The Bank of England warns that the Iran conflict is increasing the risk of a UK financial crisis

The Bank of England has warned that an escalation of conflict in the Middle East could push the UK into a financial crisis, as rising energy costs, high levels of borrowing and market volatility expose risks to the economy.

In its latest assessment, the Bank’s Financial Policy Committee (FPC) said the Iran conflict has already caused a “significant” shock to global markets, tightening financial conditions and increasing inflationary pressures at a time when risks are already high.

One of the most immediate impacts is felt by homeowners. The Bank estimates that around 5.2 million borrowers, more than half of all mortgaged households, are now expected to face higher payments by 2028, up from 3.9 million before the default.

The increase reflects a sharp shift in the market’s expectations of interest rates, with investors discounting expectations of a rate cut and, in some cases, a rate hike.

More than 1,500 mortgage products have been withdrawn from the market as lenders respond to increased volatility, some of which limit borrowers’ options.

Andrew Bailey warned that markets may be overestimating the outlook for rates, but acknowledged that the environment has become more uncertain.

The conflict has disrupted global energy supplies, particularly through the Strait of Hormuz, a key route for oil and gas exports. The effect of rising electricity prices feeds directly into inflation, raising the prospect of continued cost pressures across the economy.

The FPC warned that higher inflation would weigh on growth while raising borrowing costs, creating a challenging situation for both households and businesses.

Gasoline prices have already risen sharply, and further increases in electricity bills are expected later in the year, adding to the low cost of living.

The Bank also highlighted the growing volatility in financial markets. Hedge funds have unloaded around £19 billion of positions linked to expectations of a fall in interest rates, which has an impact on the volatility of short-term borrowing costs.

At the same time, the increasing integration of equity and bond markets, driven in part by hedge fund activity, raises the risk that stress in one area could quickly spread to others.

“A sharp correction in equity markets could transfer pressure to stronger markets,” the committee warned, pointing to the possibility of broader financial disruption.

Serious concerns have been raised about the $18 trillion private credit sector, which has grown rapidly since the financial crisis and now plays a major role in corporate lending.

The recent collapse of Market Financial Solutions has been cited as an example of the risks in the sector, including high leverage, limited transparency and positive ratings.

Bailey drew parallels with the early stages of the 2008 crisis, noting that early warnings of isolated problems can sometimes underestimate systemic risks.

The report also flagged growing risks in the sovereign debt markets, where governments, including the UK, are issuing large amounts of bonds to finance spending.

The UK is expected to spend more than £100 billion this year on debt interest alone, reducing financial flexibility and reducing the ability to react to future shocks.

The FPC warned that the combination of high borrowing costs and weak growth could create a “debt trap” in some economies, further increasing global financial risks.

Despite these warnings, the Bank stressed that the UK’s financial system remains strong, with banks well-capitalized and resilient.

However, it warned that a combination of multiple pressures, including high household debt, market volatility and political uncertainty, increases the risk of a sharper downturn if conditions worsen.

The Bank’s assessment underscores the fragility of the current economic environment, where global events are rapidly affecting domestic financial conditions.

For households, the prospect of higher mortgage payments and rising costs of living presents a major challenge. For businesses, tight financial conditions and weak demand may hinder investment and growth.

For policymakers, the task is to navigate the narrow path between controlling inflation and supporting economic stability, while preparing for the possibility that the current shock could turn into a broader financial crisis if multiple risks occur simultaneously.