Bank of England Stress Test Targets UK Private Market Financial Risks

The Bank of England (BoE) has launched an unprecedented stress test, the System-Wide Exploratory Scenario (SWES), to assess the UK financial system's exposure to private markets, including private equity (PE) and private credit (PC) funds. UK banks currently hold nearly $230 billion in exposure to these private funds and financial sponsor-backed corporates, marking a significant risk area largely outside traditional regulatory frameworks. The test responds to concerns about high leverage, opacity, and complex structures within private credit, highlighted by recent U.S. failures of private credit-backed firms such as First Brands Group and Tricolor Holdings, which raised alarms about systemic vulnerabilities reminiscent of pre-2008 crisis conditions. SWES includes broad participation from traditional and alternative asset managers, banks, and institutional investors to examine contagion risks under a severe global downturn, including potential fire sales, credit spread widening, and tighter credit conditions for UK households and businesses. Particular attention is on the high leverage within UK PE portfolio companies, averaging a debt-to-EBITDA ratio of 7.6x, which could amplify default rates and losses to banks. The BoE also scrutinizes the growing use of funded reinsurance contracts by UK life insurers, which transfer longevity and asset investment risks to often offshore reinsurers, posing potential systemic risks and regulatory challenges under Solvency UK balance sheet rules. Additionally, the BoE highlights risks linked to private lending to AI technology firms, where stretched valuations and extensive external debt financing could trigger significant financial contagion if an asset price correction occurs. The stress test confronts the tension between government initiatives encouraging UK pension funds to increase allocations to private markets for growth and the need to safeguard financial stability amid rising liquidity and valuation risks. This two-year exercise, with findings due in early 2027, aims to reveal systemic weaknesses across the UK financial ecosystem and inform both domestic and global regulatory approaches, including insights shared with the Financial Stability Board. The BoE's proactive stance reflects a broader regulatory shift recognizing non-bank financial entities as key systemic actors, emphasizing the importance of oversight over complex private market interconnections and potential contagion channels that could impact the UK's financial stability and insurance sectors.