Breeden: Financial system faces rising, familiar risks

The global financial system has demonstrated resilience against six major shocks in six years, including a pandemic, the Ukraine invasion, and the 2022 UK gilt market stress.

This resilience stems from lessons learned during the global financial crisis, leading to better capitalised and more liquid banks, alongside effective macroprudential tools.

However, risks have not disappeared; they have migrated.

Activity has increasingly shifted from banks to market-based finance, now accounting for half of UK and global financial-sector assets.

Concurrently, risk has moved towards sovereign balance sheets, with public debt in advanced economies nearing post-war highs.

This reduces fiscal space and increases sensitivity to market confidence, as demonstrated by the rapid propagation of stress in the UK gilt market in autumn 2022.

Breeden identified three key vulnerabilities.

First, the rapid growth of private markets, now $18 trillion globally.

These opaque, highly leveraged markets are untested by a broad macroeconomic shock, with recent defaults and redemption pressures raising concerns about a wider credit crunch.

Second, increasing leverage in government bond markets, driven by hedge funds.

The Bank's SWES showed how these strategies can amplify shocks and cause illiquidity, exemplified by UK short rates.

Third, stretched asset valuations, particularly in the US technology sector linked to artificial intelligence.

Compressed global risk premia and rising debt financing in AI firms could lead to abrupt price declines if earnings potential is reassessed, impacting UK investors.