(Bloomberg) -- The Bank of England warned the next blow up in financial markets may be triggered by corporate credit after a massive build-up in private debt over the past decade.

Riskier corporate borrowing — including high yield bonds, leveraged loans and private credit — is “particularly vulnerable” to interest rate rises and “heightened geopolitical risks increase the likelihood of financial vulnerabilities crystallizing,” the BOE’s Financial Policy Committee said in a report Wednesday.  

The findings are the BOE’s first official assessment of UK financial conditions since the collapse of Silicon Valley Bank and Credit Suisse Group AG earlier this month. Financial markets are wobbling due to rapid rate rises globally over the past 15 months, as central banks tackle soaring inflation, which have exposed weaknesses. 

Last autumn, an asset fire sale by Liability Driven Investment strategies caused by higher yields was only prevented from turning into a death spiral by a £20 billion ($24.7 billion) BOE intervention. 

To prevent a repeat of the crisis, the BOE unveiled new rules requiring LDI funds to withstand a yield shock of 250 basis points. Last autumn, they were brought down by a 160 basis point move in a matter of days.

While the BOE stressed that the core UK banking system was well-capitalized and had strong liquidity, it warned that risks in non-bank finance — the hedge funds and private credit markets known as “shadow banking” — are rising and “could pose risks to UK financial stability.”

“Signs of stress in these markets could cause a rapid reassessment of risks by investors, potentially resulting in sharp revaluations,” the BOE said.

Revaluations could hit non-banks such as global open-ended funds, pension funds, insurers and hedge funds which might be forced into fire sales that “amplify losses across the system.” Risks could then spill back to UK commercial banks, which have “large exposures to leveraged loans.”

“There is an urgent need to increase resilience in market-based finance,” the BOE said. “The opacity of the private credit market complicates the assessment of potential risks for both regulators and participants.”

Hedge funds have already caused increased volatility in interest rate markets by trying to reduce their exposure as authorities orchestrated rescues of SVB and Credit Suisse, the BOE said.

The BOE also said: 

  • About 2.5 million more UK mortgage borrowers are exposed to higher borrowing costs this year as their fixed-rate deals expire. They face on a £250 increase in monthly repayments on average. Around 110,000 will be at risk of default, though that’s lower than in December as energy prices has fallen and the outlook for employment has improved.
  • Higher debt servicing costs could lead to credit losses for banks in the UK.
  • Tighter credit conditions abroad could impact the foreign assets of UK banks.
  • Commercial real estate around the globe remains vulnerable to shock.

Its separate systemic risks survey, conducted from Jan. 6 to Feb. 3 showed:

  • Global investors are reining in their appetite for risk due to turmoil in the financial system and more than half of respondents are braced for a “high-impact” event.
  • Net confidence in the financial system has decreased since last year but is higher than the average from 2016 to 2019.
  • Inflation is among the most frequently cited risks, but concern has fallen.
  • Cyber attack, geopolitical and inflation risks are still considered the most challenging.

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