Geopolitical Risk Is Spreading Across the Risk Spectrum. Are You Prepared?
Whether we’re talking about, say, the Israel-Hamas armed conflict, the ongoing Russia-Ukraine war, or attacks on commercial shipping vessels in the Red Sea, geopolitical threats are escalating, causing headaches for businesses worldwide. What proactive steps can financial institutions and their risk managers take to assess and mitigate these risks?
Friday, February 9, 2024
By Clifford Rossi
Imagine the following scenario.
Militaries are facing off with increasing aggression in Europe and Asia. Nationalistic sentiments are taking root across the globe, while tensions over the control of oil are increasing. Human rights abuses, moreover, are seemingly commonplace worldwide, and populations are fleeing unstable regimes.
If this sounds a bit like today, you are right – but it could also very well describe 1937, just before the world erupted into a massively destructive war that set the post-war geopolitical landscape that largely still exists.
Contemporary geopolitical risk presents a myriad of existential threats to society and markets that requires greater attention than we collectively tend to give it. But how do we prepare for the possibility of a major geopolitical flare-up while managing to keep a steady hand on the risk management tiller? The first step is to consider how these threats are transmitted.
Complicating matters further is the fact that geopolitical risk can be transmitted through other types of risk, like sophisticated technology and cyber threats. Developments in artificial intelligence, for example, may very well amplify geopolitical risk, considering the potential for deepfake and other advanced AI tools to destabilize governments and economies. Meanwhile, the possibility of a massive cyberattack has never been greater, with the potential to inflict significant damage on, say, water-supply systems, electric power grids or financial market utilities.
The problem for risk managers faced with the task of managing geopolitical risk is the scale of this risk type and the diversity of shock waves that it could send through global markets.
Benefits from globalization include enhancing global economic welfare and providing efficient, mutually beneficial trade across countries, which in theory should lower the potential for geopolitical flashpoints to boil over. However, with war raging in Europe, heightened risk over freedom of navigation in international seaways, and huge, worldwide supply-chain risks for food, drugs and other critical products, strategic national interests are testing the limits of global interconnectedness.
Whether you are a CRO of a multinational or community bank, you need a framework for how to manage the spillover effects from a geopolitical crisis. But what steps can you take to meet this objective?
Preparing for Geopolitical Risk
A good game plan for managing geopolitical risk naturally starts with identifying how it would impact your business and risk. Understanding the severity of potential threats is one way to break potential risks down into manageable pieces.
Specifically, you must first understand what sort of geopolitical threats could pose risk at the global, national and/or sectoral levels. You should then be able to assess how they would directly or indirectly translate into risk to your firm. Such an assessment could leverage your employer’s risk taxonomy, permitting a deeper dive into how a particular geopolitical risk could impact credit, market, liquidity and operational risks, for example.
If, for instance, a cyberattack on the homeland’s telecommunications system were to shut down access to funding markets for several days, what would you do? Alternatively, if the lack of availability of semiconductors and rare earth minerals were to disrupt production of critical manufacturing and technology severely, how would that impact your business and risk response?
Developing strategies around various levels of geopolitical risk is the ultimate goal. There are, of course, a multitude of scenarios to consider, depending on your place in the business food chain.
If you are a community bank with an agricultural loan concentration in the Midwest, for example, understanding the supply chain for grain and beef shipments might be important to your credit risk profile. Curtailments of exports to hostile countries or even acts of piracy could fracture traditional supply chains that may threaten the financial viability of agricultural producers, translating into high credit losses over time.
On the other hand, if your company caters to import-export companies, understanding effects on shipping costs and insurance would be critical to sizing up potential impacts on your customers and on loan performance. Meanwhile, if you work at a multinational company, ferreting out the risks to assets held abroad – e.g., the legal/regulatory implications surrounding assets that could potentially be sanctioned or frozen – would be part of your geopolitical risk playbook.
Beyond credit risk, you must also consider the impact of a geopolitical crisis on the value of the assets in your company’s portfolio. Keep in mind that a wide-ranging geopolitical aftershock could ripple through capital markets, causing asset prices to plummet.
Indeed, with asset prices for equities, fixed income, real estate and other sectors at all-time highs, the threat of any geopolitical event could throw markets into a tailspin. So, it is critical to understand your portfolio’s vulnerability to such shocks – especially in terms of concentration risk profile, asset price sensitivity to external shocks, and potential recovery timelines.
Likewise, taking a second look at your liquidity contingency plan and your internal liquidity stress testing process will help you identify weaknesses in your liquidity position well in advance of a geopolitical crisis. Last March, I’m sure no one expected a $42 billion single-day run on deposits at SVB. Planning for the unexpected is what good risk managers do.
Although it seems too abstract and distant at times to factor into day-to-day risk discussions, rising geopolitical risk may be one of the biggest threats to financial institutions in 2024.
Geopolitical risk management, of course, isn’t for the faint of heart. The idea of a major conflagration among national powers equipped with some of the most dangerous weapons and technologies to ever exist is frightening. However, even though it rivals climate risk in its potential impact on mankind, the amount of attention and resources dedicated to managing geopolitical risk is far less than that expended on climate change.
Financial institutions must remedy this by first improving their overall geopolitical risk awareness – and by subsequently evaluating the associated implications of geopolitical threats on their risk exposure. Developing a game plan for how you would respond to such hazards may not make you sleep any better at night, but it will harden your risk defenses from such threats.
Clifford Rossi (PhD) is the Director of the Smith Enterprise Risk Consortium at the University of Maryland (UMD) and a Professor-of-the-Practice and Executive-in-Residence at UMD’s Robert H. Smith School of Business. Before joining academia, he spent 25-plus years in the financial sector, as both a C-level risk executive at several top financial institutions and a federal banking regulator. He is the former managing director and CRO of Citigroup’s Consumer Lending Group.