Bank of England warns of risks lurking in “opaque and hidden corners” of the financial system
"Shocks can arrive with little warning and the vulnerabilities that preceded past crises have not disappeared, but re-emerged elsewhere."
The Bank of England has warned that the next financial shock may not come from banks but from the dark corners of a system slipping out of view.
Since the collapse of 2008, activity has migrated away from banks into less visible arenas such as market-based finance, which now accounts for up to half of UK and global assets.
At the same time, risk has shifted onto the state as governments amassed huge debts, starting with a borrowing splurge during the era of "too big to fail" and continuing during the pandemic.
This means that public debt in advanced economies is now at levels unseen since the aftermath of World War II, reducing governments' ability to help businesses, households and institutions deal with future shocks to the financial system.
These pressures could be signs of familiar problems unfolding, Sarah Breeden, BoE Deputy Governor for Financial Stability, warned in a speech entitled "This time is different?"
She said: "Across financial crises, a common pattern emerges. Optimism slowly outruns realism. Confidence replaces caution. And risk migrates, via complex routes, to the least visible, least regulated, and least well‑understood corners of the system."
Preparing for the shocks of tomorrow
In the Wall Street Crash of 1929, investors piled into stocks using borrowed money, convinced prices could only rise, until confidence cracked and investors were forced to sell.
In the 2008 financial crisis, a similar pattern played out in housing as risky mortgages were packaged, leveraged and spread across the system under the assumption they were safe.
The Bank of England fears comparable problems could be brewing in dark corners of today's tangled, deeply interconnected system.
For example, market‑based finance involving non-bank institutions like investment funds has benefits because it "diversifies funding and moves risk from entities with fixed nominal liabilities – such as bank deposits – to investors who should expect and are better placed to absorb losses," Breeden said.
"But losses, and the behaviours they trigger, can still amplify shocks – particularly when leverage, liquidity mismatch and complexity are involved," she warned.
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Growing systemic risks, shrinking visibility
The Bank of England is worried about risk growing in three areas of the system.
- Private markets: Assets under private management have risen sixfold since 2008 to roughly $18 trillion - but institutions have not been tested by a "broad‑based macroeconomic shock in a higher‑rate environment". This area of finance is notable for dense interconnections, creating an "ecosystem where losses that are already hard to size become even harder to trace". Recent defaults and rising withdrawals are also exposing fragilities in private credit that are small for now, but are exactly the kind of stressors with a worrying tendency to spread through the system.
- Government bond markets: Hedge funds are now "increasingly important players in government bond markets" in the UK and across the world. Highly leveraged positions can support liquidity in calm conditions but amplify stress when markets turn. The BoE's first-ever system-wide stress exercise, which simulated a market downturn, found that hedge funds could amplify shocks in gilt markets if funding becomes tighter or more expensive.
- "Stretched" asset valuations: The Bank specifically named AI firms as a potential risk, warning that valuations appear "especially stretched even as the path to monetisation of this new general purpose technology remains unclear". AI companies are expected to invest more than $5trn over the next five years, funded by equity and cash. Debt financing is rising and expected to continue its upward trajectory. Any negative reappraisal of future earnings potential could trigger "abrupt price declines" and send stress rippling through the system.
Breeden warned: "Across all three of these risks, you can hear echoes of the past. The combination of leverage, complexity, concentrations and opacity rhymes with the vulnerabilities brought about by the rise of CDOs in 2007 and, more distantly, the development of investment trusts in the 1920s.
"All at a time when the disconnect between high, risky asset prices and real economy uncertainty seems marked. I am not predicting the next crisis. But history suggests that when these conditions coincide, the system becomes more fragile."
Surveillance across the system
To address potential problems, the Bank of England is moving towards "genuinely system-wide surveillance" focused on interconnections and looking beyond the boundaries of both nation-states and institutions.
Later this year, it will conduct a second system-wide stress exercise focused on private markets to gain a better understanding of how market participants behave during shocks.
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Financial chiefs are also working to build ex‑ante (before the event) resilience into market‑based finance, with updates expected early next year, and new ex-post (after the event) protections to ensure liquidity.
Breeden concluded: "The vulnerabilities that have preceded past crises have not disappeared. They have re-emerged elsewhere. Across private markets, government bond markets, and in stretched valuations, you can hear the familiar echoes of leverage, complexity, concentration and opacity. If some of these crystallise simultaneously, we may be in for a rocky ride."
