Bank for International Settlements: AI bubble and "circular financing" collapse could become one of the biggest risks to the global financial system

The Bank for International Settlements (BIS), in its latest annual report, issued multiple warnings, identifying the bursting of the AI bubble, a rebound in inflation, and fiscal pressures as the three core threats to current global prosperity. It also pointed out that if the underlying financial vulnerabilities are hit, they could produce systemic amplification effects.

The report, released on Sunday, comes just ahead of the European Central Bank's annual Sintra symposium. The report specifically highlights the potential risks in the financing structure of the AI sector, particularly the so-called "circular financing" arrangements—where chip manufacturers and hyperscale cloud providers take equity stakes in AI labs or neocloud providers, which in turn commit to multi-year chip or computing power procurement contracts. This interweaves equity, debt, and supplier-customer relationships into a complex financing network. BIS officials warned that "the terms disclosure for such transactions is often extremely opaque, and there is a risk of the same asset being pledged multiple times."

The BIS noted that if AI investment returns disappoint the market, financing could suddenly recede, transforming the current capital expenditure boom into a prolonged investment slump, with spillover effects on the overall financial environment. The report clearly states, "The potential impact of this risk repricing—whether triggered by rising interest rates or the bursting of the AI bubble—on credit markets is comparable to that of the 2008 global financial crisis," and "a major correction in today's stock markets could have more far-reaching macroeconomic consequences than in the past."

In addition to AI, BIS General Manager Pablo Hernandez de Cos issued warnings on inflation and sovereign debt risks. He said the cost-of-living shock of 2022 "still remains in the memory of economic agents," implying a higher probability of second-round effects. Meanwhile, hedge funds are playing an increasingly prominent role in government bond markets, and their highly leveraged strategies could trigger "fire sales" and deleveraging feedback loops under market stress, allowing financial pressure to spread rapidly through funding markets, across borders, and between banks and non-bank institutions.

AI "Circular Financing": The Same Asset May Be Pledged Multiple Times

The BIS gave prominent attention to the structural risks of AI-related financing arrangements in its report. The so-called "circular financing" refers to chip manufacturers and hyperscale cloud providers taking equity stakes in AI labs or neocloud providers, which then reciprocate with multi-year chip or computing power procurement contracts. Meanwhile, data center construction is largely undertaken by third parties, who then lease the facilities back to hyperscale cloud providers through long-term contracts with exit clauses.

BIS officials wrote, "The terms disclosure for such transactions is often extremely opaque, and there is a risk of the same asset being pledged multiple times." This structure means that the related financial risk exposures are difficult for market participants and regulators to fully identify. The BIS warned that if AI investment returns fail to meet expectations, "this sudden withdrawal of financing could transform the capital expenditure boom into a prolonged investment slump, with spillover effects on the financial environment." The report also noted that the bursting of the AI bubble could transmit to the broader macroeconomy through a significant stock market correction, with effects that may surpass historical precedents.

Inflation Shadow Lingers, Risk of Second-Round Effects Rises

The BIS's warning on inflation contrasts with some previous market optimism. After progress in Middle East peace talks, oil prices have fallen back to levels seen before the Iran war broke out in February this year. However, BIS officials, consistent with institutions like the European Central Bank, believe that energy supply disruptions may not be over, infrastructure reconstruction takes time, and the impact of existing shocks could continue to ferment.

This warning comes after US data last week showed the fastest price increase in over three years, while upcoming eurozone data may show inflation still well above the official 2% target. Pablo Hernandez de Cos said the previous inflation shock "still remains in the memory of economic agents," implying a "higher probability of second-round effects." According to a Bloomberg report, the BIS advises central banks to maintain monetary discipline, ensuring that inflation expectations do not become unanchored due to recent energy price spikes and other supply shocks, and emphasizes that interest rate hikes should not be avoided when necessary, even if it harms economic growth in the short term.

Sovereign Debt and Hedge Funds: Highly Leveraged Strategies Pose Hidden Risks

On fiscal risks, the BIS reiterated the long-term dangers posed by high sovereign debt levels and highlighted the expanding role of hedge funds in government bond markets as a new variable to watch. The report noted that hedge funds are becoming increasingly important as buyers of government bonds, typically relying on short-term financing to support highly leveraged basis trading strategies, which can quickly reverse when market conditions deteriorate.

"These hedge funds employ highly leveraged strategies that rely on short-term financing obtained on favorable terms, creating risks of fire sales and deleveraging feedback loops," the BIS said. "Financial stress can now spread rapidly and widely through funding markets, across borders, and between banks and non-bank institutions." This year, there have been several tense moments in the UK government bond market, reigniting concerns about a repeat of the 2022 crisis; similar turmoil in Japan's government bond market has also rippled globally, affecting the US Treasury market. Pablo Hernandez de Cos said, "Market reactions can occur at any time, depending on certain political or economic events. It is crucial to reduce these vulnerabilities before such market reactions occur."

At the policy level, the BIS calls for coordinated efforts to address the complex landscape of multiple overlapping risks. "Policies reinforce each other," officials wrote. "Fiscal discipline supports monetary credibility and financial stability; robust regulation enhances market resilience, preserves fiscal space, and reduces the need for frequent central bank intervention; credible monetary policy anchors inflation expectations."

The BIS emphasized that "the global economy remains at the intersection of progress and risk, with resilience facing increasingly severe tests." The current environment of multiple pressures requires policymakers to proactively address potential vulnerabilities rather than waiting for market stress to erupt before responding.

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