Bank of England warns about 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 Policy Committee said the two sectors faced significant headwinds given high interest rates, persistent inflation and “increased uncertainty” about the long-term economic outlook.

“Riskier corporate borrowing in financial markets such as private credit and leveraged lending is particularly vulnerable in the current environment,” BoE governor Andrew Bailey told reporters.

His comments came after his financial stability experts warned economic fears could drive “sharp revaluations of credit risks” in a market that came of age during an era of ultra-low interest rates.

Although there had been some improvements in market conditions, the Israel-Hamas conflict had increased geopolitical risks, the FPC noted.

Bailey said it was “quite a sweeping statement” to predict that financial institutions beyond regulated banks would cause the next financial crisis, but that regulators had to pay “much more attention” to them now because the non-bank financial sector had grown so much since the 2007-08 crash.

He pointed to hedge funds’ ballooning bets on US government bonds as a particular area of concern, saying they could result in “significant market volatility” in a core part of the global financial system and “tighter credit conditions” in the event of a shock.

BoE data shows hedge fund short positions in Treasuries 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.

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. Bailey said that from a financial stability point of view, he “would not put great weight in the fact that we have seen particular movements in the last week or two”.

The BoE governor stressed that policymakers in the UK and elsewhere were taking action to stem the risks in non-banks, including a consultation announced by the UK’s markets regulator on Wednesday on increasing liquidity in UK money market funds.

The BoE recommended in October that liquidity requirements for those funds be doubled, to reduce the chance of the kind of forced sell-off of assets that triggered the UK’s gilt market crisis in September 2022.

The proposals on Wednesday from the Financial Conduct Authority include doubling daily liquidity requirements for some funds and more than trebling weekly liquidity minimums. Most of the UK’s funds are held offshore, in the EU, which has yet to propose similar measures.

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

The Financial Policy Committee also signalled that it would carry out its first review into the potential impact of artificial intelligence on financial stability.

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