Growing threats to UK financial stability
What keeps you up at night? For the governor of the Bank of England it’s a long list of threats to the UK’s financial system – so let’s take a look at them.
The Bank of England’s latest financial stability report makes for a sobering read. It says “risks to financial stability have increased during 2025” and that “global risks remain elevated and material uncertainty in the global macroeconomic outlook persists.”
So what are these threats?
The Chancellor may have avoided a messy bond market reaction to her Budget, for now, but there’s something else lurking in the deep waters of government debt that has Bank of England officials worried: hedge funds. Specifically, leveraged trading in the gilt repo markets. What’s that? Well, simply put, this refers to the practice of hedge funds and other asset managers arranging short term loans using their holdings of UK government debt as collateral.
And hedge funds, in fact a small number of US hedge funds, have increasingly taken out enormous bets on small price fluctuations in the UK bond market, which they then borrow against and reinvest to boost returns. The arrangement tends to suit all parties as government debt is seen as a safe bet.
However, the Bank of England is worried about what would happen if those hedge funds suddenly needed cash in response to a shock elsewhere and had to liquidate their holdings of UK bonds. As the Bank put it:
“Forced or widespread deleveraging would have the result of amplifying initial moves and potentially triggering a feedback loop of further forced selling.”
Chaos in the bond markets
They warn that the world is a dangerous place and that there are plenty of possible shocks in the future that could force a fire sale of UK debt that, in turn, could cause havoc in the bond markets, forcing up the cost of borrowing.
The amount of debt taken out against UK gilts has reached its highest level since the central bank started monitoring the trend in 2017. Hedge funds used their gilt portfolios to borrow some £100bn of extra cash in November, a pattern of behaviour the Bank said “increases the risk of sharp moves” in the UK government bond market.
Officials are so worried about this that they’re now exploring plans to limit the size of hedge fund bets on gilts in a bid to avoid the worst of any market fallout.
Next up, growing concerns about so-called shadow banking – private credit. This refers to lending and financing by financial institutions that are not banks. A business could get a loan from HSBC or Barclays or it could get that loan from a private debt fund or an asset manager like Blackstone or Apollo, or even the private credit wing of banks.
Watchdogs across the world have become increasingly worried about the opaque role that private markets play in the global financial system, after a string of high-profile corporate collapses with ties to private lending. And these shadow banks are not regulated like traditional lenders.
$2 trillion shadow banking risk
The International Monetary Fund devoted a chapter of its 2024 financial stability report to the systemic threat posed by the private credit industry, which now boasts an estimated $2 trillion under management. Bank of England governor Andrew Bailey has also compared some of the riskier lending issued by industry players to the sub-prime mortgage crash that foreshadowed the 2008 financial crisis, saying “alarm bells” were ringing.
Officials warn that: “UK banks are estimated to have £173 billion of banking book exposures to private market funds and corporates backed by financial sponsors, including private equity funds.” So what are they doing about this risk? Well, they’re going to start subjecting private credit providers to the same kind of ‘stress tests’ applied to traditional banks, where they’re required to demonstrate their resilience to a range of hypothetical risks and shocks to see if they could withstand them.
AI stock market bubble burst?
Another area of concern reiterated by the Bank of England is the runaway valuations of AI companies and the risk of a stock market bubble bursting. They said many equities “remain materially stretched” and drew comparisons to the dot-com bubble and the global financial crisis.
The report warns of the risks of a “sharp correction” in the sector and of the various ways in which the UK economy – and UK market – is exposed to this risk, saying “as an open economy with a large financial centre, the UK is exposed to global shocks, that could transmit through multiple, interconnected channels,”
It also gave a stark warning on the role debt financing was playing in the AI sector.
Bad actors and cyber threats
And to end on a cheerful note, the Bank also said that cyberattacks remain a critical threat to financial stability. Andrew Bailey said it’s a risk that “never goes away” and that “You can’t mitigate cyber risk in a way that just takes it off the table.” The report highlighted recent attacks on “retailers and carmakers” – aka, M&S and Jaguar Land Rover, and warned of “bad actors out there in the world economy.”
So, from vulnerabilities in the bond market to a booming and lightly regulated private credit industry to rogue states and cyber attackers, the risks are real and they’re growing and getting more complicated. Fortunately, being alive to these risks is the first line of defence. The question, as we approach the end of this year, is whether anything happens next year that turns these risks into active threats.
UK government presents its own risk
Finally I should point out another critical risk to our stability, wealth and wellbeing: this government. The Consultancy Oxford Economics this morning released its own “Key Themes for 2026” document and it’s not pretty.
They forecast a growth rate of just 1 per cent next year – abysmal – and they expect that “markets will increasingly question the fiscal credibility of the Budget and the survival of the Labour leadership” adding “a slow burn of a steepening yield curve and weaker sterling could morph into a more serious confidence crisis” – a risk heightened by the fact that the UK “lacks a sustainable growth driver” – meaning that “prospects for the private sector remain poor, consumers face a sharp slowdown in real income growth in 2026…and the jobless rate will rise further.”
The Christmas holiday can’t come soon enough.