Facing a dangerous world
ECB leaders highlight increasing geopolitical risks facing European banks
Geopolitical risk
We live in dangerous times. As conflicts around the world remind us daily, geopolitical risks have risen dramatically over the past decade. Today's wars and great power rivalry are far from what so many hoped for - and expected - at the start of the 21st century, when the end of the Cold War was seen by many (at least in the West) as heralding the dawn of a new world order of international stability, cooperation and trade.
As well as its potentially terrible human cost, the end of that 'End of History' has profound consequences for the global economy and financial system. Disputes, or even war, between world powers could suddenly disrupt international trade flows and supply chains with impacts that could ripple out across the global economy. Companies in every sector could find their business models suddenly under threat due to direct physical damage, the closure of key markets or the loss of access to essential raw materials or intermediate goods. These risks, along with the experience of the Covid-19 pandemic, have led to many businesses reviewing and reengineering their value chains to become more resilient to geopolitical shocks.
Impact on banks
Banks too must think about geopolitical risks. So Claudia Buch and other senior ECB supervisors have argued in recent weeks. Since she was first nominated as ECB Supervisory Chair, Buch has identified heightened geopolitical risk as one of the key macro trends to which European banks must react. As part of their forward-looking risk assessment, she has argued, European banks should consider how geopolitical shocks could impact their businesses and how to make themselves more resilient in advance.
In a late September speech, Buch set out the ECB's approach to geopolitical risk. The ECB, she explained, has identified several channels by which a geopolitical shock could affect banks. These include:
Real economy channel: international tension or conflict could hit household and corporate incomes and damage property, impacting borrowers' ability to repay loans;
Financial markets channel: geopolitical shocks could trigger shifts in asset prices and increase financial market volatility; and
Safety and Security channel: conflict including cyber attacks could damage banks' own systems or the critical infrastructure on which they depend.
Through these channels, Buch said, a geopolitical shock could result in increased credit, liquidity, market and operational risk and/or threaten parts of a bank's business model. Banks must therefore assess how geopolitical risks could affect their businesses, and how they can become more resilient - a message subsequently echoed by both Frank Elderson and Elizabeth McCaul.
Forecast uncertainty
Buch is concerned, however, that banks may underestimate their exposure to geopolitical risk. That is partly because standard statistical risk models cannot estimate risks not captured in the historical data on which they are based. (Essentially a simple statistical model assumes that something that has not yet happened will never happen.) Hence geopolitical risk has been an important topic in the ECB's recent review of banks' credit models. When estimating future loan losses (and deciding what 'provisions' or reserves to set aside to cover expected losses), many banks apply adjustments or 'overlays' to their statistical models to account for geopolitical (and other new) risks. In its review, however, the ECB found many banks' adjustments to be too crude or subjective. So it may require them to adopt more sophisticated techniques and/or make larger provisions for potential loan losses. This in effect requires loan portfolios to be backed by more loss-absorbing but costly capital.
Buch also argued that banks may lack the capacity to monitor geopolitical risks. Strong supervision, she said, could therefore help by testing banks' risk management, conducting stress tests and sharing good practices across the industry. This sounds reasonable, but the ECB should take care to maintain a degree of humility.
As Buch herself acknowledged geopolitical events are inherently uncertain - I keep recalling how several European intelligence agencies continued to deny that Russia would attack Ukraine in February 2022 until very shortly before the invasion took place. So it is not obvious that supervisors are any better than banks at predicting what geopolitical crises may occur. Indeed, there is a good argument that banks’ sovereign risk analysis teams may well have more experience than supervisors of thinking through the impact of political or geopolitical events.
Similarly, the impact of a given geopolitical shock is also highly uncertain: the economic damage of a conflict may (or may not) be mitigated by government policy support; financial markets may (or may not) have priced in the risk in advance; banks' systems may (or may not) withstand attacks on cyber or physical infrastructure. So even once a particular geopolitical scenario has been selected, forecasting its impact with any certainty is all but impossible.
Weak points
Requiring banks to predict what geopolitical risks might arise and simulate their impact may therefore be misguided. Supervisors would be better off encouraging banks to focus on assessing their vulnerabilities. Risk managers could use the framework Buch set out to analyse their exposures to different ways that a geopolitical shock could manifest itself. For example, they could consider their exposures to different geographies or industry sectors that might be affected by a conflict or trade dispute. And they could assess how big a disruption to financial markets would be needed to generate either significant losses in their securities portfolios or problems of liquidity.
A fuller awareness of their weaknesses would then allow bank management to make informed decisions about the level of geopolitical risk they are prepared to tolerate. They can then determine how to mitigate risks beyond that threshold (by reorienting credit portfolios perhaps, or changing funding strategies) and make contingency plans in case a crisis does occur.
Living with risk
Geopolitical risk - for banks as for the rest of the world - cannot be entirely eliminated. It is always possible to imagine plausible but extreme scenarios in which an escalating conflict causes such catastrophic damage that mitigating its economic and financial harm is impossible (and perhaps beside the point). But that does not absolve banks of responsibility to confront their vulnerabilities and take a clear-eyed view of what risks they are and are not willing to bear. Understanding their weak points may be key to prepare banks to face what is unfortunately and ever more dangerous world.