFA warning as its version of the "irrational exuberance" comment made by Alan Greenspan, chairman of the US Federal Reserve last December. The report added: "The strains evident...on firms' risk management cultures are all too evident and they are highly concerning. They may intensify still further."
Describing a year in which the "regulatory cake...has been well spiced...with the currants of rogues" which had caused the Sumitomo, Morgan Grenfell and Fidelity Brokerage scandals, Mr Durlacher also criticised the City's star culture, saying there was a danger that it encouraged over-ambitious speculation by bonus-hungry traders.
"Management should think of the consequences of their remuneration packages. The danger is they are separating the objectives of the individual from those of the company." he said.
"The emphasis on next year's bonus can lead to an unhealthy culture that can promote imprudent risk-taking." It might be wiser to spread bonuses over longer periods, he added.
Richard Farrant, the SFA's chief executive, said in his annual statement that the creation of a new, all-encompassing regulator, the so-called "super-SIB", might prove a distraction from the day-to-day regulation.
"The present environment demands improvement and not just simple maintenance of our regulatory performance."
The SFA said there was a danger that the regulatory authorities would feel "in a state of limbo" as the new Financial Services act would not be passed until 1999 or be implemented until the following year.
The intense competition in financial markets and the speed with which new products were developed and marketed meant that on-going improvements to the existing regulatory system were essential if super-SIB were not to be left years behind.
Mr Farrant said: " Our constituency of firms has so far avoided the worst excesses of self-interested mis-selling of its products, not least because the firms are often selling services ...to other professionals ...and thus have an informed and discriminating customer base.
"On the other hand, the risk that intensifying competition between firms will lead to a degradation of standards cannot be ignored. They may also seek to diversify into less discriminating markets."
Mr Durlacher said that with derivative products becoming increasingly complicated, it was essential that management were fully aware of the risks.
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