Banks Learning Geopolitics
In recent years, geopolitical risk has emerged as a significant threat to the stability of financial markets and banking systems. Examples are the war in Ukraine and the ensuing sanctions, the Trump administration’s proposed tariffs and military strikes on Iran.
Growing Geopolitical Risk Requires a New Approach
While banks are by now well-equipped to deal with traditional risks like credit, market and liquidity, making sense of geopolitical risk may prove challenging in that they are wide-ranging, may deteriorate quickly along unexpected paths and involve multiple second- and third-order effects. Nevertheless, as these threats can trigger significant losses, large lenders have been introducing new processes and responsibilities to measure and contain them, trying to develop a framework that allows for faster and better-focused responses to emergent adverse scenarios. I have covered such innovations and their remaining weaknesses in a recent study for the European Parliament and would like to summarize some of the main findings below.
The Fundamental Components of an Effective System
There are no “best practice” documents or detailed supervisory expectations related to geopolitical risk management. Nevertheless, the following may be seen as the key components of a sound geopolitical risk management system.
Governance schemes. It is essential to clearly define powers, responsibilities, processes and structures (which must be independent but firmly connected with the board of directors and the internal functions responsible for risk management). Once a coordination center for geopolitical risk has been identified, it must be provided with adequate resources. A predefined crisis response process must be formalized, in order to reduce the time required in case of an emergency and maximize the effectiveness of the bank’s response; the robustness of such a process must be assessed through simulations and stress tests.
Materiality analysis. Banks must identify, on the basis of a probability/severity matrix, the relevant channels (like energy and commodity prices) through which geopolitical risks could affect their business, depending e.g. on the geo-sectoral composition of their customers and subsidiaries.
Access to relevant and timely data. Once the most material areas have been identified, one must ensure access to quantitative data (e.g. on import/export flows or credit ratings) and qualitative information (such market sentiment analyses and intelligence reports) which must be available on an ongoing basis.
From Analysis to Operational Decisions
Integration of the relevant channels into traditional risk estimation processes: the relationship between any material sources of geopolitical risk and the risks traditionally faced by the bank must be monitored through econometric models (whose results may however be inaccurate, given the ever-changing nature of geopolitical threats), but also through qualitative tools and scenario analysis. This should translate into a rough estimate of the impact of different scenarios on some of the bank's KPIs (profitability, capitalization, liquidity, corporate reputation and employee wellbeing) and should be used to identify pre-emptive actions (like reducing the bank’s exposure to certain sectors or countries) and inform the dialogue with supervisory authorities.
Integration of results into business decisions. When one or more scenarios go from merely possible to probable, the analyses outlined above must be used to make appropriate management decisions by implementing more stringent concentration limits, revising prices to trigger changes in demand, increasing the amount of funds set aside for risk coverage and so on.
Continuous Assessment and Strengthening of Resilience
Backtesting and review of processes. The responses provided by the geopolitical risk management system in the event of a crisis must be subjected to a careful retrospective evaluation to identify any improvements that are required regarding each of the steps listed above.
Furthermore, it also by stepping up their ability to address risks (such as liquidity risk, concentration risk or cyber risk) that may not seem directly related to geopolitical threats that lenders can significantly reduce their vulnerability to the latter.
