FSB Warns G20 of AI Leverage, Stretched Asset Prices, Private Credit and Government Debt Risks

Ahead of the G20 Finance Ministers and Central Bank Governors' two-day meeting, the Financial Stability Board (FSB) — the international body that reports to the G20 and coordinates financial regulation among its member jurisdictions — issued a stark warning about the risks that have built up in the global financial system. This time, artificial intelligence, pervasive leverage, sky-high asset prices driven in part by AI and leverage, and the interconnectedness of everything topped the list. Government debt globally, with all eyes on the US, was also front and center.

Practically everything was on the list, but AI received special treatment in the letter: AI poses a risk to the global financial system in terms of cyber risk, and in terms of the leverage, asset prices, and "cross-investments" (circular financing) of the entities involved.

In the letter (FSB letter to the G20), FSB chair Andrew Bailey, Governor of the Bank of England, warned of a "potentially disorderly correction" in the markets that "could spread across borders." And it all boils down to leverage:

"As we have seen multiple times in the past, rising leverage is a feature of a maturing financial cycle. While it can reinforce rising markets, it can also intensify declines when sentiment turns, as recent weeks have demonstrated."

"The issue is not simply that investors are borrowing more, but that leverage is interacting with high valuations and market concentration, in particular the increasing cross-investment between artificial intelligence (AI) companies and hyper scalers, in a way that could amplify a future market correction."

"I remain concerned therefore that a large shock or combination of shocks could concurrently trigger multiple vulnerabilities."

Fragilities in Government Debt Markets

The letter listed "fragilities" in government debt markets, including:

• "Elevated issuance" — the US alone issues $1 trillion in additional debt every three to five months, all of which has to be absorbed by investors.
• "Shortening maturities" — a reference to Treasury Secretary Bessent's efforts to shift some of the debt toward short-term Treasury bills via issuance and buybacks. A larger share of T-bills makes the bond market riskier, as increasingly huge amounts of T-bills must be sold at massive auctions every week, now in the $500–600-billion-a-week range.
• "Leverage" — such as the highly leveraged Treasury basis trade, in which hedge funds buy Treasuries and create and sell Treasury futures, leaving them long Treasuries and short Treasury futures. The last time this trade blew up was in March 2020, when it locked up the huge Treasury market and forced the Federal Reserve to intervene with massive emergency purchases to restore functioning.

Bessent, who is in charge of the Treasury debt, added his own comments today on the focus on government debt: "The world is awash in debt post GFC, post COVID, and the only way for us to get out of this is to grow our way out of this," he told reporters ahead of the G20 meeting. That is the principle of letting the economy run hot — higher inflation, higher nominal economic growth, and higher long-term interest rates. But it does not address the other risks listed in the FSB's letter.

Vulnerabilities in Private Credit

The FSB's letter listed "vulnerabilities in private credit," including:

• "Levels of interconnectedness" with banks — banks took some big hits last year when several private credit deals blew up.
• "Liquidity mismatch" — a reference to the recent runs on private credit funds, when investors tried to yank their money out after the issues became more apparent. The funds had promised daily liquidity within small-print limits that no one read, while the funds' investments were illiquid, questionably valued loans made to riskier companies.
• "Opacity" — beyond the usual opacity about what these loans might really be worth, this covers the instances of fraud that caused some private-credit deals to blow up in the US last year.

Private credit has grown into a multitrillion-dollar market that operates largely outside the regulated banking system and public disclosure requirements, which is precisely why regulators such as the FSB have flagged transparency as a priority area in their monitoring work.

Stretched and Elevated Asset Valuations

The letter also listed "stretched" and "elevated" asset valuations, including:

• "Particularly artificial intelligence-related investments" — the stocks involved in the AI trade, including semiconductor stocks, anything that shot up amid the AI infrastructure investment mania, and the valuations of AI-related startups, now measured — almost comically — in the trillions of dollars each.
• "Risky assets" whose valuations are "elevated."
• Increased "leverage in equity markets."
• "Leveraged exchange-traded funds (ETFs) and correlated momentum-driven investment strategies" — which have become favorites of retail investors and blow up routinely.
• The "growing footprint" of leveraged hedge funds in the stock market, some of which are also exposed to government debt (such as those in the basis trade or making highly leveraged directional Treasury bets), which "increase the scope for contagion risk" from the stock markets to government debt markets.

AI Risks Get Special Treatment

A large portion of the letter was reserved for AI, which the FSB framed as a stack of risks layered on top of each other, including:

• The ability of frontier models to hack financial institutions across borders: "cyber disruption can spread across jurisdictions through common technology providers, shared infrastructure, and cross-border financial activity."
• This cyber risk "could undermine market confidence system-wide, especially due to highly concentrated third-party service providers." Market confidence is essentially the only force keeping asset prices "stretched" — and if that confidence fizzles, it could lead to the "potentially disorderly correction" that "could spread across borders" that Bailey warned about.
• "The increasing cross-investment" between AI companies and hyper scalers "that could amplify a future market correction" — referring to the vertigo-inducing amounts and complexities of circular financing and opaque off-balance-sheet liabilities.
• The sky-high stock prices and valuations of companies associated with AI, which could contribute to or cause that disorderly correction.

Central Banks' Own Role

The G20 Finance Ministers and Central Bank Governors will have a lot to mull over — not that they didn't already know all this, watched it develop over the years, encouraged it to happen, or made it happen. As for the central bank governors at the meeting: these debt levels, leverage, asset valuations, and risks were the inevitable results of many years of their central banks' free-money policies of QE, ZIRP, NIRP, and forward guidance since 2008. They did it — including Bailey, who has been BOE governor since March 16, 2020. What bears watching going forward is whether the FSB's warnings translate into concrete supervisory action — the board has said it will continue monitoring AI-related financial vulnerabilities as part of its regular reporting to the G20 — or remain another chapter in the long series of pre-crisis warnings that only get taken seriously after the "disorderly correction" arrives.