By Phoebe Seers and David Milliken
LONDON, Sept 30 (Reuters) - The Bank of England on Wednesday warned of an increase in the risk that interconnected weaknesses in the financial system will crystallise, highlighting the re-escalation of the conflict in Iran and increased AI-related debt issuance.
Rises in oil and gas prices had led to bond yields increasing to levels not seen since 2008, the BoE's Financial Policy Committee said.
While the financial system and equity markets had so far proved resilient,
the FPC warned that the danger of a sharp adjustment persists. It maintained its Countercyclical Capital Buffer – a varying buffer against financial risks - at 2%.
"The likelihood that interconnected vulnerabilities in the financial system crystallise has risen," the FPC said in a record of its quarterly meeting.
"Specifically, the re-escalation of the conflict and the associated rises in oil, gas and refined product prices are leading to a more protracted negative supply shock," it added.
AI RISKS WORRY GOVERNOR BAILEY
The FPC is chaired by BoE Governor Andrew Bailey and focuses on financial stability risks.
In an article on AI risks released alongside the FPC record, Bailey expanded on his concerns about risks from frontier AI and stressed the need for "rigorous model testing, conducted both before and after deployment" ahead of tighter regulation.
"Over time, a more formal regulatory framework may well emerge. But regulation is not, in my view, the right place to start. Understanding, testing and establishing credible points of intervention must come first," he wrote.
The "rapid increase" in AI-related debt issuance had also increased the exposure of capital markets to developments in AI, the FPC said.
In early September, Morgan Stanley estimated that global AI-related debt issuance totalled around $450 billion, double that of 2025.
While AI-related and semiconductor stocks had fallen sharply in July, market functioning remained orderly. While valuations remain high, a more significant shock could trigger a sharper repricing, it warned.
A series of incidents has boosted policymakers' concerns about the potential for AI systems to circumvent safeguards, including in July when an OpenAI agent escaped a controlled testing environment and hacked AI company Hugging Face.
"These developments reinforced the Committee's assessment…that advances in AI could increase cyber and operational risks," the BoE said.
TIMELINE SET FOR BANK LEVERAGE AND GILT REPO REFORMS
The BoE said it would produce more detailed proposals in early 2027 for changes to bank leverage rules and those governing the gilt repo market, where traders seek to profit from moves in interest rates, and investors turn bond holdings into temporary cash.
In July, the FPC said it would soften the impact of the leverage ratio, which requires lenders to hold a minimum ratio of capital against total assets.
A consultation on these changes will begin early next year, which the BoE said "increases the importance of continuing to develop and implement measures to improve the resilience of the gilt repo market.
In July, Deputy Governor Sarah Breeden said "doing nothing is not an option" for regulating the gilt repo market, due to the continued risk that it causes bond trading to dry up in a financial crisis.
Net borrowing in the gilt repo market totals around £200 billion ($270 billion) according to BoE data, and the central bank said hedge fund leverage had remained high but stable in recent months.
Last year, the BoE set out initial proposals for tighter rules after it had to intervene in 2020 and 2022 at the start of the COVID-19 pandemic and following Prime Minister Liz Truss' mini-budget.
However, the proposals have led to pushback from the finance industry, and Breeden said some reforms such as greater use of central clearing "will likely take years, not months".
(Reporting by Phoebe Seers and David Milliken)
((david.milliken@thomsonreuters.com; +44 20 7513 4034))
Keywords: BRITAIN BOE/
