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The Bank of England said on Tuesday that threats to Britain’s financial system had risen this year due to stretched valuations of companies investing in artificial intelligence, risky lending and bets with borrowed money in government bond markets.
The comments in its half-yearly Financial Stability Report, build on warnings made in recent months by BoE Governor Andrew Bailey and other policymakers, although it also accompanied the first reduction in capital requirements for British banks since the 2008 global financial crisis.
The BoE judged that Britain’s banking sector was well capitalised and that aggregate indebtedness in the domestic corporate and household sector remained low, but saw risks from overseas and in other corners of financial markets.
“Overall risks to financial stability have increased during this year. Key sources of risk include geopolitical tensions, fragmentation of trade and financial markets and pressures on sovereign debt markets,” Bailey told a press conference.
“As governments around the world face increasing spending pressures, their capacity to respond to shocks in the future may be more constrained than we’ve seen in the past,” he added.
BOE SEES SHARE VALUATIONS STRETCHED DUE TO AI
Investor enthusiasm for AI had pushed share valuations in the United States to their most stretched since the dotcom bubble, and in Britain to their highest since the global financial crisis, the central bank estimated.
“Deeper links between AI firms and credit markets, and increasing interconnections between those firms, mean that, should an asset price correction occur, losses on lending could increase financial stability risks,” the BoE said.
Bailey said that even if AI proved a success, there was no guarantee that all companies which were currently highly valued would turn out to be winners.
The BoE also noted the collapse of U.S. car parts maker First Brands and auto dealership and lender Tricolor, which Bailey said in October might be a warning of bigger problems to come.
The BoE intends to conduct a stress test focused on the resilience of the private market ecosystem, with more details to come later this week.
“It’s important for firms to manage their risks by including scenarios in their analysis where losses are greater, or more correlated, than in the past,” Bailey said.
The British Private Equity & Venture Capital Association, a trade body, said that private equity finance had proven resilient in past crises.
“Private capital has been an important part of the UK economy for over 40 years, showing its resilience through different economic cycles,” BVCA Chief Executive Michael Moore said in a statement in response to the BoE report.
HEDGE FUNDS MAKE 100 BILLION POUNDS OF LEVERAGED GILT BETS
The central bank also highlighted that leveraged activity by hedge funds in the gilt repo market had reached its highest on record at nearly 100 billion pounds ($132 billion) last month, dominated by a small number of mostly U.S.-managed hedge funds reliant on very regular refinancing.
If this financing suddenly dried up, hedge funds might have to dump British government bonds in a fire sale.
“The resilience of the gilt repo market is fundamental to the resilience of the sovereign bond market, which is the basis of all financial market activity in the UK. So it’s a natural area of focus for us,” BoE Deputy Governor Sarah Breeden said.
The central bank said other countries’ bond markets faced similar challenges. BoE policymakers think, though, that the gilt market is on a firmer footing than a few years ago, due partly to measures taken to strengthen liability-driven investment funds after the central bank had to intervene in 2022.
Nonetheless, hedge funds have crowded into debt-fuelled bets on British government bonds due partly to activity in short-term lending markets, investors and hedge fund sources told Reuters earlier this year.
In September, the BoE published suggestions to boost resilience in the bond market including greater use of central clearing for gilt transactions and higher margin requirements. But any such reforms would take time and investors needed to be well prepared for shocks in the meantime, the BoE said on Tuesday.