AI valuations could see ‘sharper correction’, Bank of England warns

The Bank of England warns that artificial intelligence valuations may experience a more pronounced downturn than the one witnessed in July. In its quarterly financial stability record, BOE policymakers noted that interconnected risks in the financial system have increased, and a crash in AI stocks could have significant repercussions on global growth and sovereign bond yields.

The multi-trillion dollar AI sector is a key contributor to these risks, alongside the ongoing Middle East conflict, which the BOE perceives as leading to prolonged supply shocks and higher sovereign bond risks.

Bank officials previously cautioned about potential asset bubbles in AI-related stocks, credit markets, and sovereign debt. Since their last review, AI stocks have been highly volatile, and companies have delayed initial public offerings in response to fears of a slowdown in development. The BOE attributed the July AI shock to "an unwinding of stretched positions and associated deleveraging activity," but stressed that there was "no spillover to core markets."

Growth prospects for economies are increasingly linked to expectations that AI will enhance productivity; a reassessment of these expectations could impact AI-related asset valuations and sovereign debt markets. In a Bank Insights article published on September 30, BOE Governor Andrew Bailey highlighted the importance of rigorously testing AI capabilities to minimize the risk of cyber threats.

While regulation may eventually emerge, Bailey argued that understanding, testing, and establishing credible intervention points should come first.

The BOE's Financial Policy Committee reported that risky credit markets, including some private credit segments, remain vulnerable to tighter financing conditions, and risk-taking in certain areas is elevated. Nonetheless, the Bank confirmed that further analysis supports their July proposal to ease an absolute cap on banks' leverage, suggesting that gilt market reforms could better manage risks from gilt market leverage, rather than relying on the leverage ratio governing banks' balance sheets.

Nonetheless, policymakers will continue to monitor the situation and may increase banks' leverage ratio buffers by 25 basis points if risks change.

Gilt yields have risen alongside global government bond markets due to higher energy prices and fears of central banks having to raise interest rates further to combat inflation. Persistently higher sovereign yields could result in tighter financing conditions for households and businesses, and increased market volatility. The BOE maintains its stance that households remain resilient to rising debt costs, while banks are well-capitalized to withstand potential shocks.

Swaps markets are pricing in as many as five interest rate increases by the end of 2027, starting in November. Financial stability officials reiterated their conviction that households remain resilient to rising debt costs, with banks being well-capitalized to handle potential shocks.