I’ve seen enough B-grade, end-of-the-world flicks to know that bank solvency will not be a priority for those desperately trying to prolong the survival of the human species! So, then, what’s all the hullabaloo today about geopolitical risk in the financial services industry?
Tony Hughes
Remember, capital is used to ensure that banks can keep lending during a downturn and to cushion investors when non-performing loans start to rise. But if losses are absolute, capital won’t be sufficient to ensure the ongoing survival of the bank or to protect the wealth of any investors lucky enough to survive a doomsday scenario.
Indeed, scenarios causing losses that are higher than the highest level of capital a bank could ever plausibly retain are completely irrelevant for CROs. One therefore must wonder why dire geopolitical risk is dominating discussion in the banking industry.
Let’s now examine how current geopolitical dangers, like tariffs and wars, actually impact banks.
Dual Obsessions
As the spring conference season wrapped up, it was clear that there are twin obsessions for the financial services industry: the rise of AI and geopolitical risk.
I can readily grasp the interest in AI, especially natural language processing. It holds the potential to automate many low-value tasks and enhance many high-value ones that those in banking and finance face daily. I saw some really interesting presentations demonstrating new techniques and applications that are coming on board across the industry. There remains an open question about whether AI is more hype than substance, but it’s a topic that demands our attention.
The focus on geopolitical risk was, and remains, much more surprising. Many of the speakers I heard were compelling, but you don’t need to attend a financial risk conference to find out that the Trump tariffs may derail the global economy or that the Middle Eastern conflict may escalate into something even more catastrophic. You could get up to speed on many of the topics covered by leafing through some foreign policy journals or even by reading the “world news” section in the Financial Times or Wall Street Journal.
The Tariffs Dilemma
Whenever I attended a talk on geopolitical risk, I kept asking whether, and in what way, any of this could be relevant for banks? I agree, for example, that the Trump tariffs threaten economic growth, but does this mean that your bank should currently be doing anything different?
If you genuinely believe that the global economy is threatened in a way that will harm profitability or solvency, the logical response would be to restrict the availability of credit and to turn away new clients. Conversely, you could raise capital and/or loan loss reserves by a substantial amount to cover the newly anticipated losses. Either approach, however, would harm profitability, rankling the bank’s board and its voracious investors.
I guess you could do a deep dive and try to identify the corporate clients most exposed to risks associated with North American trade. This will certainly be a new experience for analysts, because it was previously impossible to imagine a situation where the U.S. was the country most hostile to the notion of conducting commerce with foreigners.
The unprecedented nature of the new tariff regime under the Trump administration means that, even if you can identify each client's financial exposure, it will be difficult or impossible to model the potential impact on your bank’s expected losses.
The tariffs will likely cause a recession in the U.S. and more widespread disruption, as other countries redirect their exports to other markets. But recessions generally don’t cause solvency issues for banks, except when they are caused by the prior collective actions of banks. If bank balance sheets are sound – which the data seems to suggest is true – the tariffs are unlikely to cause a broad-based banking crisis, even if the economy tanks.
Insufficient data on tariffs will, I suspect, lead to a form of paralysis across the industry – unpalatable actions will only be taken if the potential for losses is concrete. But the imposition of bizarre, novel economic policies – and the haphazard nature of their execution – means that compelling evidence of their effect on borrowers will be elusive until it is too late to act.
War Fallout
Other elements of geopolitical risk are even more removed from financial interests. I mentioned last year that wars – the ultimate tragedy for humanity – are normally pretty good for banks.
The Ukrainian financial sector, for example, has performed very well despite the ongoing hostilities. Ukraine’s banks have, in fact, continued to increase profits and reduce non-performing loans over the past year. The Zelenskyy government is even imposing a windfall tax on banks to help with the war effort.
In my view, bankers tend to personalize these “big picture” risks. The logic is that because a full-blown war in the East China Sea or the Middle East would be horrible for humanity, the banks and the rest of the financial system must also suffer. In other words, war would be terrible for affected families, therefore it will also be bad for JP Morgan Chase.
But banks are not people. Banks and wars have coexisted for centuries, and the data confirm that profits invariably rise during these horrendous events.
Of course, if the Middle East crisis erupts into a full-blown war, or if tensions in the East China Sea escalate, the stakes may be even higher. With nuclear powers involved in a conflict, existential risks cannot be ruled out.
But existential risks, critical and potentially devastating for people, are always irrelevant for banks. They simply do not impact any decision that any banker will ever have to make in their professional capacity.
Parting Thoughts
The practice of risk management cannot be solely focused on the identification of potential problems. Similarly, it cannot just be about creating awareness and sparking discussion in the boardroom.
Risk identification is fine, but it’s more important to identify problems that are actionable and then take steps to fortify the business against those threats. Banks must realize, moreover, that there are some risks that they are powerless to do anything about.
To my mind, there’s a lot of white noise in the news today about geopolitical risk, at least when viewed from a banker’s narrow perspective.
Tony Hughes is an expert risk modeler. He has more than 20 years of experience as a senior risk professional in North America, Europe and Australia, specializing in model risk management, model build/validation and quantitative climate risk solutions. He writes regularly on climate-related risk management issues at UnpackingClimateRisk.com.
Topics: Geopolitical
