Bank of England Warns of Rising Financial Risks as Capital Buffers Are Cut

FPC highlights stretched asset valuations, geopolitical threats and AI-driven bubbles while easing bank reserve requirements to support lending

The Bank of England has issued a stark warning over rising risks within the UK financial system, even as it moves to trim the capital reserves banks must hold. The decision — reducing the sector’s key capital requirement from 14% to 13% — aims to support lending and stimulate economic growth at a time of heightened uncertainty.

In its twice-yearly Financial Stability Report, the Bank’s Financial Policy Committee (FPC) flagged concerns around stretched market valuations, elevated geopolitical tensions and the growing use of debt by major technology companies.

Financial Stability Risks Are Increasing

The FPC did not mince words:

• “Risks to financial stability have increased during 2025,” it said, noting a more fragile macroeconomic environment.
• Global pressures remain intense, driven by:
  • geopolitical tensions and conflict
  • fragmentation of trade
  • stresses across sovereign debt markets

The Bank also warned that heightened geopolitical friction raises the likelihood of cyberattacks, adding that operational disruptions are an increasingly serious threat for financial institutions.

Concern Over AI-Linked Asset Bubbles

A key focus of the report was the rapid rise in AI-related tech valuations, which the Bank fears may be echoing past financial manias:

• US equity valuations are “close to the most stretched since the dot-com bubble”.
• In the UK, valuations for AI-exposed tech stocks are “the most extended since the global financial crisis”.
• The FPC also highlighted the growing trend of tech firms funding expansion through debt, a practice that could amplify systemic risks if markets correct sharply.

The warnings echo similar concerns raised by the IMF in October, which also cited the dangers of an AI-fuelled bubble.

A Cut to Capital Requirements to Support Growth

Despite rising risks, the Bank has moved to lower capital reserve requirements — a policy long urged by the Government and UK businesses.

Key points:

• The main capital requirement has been reduced from 14% to 13%.
• The aim is to free up lending capacity for households and businesses.
• The move coincides with a wider Government push to encourage pro-growth regulatory policy.

The decision follows confirmation that the UK’s seven largest lenders — Barclays, HSBC, Lloyds, NatWest, Santander UK, Standard Chartered and Nationwide — all passed the latest stress tests.
These tests included scenarios such as:

• a 5% fall in GDP,
• a 28% drop in house prices, and
• interest rates rising to 8%.

The Bank concluded that UK banks remain resilient and capable of absorbing severe shocks.

Mortgage Outlook: Winners and Losers

The report also highlights shifting pressures within the housing market:

• Around three million households are expected to see mortgage payments fall over the next three years as fixed-rate deals reset lower.
• However, 3.9 million borrowers will refinance onto higher rates, facing an average increase of £64 per month, or 8%, over the next two years.

What This Means for Investors

For financial market investors, the Bank’s assessment offers both caution and opportunity:

Risks

• Potential correction in AI-exposed tech stocks, particularly in the US and UK, where valuations look stretched.
• Cybersecurity vulnerabilities may increase volatility for banks and critical infrastructure providers.
• Sovereign debt pressures could weigh on bond markets and risk-sensitive assets.

Opportunities

• UK banking stocks remain well-capitalised and benefited from the stress-test results; the easing of capital buffers could support greater lending, higher returns, or increased dividends/share buybacks.
• A shift towards lower interest rates next year may strengthen loan demand and reduce funding costs.
• Investors seeking defensive positioning may find opportunity in banks with strong capital ratios and conservative lending practices.

Overall, the Bank’s message is clear: risks are rising, but Britain’s major lenders remain strong — and regulatory easing could unlock new value across the financial sector.

Sources: (SKY.com, Reuters.com)