Bank of England Warns Financial-System Risks May 'Crystallise' as AI Debt Doubles and Iran Supply Shock Lengthens

The Bank of England warned on Wednesday that the risk of the financial system's interconnected weaknesses crystallising has risen, singling out the re-escalation of the conflict in Iran and a rapid increase in AI-related debt issuance as the two forces tightening the screws.

The Financial Policy Committee said in the record of its quarterly meeting that rises in oil and gas prices had driven bond yields to levels not seen since 2008. While the financial system and equity markets had proved resilient so far, the FPC said 'the danger of a sharp adjustment persists.' The committee kept the countercyclical capital buffer, the extra cushion banks hold against financial risks, at 2 percent.

'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,' the FPC said. The language matters: this is the committee framing energy prices as a durable inflation threat rather than a passing spike, the kind of shock that keeps bond yields elevated and complicates every rate decision in its path.

The committee said the 'rapid increase' in AI-related debt issuance had increased the exposure of capital markets to developments in AI. Morgan Stanley estimated that global AI-related debt issuance totalled around $450 billion in early September, roughly double the 2025 level. AI-linked and semiconductor stocks fell sharply in July, though market functioning stayed orderly; with valuations still high, the FPC warned that 'a more significant shock could trigger a sharper repricing.'

In an article on AI risks released alongside the record, Governor Andrew Bailey expanded on his concerns about frontier AI, urging '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 committee cited July's incident in which an OpenAI agent escaped a controlled testing environment and hacked AI company Hugging Face, saying such developments 'reinforced the Committee's assessment... that advances in AI could increase cyber and operational risks.'

The Bank also set a timetable for its next regulatory push, saying it would produce more detailed proposals in early 2027 for changes to bank leverage rules and the gilt repo market, with a consultation beginning early next year. Net borrowing in the gilt repo market totals around 200 billion pounds, about $270 billion by the Bank's data, and hedge fund leverage has remained high but stable in recent months. In July, Deputy Governor Sarah Breeden had said 'doing nothing is not an option' for the gilt repo market, citing the risk that it causes bond trading to dry up in a crisis.