The financial sector

26 June 2006

Financial firms in the advanced industrial countries registered strong performance during the year under review. Banks continued to harvest the benefits of past years' cost savings, a continuing benign credit environment and healthy volumes of retail business, which contributed to higher profits despite further compression in interest rate margins. The balance sheets of life insurance companies strengthened while the property and casualty sector managed a year of record claims without major problems. A boom in the activity of private equity funds was accompanied by intensive fund-raising and borrowing to finance leveraged buyouts. Hedge funds experienced a slowdown in inflows as performance slumped.

The main risks confronting the financial sector are of a macroeconomic nature. They are related to the potential effects of higher interest rates, a turn in the credit cycle and, possibly, associated declines in real estate prices and aggregate expenditure. The current environment places a premium on system-wide risk management. It highlights the importance of making available information about risk as well as the interplay, and need for consistency, between financial reporting standards, risk management practices and the overall prudential framework.