Geopolitics is more frequently appearing in the top three sources of risk for the financial sector. Investors and the broader economy that the banking and capital markets sectors support are also affected. When Blackrock’s Geopolitical Risk Indicator becomes a well-used acronym amongst retail investors, which the BGRI apparently has, geopolitical risk has arrived as a significant data point for the markets and the system.

Evolving geopolitical risk

The question is no longer how important geopolitical risk is. The Bank of England and its counterparts around the world have been keen to express to varying degrees of stress that it is one of the top risks for the financial sector, and where it is not it is often second only to cybersecurity risk. The Bank in its Systemic Risk Report earlier this year set out geopolitical risk is the most commonly cited ‘number one’ source of risk. Cyber risk itself is arguably becoming part of geopolitical risk, as state sponsored cyber-attacks top the threat level.

This second point indicates the nature of the risks in this area are evolving. Traditional approaches to defining geopolitical risk may need to be reconsidered for a fuller and meaningful understanding. The established view of geopolitical risk that focuses on big global event-driven factors with an international relations dimension has been dominated by assessments focusing on conflict, hot and cold, and economic and trade. Occasionally elections have captured the analysis, but usually a little late to the event.

The fast evolving and potential impact on traditional banking sector risks and newer ones, such as resilience, cyber and asset risk, means traditional tools may not be adept at picking up or dealing with threats as they materialize.

This approach relies on a narrow approach to assessing geopolitical risk. It is also limited to the established risk matrix analysis, namely market, credit, and operational risks. There is however growing recognition of newer more direct risks, including risk to assets, but this has not led to definitive work on risk mitigation in the traditional sense. This is despite the solvency risk for banks, exposures of other direct lenders, including private credit, and disruption and costs to capital markets participants.

The fast evolving and potential impact on traditional banking sector risks and newer ones, such as resilience, cyber and asset risk, means traditional tools may not be adept at picking up or dealing with threats as they materialize. Regulators, however, have not provided meaningful guidance on regulatory expectations on risk management and mitigation. It is unlikely insurance against identified risks is a meaningful mitigation. Firms and regulators have not identified all risks, and it is unclear how the knock-on impacts on the insurance sector will be transmitted.

Domestic v international political issues

Recent market and political events draw out further shortcomings of the traditional view. The relationship between domestic and international political issues has become more complex. Risk assessment should now consider developing domestic issues as factors, as well as more traditional international relations issues. Domestic policy issues, including responses to international policy agendas such as ESG, should be identified and accounted for. Domestic changes can also have far-reaching impact on regional and international issues. This is true for developed and developing economy jurisdictions. Recent changes in the government in Bangladesh are expected to hold profound consequences for China and India relations in the region, as well as the US policy in the region regarding China. All this change is expected to affect asset pricing, specific sectors, supply chain and trading routes.

The narrow view of geopolitical risk also fails to recognize the growing implications of sectors and asset classes. Domestic and international policies associated with specific assets and sectors can give rise to shifts in international relations and trade, and importantly vice versa. The impact of competitive forces in the semiconductor sector has knock-on implications not just for downstream sectors, such as batteries and electronic devices, but also exacerbates existing geopolitical tensions. Importantly it creates new international relations dynamics as previously unconcerned countries become interested, with potential for further knock-on implications for trade.

Sanctions policy

Sanctions policy has become an important feature of enforcement of international rules and a significant physical hand in financial markets and the economy. This has given rise to significant supply chain disruption and rerouting of goods and sourcing destinations. More importantly from a geopolitical perspective, sanctions associated with the Russia-Ukraine conflict have been divisive, with the so-called “Global South” less receptive to enforcing US, UK, and EU sanctions on Russia.

This may reflect deeper geopolitical shifts, but what is for certain is that it has resulted in significant costs and disruption to the financial sector in the West and elsewhere.

Enhanced assessment capabilities

The unpredictability of political risk makes risk assessment and mitigation difficult. Proactive approaches should include developing business and operational resilience. It should also include enhanced geopolitical assessment capabilities. On the latter, engaging with both regional and political experts should be complemented with sector and local market expertise. Local experts embedded in the region and market sector are a crucial source of intelligence, serve as better risk assessment and early warning systems, and can provide significant advantage.

Business model and operational resilience should feature three main components.

• One, diversification of exposures, across jurisdictions as well as sectors, will be increasingly important, for banks and asset managers. The costs to banks and financial firms, and their counterparts and investors, arising from supply-chain impact arising directly from sanctions imposed in the wake of the Russian invasion of Ukraine have been profound.
• Perhaps more interesting to investors and their advisers is that this has also given rise to opportunities and established sourcing destinations and logistical routes have been disrupted. In instances there have been entire product substitution. Scenario testing and enhanced geopolitical exposure assessment should mean more risks and opportunities become identifiable.
• Third, crisis management framework and protocols with strong communications function should serve organisations well in mitigating the impacts of unforeseen geopolitical issues occur.

Traditional approaches to risk assessment and mitigation in the banking and financial sector are not adequately addressing geopolitical risk exposures of banks and firms. This is due to not only an increase in volatility in international relations around the world but also the way individual sectors, financial markets and domestic policy interact. Domestic ESG policy responses to the international agenda, to trade relations as well as regulatory requirements are creating geopolitical implications, including restrictions and supply chain disruption. Sanctions policy as a response to geopolitical and trade tensions is also creating risk exposures.

Importantly, regulatory authorities are not decisively providing guidance and so it is down to the financial sector itself to determine the most appropriate way to manage new and emerging risks in a fast-moving environment. Banks and capital markets sector participants should focus on a proactive approach to identifying risks and opportunities early as part of an ongoing resilience building exercise.