Bank of England warns on risks in private credit and leveraged lending

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Private credit and leveraged lending markets remain vulnerable to “sharp revaluations”, the Bank of England warned on Wednesday, in its latest attempt to sound alarm bells about risks building up in non-bank finance.

The BoE’s financial stability watchdog said that despite some recent improvements in market conditions, the two sectors appeared “particularly vulnerable” as war in the Middle East adds to geopolitical risks.

“Although there are few signs of stress in these markets so far, a worsening macroeconomic outlook could . . . cause sharp revaluations of credit risks,” the BoE’s Financial Policy Committee wrote in its quarterly update, adding that valuations appeared “stretched . . . particularly in the US”.

The BoE’s financial stability experts also drew attention to the continued growth in bets on US government bonds. Hedge funds have taken on big short positions as asset managers add US Treasuries to their portfolios.

Those hedge fund short positions have continued to grow, the BoE said, and are now bigger than they were in the run-up to the March 2020 “dash for cash” when bets against Treasuries were swiftly unwound as the value of government bonds rose when investors dashed towards safe assets.

Global financial regulators have also expressed concerns about the trend’s potential to destabilise one of the world’s most important financial markets.

US government bond yields have fallen sharply in recent weeks, and markets are now pricing in faster interest rate cuts, relieving some of the pressure on asset valuations.

Despite the tough outlook for global financial stability, the BoE said that in the UK households, businesses, and banks had been “broadly resilient” to a steep rise in interest rates and a bruising cost of living crisis, and that some trends around UK debt levels were improving.

The BoE said that while the full impact of interest rate increases had “yet to come through for households, businesses and borrowers”, there was some evidence of improving trends.

The percentage of households with a high cost of living adjusted debt burden fell slightly to 1.4 per cent in the third quarter versus 1.8 per cent in the first quarter of the year, “driven by a stronger-than-expected recovery in real incomes”, the BoE said.

Regulators are also moving to make money market funds more resilient, and the Financial Conduct Authority on Wednesday published a consultation plan on measures to boost liquidity in UK-based funds.

The Financial Policy Committee also signalled that they will carry out their first review into the potential impact of artificial intelligence on financial stability, but did not give details on what it would involve.