BoE Warns: AI-Driven Valuations and Leveraged Gilt Bets Are Lifting Systemic Risk
Britain's financial system looks sturdier on the surface, but risk is building in the cracks. The Bank of England's latest Financial Stability Report flags higher threats this year, even as it announced the first cut to bank capital requirements since 2008.
Banks remain well capitalized and domestic leverage is still moderate. The problem sits offshore and in market plumbing: AI-fueled equity exuberance, private credit stress points, and leveraged trades in gilt markets.
Where the pressure is coming from
- AI equity froth: The BoE estimates AI enthusiasm has pushed U.S. share valuations to their most stretched since the dotcom era, and UK levels to their highest since the global financial crisis. Deeper ties between AI firms and credit markets mean a sharp correction could spill into lending losses.
- Private market fragility: Recent U.S. defaults (e.g., First Brands and Tricolor) are a reminder that tighter funding can surface weak underwriting fast. The BoE will run a stress test focused on the private market ecosystem.
- Macro and sovereign risk: Geopolitical tensions, fragmented trade and finance, and heavier sovereign balance sheets raise the odds of policy constraints when the next shock hits.
Hedge funds' £100bn leveraged gilt trades
Leveraged activity in the gilt repo market has hit a record near £100 billion, concentrated in a small set of mostly U.S.-managed funds that rely on frequent refinancing. If that funding tightens, forced sales could follow.
Officials stress the repo market's resilience is foundational for UK sovereign debt and, by extension, the broader market. Other countries face similar issues, but the UK's experience in 2022 still looms large.
Are conditions better than 2022?
Yes, to a degree. Steps to strengthen liability-driven investment funds after the 2022 gilt shock have improved resilience, according to the BoE.
Further reforms are on the table-such as more central clearing of gilt transactions and higher margin requirements-but they take time. In the meantime, investors should assume liquidity can vanish quickly and fund accordingly.
What finance teams should do now
- Reprice AI risk: Run drawdown scenarios of 20-40% on AI-heavy equity and credit exposures. Look through to counterparties-vendors, borrowers, and funds with AI concentration.
- Tighten private credit controls: Recheck covenants, update borrower cashflow cases for higher-for-longer rates, and model extension/default clusters rather than isolated names.
- Repo and funding drills: Map exposure to hedge funds and strategies dependent on short-term financing. Pre-position high-quality collateral, widen haircuts in stress, and test same-day liquidity access.
- Margin and liquidity traps: Build playbooks for multi-day margin calls. Pre-arrange contingent lines and define governance triggers for de-risking before liquidity thins.
- Correlation shocks: Push scenarios where equities, private credit, and rates sell off together. Don't anchor to past correlations-they can jump under stress.
- Sovereign sensitivity: Stress a higher term premium and wider gilt-bund spreads. Reassess collateral sets and thresholds across CCPs and bilateral CSAs.
Signals worth watching
- Market breadth and valuation dispersion in AI-linked equities.
- Repo specials, fails, and spikes in short-term funding rates.
- Basis moves in gilt futures vs. cash and shifts in GC liquidity.
- Private credit downgrades, extensions, and fundraising pace.
- Gilt volatility and changes in margin models at CCPs.
Policy and next steps
The BoE plans a stress test on private markets and continues to explore market-structure fixes. Capital relief for banks doesn't equal broad safety-risks are migrating to non-banks and leverage embedded in market strategies.
If you oversee risk, treasury, or portfolio construction, this is the moment to shore up liquidity, shorten reaction times, and assume correlations can bite harder than your backtests suggest.
Further reading
- Bank of England Financial Stability Report
- AI tools used across finance functions: inventory and risk visibility
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