The Bank of England has warned that escalating tensions in the Middle East could push the UK into a financial crisis scenario as rising energy costs, higher borrowing rates and market volatility expose the economy’s underlying vulnerabilities.
In its latest assessment, the bank’s Financial Policy Committee (FPC) said the Iran conflict had already triggered a “significant” shock to global markets, leading to tightening financial conditions and increased inflationary pressures, at a time when risks were already elevated.
One of the most immediate impacts is felt by homeowners. The bank estimates that around 5.2 million borrowers, more than half of all mortgage households, will face higher repayments by 2028, up from 3.9 million before the conflict began.
The increase reflects a sharp shift in market expectations about interest rates, with investors scaling back hopes for rate cuts and, in some cases, pricing in further rate hikes.
More than 1,500 mortgage products have already been withdrawn from the market as lenders respond to increased volatility, further limiting options for borrowers.
Andrew Bailey warned that markets could be overreacting to the interest rate outlook, but acknowledged that the environment had become significantly more uncertain.
The conflict has disrupted global energy supplies, particularly through the Strait of Hormuz, a key route for oil and gas exports. The resulting rise in energy prices has a direct impact on inflation and raises the prospect of continued cost pressures across the economy.
The FPC warned that higher inflation would weigh on growth while increasing borrowing costs, creating a challenging environment for both households and businesses.
Fuel prices have already risen sharply and household energy bills are expected to rise further throughout the year, exacerbating pressure on the cost of living.
The bank also pointed to increasing instability in financial markets. Hedge funds unwound around £19 billion in positions tied to expectations of falling interest rates, adding to volatility in short-term borrowing costs.
At the same time, the increasing interconnectedness of stock and bond markets, driven in part by hedge fund activity, increases the risk that stress in one area will quickly spread to other areas.
“A sharp correction in equity markets could spread stress to gilt markets,” the committee warned, pointing to the potential for wider financial disruption.
Particular concern has been expressed about the $18 trillion private credit sector, which has grown rapidly since the financial crisis and now plays a significant role in corporate lending.
The recent collapse of Market Financial Solutions was cited as an example of the sector’s vulnerabilities, including high leverage, limited transparency and optimistic valuations.
Bailey drew parallels to the early stages of the 2008 crisis, noting that initial warnings about isolated problems could sometimes underestimate systemic risks.
The report also highlighted rising risks in government bond markets as governments, including the UK, issue large amounts of bonds to finance spending.
The UK is expected to spend more than £100 billion on debt interest alone this year, limiting fiscal flexibility and reducing the ability to respond to future shocks.
The FPC warned that the combination of higher borrowing costs and weaker growth could create a “debt trap” for some economies and further exacerbate global financial risks.
Despite the warnings, the bank stressed that the UK’s core financial system remains resilient, with banks well capitalized and able to absorb shocks.
However, it noted that the combination of several pressures, including high household debt, market volatility and geopolitical uncertainty, raises the risk of a more severe downturn if conditions continue to deteriorate.
The bank’s assessment highlights the fragility of the current economic environment, where global events are rapidly impacting domestic financial conditions.
For households, the prospect of higher mortgage payments and rising living costs poses a major challenge. For companies, tighter financial conditions and weaker demand could slow investment and growth.
For policymakers, the task is to tread a narrow path between controlling inflation and supporting economic stability, while preparing for the possibility that the current shock could evolve into a broader financial crisis if multiple risks materialize simultaneously.
