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Daniel Dieckelmann
Financial Stability Expert · Macro Prud Policy&Financial Stability, Systemic Risk&Financial Institutions
Christoph Kaufmann
Senior Financial Stability Expert · Macro Prud Policy&Financial Stability, Market-Based Finance
Chloe Larkou
Peter McQuade
Senior Economist · International & European Relations, International Policy Analysis
Caterina Negri
Cosimo Pancaro
Denise Rößler
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Turbulent times: geopolitical risk and its impact on euro area financial stability

Prepared by Daniel Dieckelmann, Christoph Kaufmann, Chloe Larkou, Peter McQuade, Caterina Negri, Cosimo Pancaro and Denise Rößler

Published as part of the Financial Stability Review, May 2024.

Geopolitical risk can be a threat to financial stability and the global economy. It can adversely affect the economy and financial markets and consequently have a negative impact on the funding, lending, solvency, asset quality and profitability of banks and non-banks alike. Recent history suggests that adverse geopolitical events alone are unlikely to cause a systemic crisis, although they may act as a trigger for systemic distress if they interact with pre-existing vulnerabilities. Looking ahead, policy authorities need to monitor geopolitical risk and assess its possible consequences for financial stability. Financial institutions should apply a combination of sound risk management and business diversification to address geopolitical risk.

Introduction

Geopolitical risk, which has increased of late, can be a threat to financial stability. Recent conflict in the Middle East, fears of an escalation in US-China tensions over Taiwan and the Russian invasion of Ukraine have all raised concerns about geopolitical stability. Adverse geopolitical events can trigger rapid shifts in market sentiment and sharp increases in uncertainty, exposing existing vulnerabilities in financial institutions and markets. Moreover, they can dent consumption and investment plans, with knock-on effects for economic growth, and activate adverse feedback loops between the real economy and the financial world. This special feature starts by providing a conceptual overview of the channels through which geopolitical risk can affect euro area financial markets, the economy and the financial sector. It then goes on to present empirical evidence on the effects of geopolitical risk on euro area non-banks and banks.

Geopolitical risk is the threat, realisation and escalation of adverse events associated with wars, terrorism and tensions among states and political actors that affect the peaceful course of international relations. This definition is consistent with the geopolitical risk (GPR) index created by Caldara and Iacoviello and used in this special feature.[1] Higher values for the GPR index suggest an increase in the likelihood or intensity of adverse geopolitical events, and vice versa. By contrast, the concept of geopolitical fragmentation is different – it captures the reversal of global economic and financial integration due to geopolitical considerations.[2]

Channels through which geopolitical risk affects financial stability

Geopolitical risk could adversely affect the global economy and spark financial instability through a variety of channels. On the real-economy side, geopolitical risk can impact the economy by negatively affecting real GDP growth, inflation, trade, investment, consumption and savings (Figure A.1). On the financial side, geopolitical risk can affect capital flows and asset prices, among other things, and lead to volatility in commodity markets, exchange rates, stock prices, interest rates and credit spreads. Given the linkages between the real economy and the financial sectors, feedback processes may reinforce direct effects. These adverse effects on the real economy and financial markets could have negative consequences for the funding, lending, solvency, asset quality and profitability of non-banks and banks.

Figure A.1

Transmission channels of geopolitical risk to financial stability

Source: ECB staff.

Geopolitical risk can have adverse effects on the economy. Adverse geopolitical events tend to increase uncertainty, causing a deterioration in investor and consumer sentiment that weighs on economic growth. In addition, international trade could also be curtailed as confidence is hit or trade restrictions and sanctions are increased. Furthermore, disruptions to global supply chains and commodity markets, such as the oil shocks in the 1970s that arose from geopolitical developments in the Middle East, may also have a negative impact on growth (Chart A.1).[3],[4] An empirical analysis estimating the effect of global geopolitical risks on macroeconomic variables suggests that inflation increases by almost 0.1 percentage points and industrial production declines by around 0.15% six months after a 1 standard deviation geopolitical shock (Chart A.2, panel a).[5] In some circumstances, this could necessitate tighter monetary policy, which would have an adverse effect on financing conditions for firms and governments.

Chart A.1

Severe geopolitical risk events have often had large effects on oil prices

Brent crude oil price and GPR index since 1970

(Jan. 1970-Feb. 2024; left-hand scale: USD/barrel, right-hand scale: percentage share of all articles)

Sources: Bloomberg Finance L.P., Energy Intelligence Group, OPEC, World Bank, and Caldara and Iacoviello*.
*) Caldara, D. and Iacoviello, M., op. cit.

Geopolitical risks could destabilise financial markets by increasing uncertainty and weighing on the macroeconomic outlook.[6] Expectations of slower macroeconomic growth and higher inflation can weigh on the outlook for firm profitability. This, together with increased credit risk, would reduce equity and corporate bond valuations and raise the rates banks charge on loans, tightening financing conditions for non-financial corporations. The threat of adverse geopolitical developments can also increase financial market uncertainty more broadly, undermining confidence among investors and heightening risk aversion. Empirical estimates confirm that euro area financial variables react to geopolitical risk. The EURO STOXX 50 index is estimated to fall by around 1% on impact in response to a geopolitical shock of 1 standard deviation. The VSTOXX (an option-implied equity market volatility index) increases by around 1.5 index points in the same scenario, suggesting that geopolitical risk not only affects asset prices but also increases market uncertainty (Chart A.2, panel b).[7] The effects of geopolitical risk events on financial markets are found to be strongest on impact, after which they tend to fade somewhat.[8] However, the persistence of the effects on markets is likely to vary depending on the underlying geopolitical risk, with larger and longer-lasting tensions leading to more severe and more persistent effects.

Financial market volatility may prompt investors to reduce the weight of riskier assets in their portfolios and potentially engage in flight-to-safety behaviour. Econometric estimates suggest that initially yields on risky assets go up (as reflected in widening corporate bond spreads) while those on safe assets, such as German sovereign bonds, go down in response to a geopolitical shock (Chart A.2, panel b). This is consistent with flight-to-safety behaviour, as also seen in the appreciation of the US dollar in response to rising geopolitical risk, which is consistent with its role as a safe-haven currency.

Chart A.2

The materialisation of geopolitical risk could push up inflation, reduce industrial production and lead to a deterioration in financial conditions

a) Impulse responses of euro area economic variables to a geopolitical risk shock

b) Impulse responses of financial indicators to a geopolitical risk shock

(Jan. 2001-Dec. 2023; percentage points, percentages)

(Jan. 2001-Dec. 2023; percentages, indices, basis points)

Sources: ECB, Bloomberg Finance L.P. and ECB calculations.
Notes: Impulse responses to a 1 standard deviation global geopolitical risk shock (Caldara and Iacoviello*), based on a Bayesian vector autoregression model with monthly data from January 2001 to December 2023. The shocks are identified using a Cholesky decomposition, with geopolitical risk ordered first. All values are statistically significant at levels of at least 10%, except where shaded. Panel a: results are based on a model including the GPR index, the VSTOXX index, the EURO STOXX 50, the two-year Bund rate, the corporate bond spread, euro area HICP inflation and euro area industrial production. Panel b: results are based on a baseline model including the GPR index, the VSTOXX index, the EURO STOXX 50, the two-year Bund rate (extended to the USD/EUR exchange rate) and the oil price volatility index in separate estimations.
*) See Caldara, D. and Iacoviello, M., op. cit.

Geopolitical risk can also have profound consequences for banks and non-banks. The following sections describe what can happen to banks and non-banks when geopolitical risk increases and presents empirical estimates of the magnitude of these effects.

Non-banks are among the first to feel geopolitical stress

Investors are exposed to geopolitical risk through their asset portfolios. The degree of vulnerability varies between the different industrial sectors and depending on firms’ geographical location and trade links. Businesses related to transport, the aircraft industry and specific areas of manufacturing, such as steel, are most vulnerable to geopolitical risk.[9] Industries like technology and most types of manufacturing have an intermediate risk exposure, while the least exposed business lines include mining and consumer goods. Some sectors, such as fossil fuels, natural gas and defence, may even profit from geopolitical risk-related stress.

Stock and bond exposures to industries most vulnerable to geopolitical risk are concentrated among non-banks. This exposure makes them vulnerable to market risk since asset valuations tend to fall when adverse geopolitical events occur (Chart A.2, panel b). Credit risk could also materialise when real economic activity deteriorates after an adverse event (Chart A.2, panel a). Investment funds hold more than €8 trillion in corporate stocks and bonds, of which around 10% are invested in the most vulnerable industry categories (Chart A.3, panel a). Banks’ holdings mainly consist of securities issued by other financial corporations – these are classified in the intermediate risk categories. Households’ exposures are more limited in absolute terms. Such direct securities investments only make up a relatively small share of their total wealth that also includes real estate assets and bank deposits, among other things.

Investment funds’ exposure to valuation losses and credit risk could exacerbate financial stress stemming from geopolitical tensions. Investment fund returns tend to fall after geopolitical shocks and can be subject to sizeable investor redemptions (Chart A.3, panel b). The latter may induce investment funds, especially those with small cash positions, to sell assets, exacerbating any initial pressure on asset prices and, as a result, firms’ financing conditions. Equity funds experience sizeable and persistent outflows, although investors differentiate between fund types focusing on specific industries. Funds investing in financials and industrials, which include some of the sectors most heavily exposed to geopolitical risk, have immediate and persistent outflows (Chart A.3, panel b). At the same time, equity funds focusing on energy companies, and to a lesser extent commodities, receive strong inflows. This is consistent with the observation that the prices of fossil fuels and raw materials often rise when geopolitical tensions increase (Chart A.1).

Chart A.3

Stocks and bonds of industries vulnerable to geopolitical risk are held by non-banks that could withdraw their funding quickly

a) Equities and corporate bonds, by holding sector and exposure to geopolitical risk

b) Impulse responses of euro area-domiciled equity fund flows to a geopolitical risk shock

(Q4 2023; left-hand scale: € trillions, right-hand scale: percentage shares of equity and corporate bond portfolios)

(Jan. 2002-Dec. 2023; months after shock, percentage shares of funds’ total net assets)

Sources: ECB (SHS, CSDB), EPFR Global, Bloomberg Finance L.P. and ECB calculations.
Notes: Panel a: equity and corporate bond holdings of euro area investors at market value, classified into heatmap of SIC-classified industry sectors’ exposure to geopolitical risk using stock returns following the methodology of Caldara and Iacoviello*. Most exposed sectors include transport, aircraft, steel works and electronics. Least exposed sectors include mining, petroleum and gas, defence and consumer goods. ICPFs stands for insurance corporations and pension funds; IFs stands for investment funds. Panel b: impulse responses to a 1 standard deviation global geopolitical shock (Caldara and Iacoviello*) based on a Bayesian vector autoregression model with monthly data from January 2002 to December 2023. All responses are based on separate models that include the GPR index, one category of cumulative flows into euro area-domiciled equity funds, the VSTOXX index, the EURO STOXX 50 and the two-year Bund rate. The shocks are identified using a Cholesky decomposition with geopolitical risk ordered first. All values statistically significant at levels of at least 10%. Estimation for industrials equity funds begins in March 2006 due to data availability.
*) See Caldara, D. and Iacoviello, M., op. cit.

Corporate bond funds are directly affected and experience both strong outflows and lower returns when geopolitical risk rises. Interest rates on sovereign bonds fall mildly on impact, while corporate bond spreads tend to rise, pointing to reduced risk appetite in financial markets (Chart A.4, panel a). Bond yields tend to rise in the months following a shock, implying that financing conditions are deteriorating for both firms and governments (Chart A.2, panel b). Returns on both corporate and sovereign bond funds fall in the wake of a geopolitical shock because of the asset valuation losses caused by the shock (Chart A.4, panel b). Specifically, a 1 standard deviation shock decreases the returns of corporate and sovereign bond funds by almost 0.5 percentage points and 0.4 percentage points respectively after six months. At the same time, investors persistently withdraw from corporate bond funds, potentially forcing fund managers to sell assets.

Sovereign bond funds receive sizeable inflows, pointing to flight-to-safety behaviour on the part of investors. This could support government financing needs, which often rise in the context of geopolitical tensions.[10] Interestingly, geopolitical stress does not lead to elevated fragmentation risks in euro area sovereign bond markets. Spreads between more and less indebted euro area sovereigns do not react significantly to geopolitical shocks (Chart A.4, panel a). Sovereign debt holdings of countries directly involved in conflicts could be subject to credit or repudiation risks if a belligerent decides not to honour its debt obligations to international investors, as was the case with Russian government debt during 2022.

Chart A.4

Geopolitical risk can trigger flight to safety and stress corporate bond markets

a) Impulse responses of bond spreads to a geopolitical risk shock

b) Impulse response of euro area-domiciled bond funds to a geopolitical risk shock

(Jan. 2001-Dec. 2023, basis points)

(Nov. 2003-Dec. 2023; x-axis: months after shock, y-axis: model responses to a 1 standard deviation shock, percentages)

Sources: ECB (SHS, CSDB), EPFR Global, Bloomberg Finance L.P. and ECB calculations.
Notes: Impulse responses to a 1 standard deviation global geopolitical risk shock (Caldara and Iacoviello*) based on a Bayesian vector autoregression model with monthly data. The shocks are identified using a Cholesky decomposition with geopolitical risk ordered first. All values are statistically significant at levels of at least 10%. Panel a: the model includes monthly observations from January 2001 to December 2023 for the GPR index, the VSTOXX index, the EURO STOXX 50, the two-year Bund rate, the European corporate bond market spread and the spread between ten-year Italian and German government bonds. Panel b: the model includes monthly observations from November 2003 to December 2023 for the GPR index, the VSTOXX index, the EURO STOXX 50, the two-year Bund rate and one category of cumulative returns or flows into euro area-domiciled bond funds, measured as a share of past total net assets.
*) See Caldara, D. and Iacoviello, M., op. cit.

Geopolitical risk can also have adverse implications for banks

The vulnerability of euro area banks to geopolitical risk varies from institution to institution, depending on their actual exposure to adverse geopolitical developments. To evaluate the exposure of individual banks to geopolitical risk, we construct a new bank-level indicator of geopolitical risk which uses the GPR index and ECB supervisory data on banks’ asset exposures across countries. More specifically, the new indicator is built by weighting the standardised country-level geopolitical risk indices with bank-level asset-side exposure to the different countries where banks operate (Chart A.5, panel a).[11] The indicator exhibits significant variation and peaks around the start of the Russian invasion of Ukraine.[12] As expected, the peaks are especially high for banks operating in countries located closer to Ukraine and Russia as they face relatively higher levels of geopolitical risk (Chart A.5, panel b). The indicator exhibits other highs corresponding, for example, to the terrorist attacks in Paris in the third quarter of 2015, in Brussels in the first quarter of 2016 and in Germany in the first quarter of 2020.

Chart A.5

Euro area bank exposure to geopolitical risk spiked when Russia invaded Ukraine

a) Bank exposure-weighted GPR index

b) Average bank-level exposure-weighted GPR index at the time of the Russian invasion of Ukraine, by country

(Q1 2015-Q3 2023, standard deviations from long-term average)

(Q1 2022)

Sources: ECB (supervisory data), Caldara and Iacoviello*, Factiva and ECB staff calculations.
Notes: The exposure-weighted bank-level GPR index is constructed by weighting the country-level GPR indices with bank-level asset-side exposure shares to different countries, obtained from ECB supervisory data. The GPR index is available at the country level for 44 countries (including eight euro area countries). To make the analysis more comprehensive, we use the same methodology and the Factiva news monitoring platform to extend the coverage of the index to all missing euro area and EU countries, meaning that the analysis considers a total of 62 countries. This ensures that for all 73 euro area significant institutions considered in our sample, at least 80% of their asset-side exposure is accounted for. Country-level GPR indices are weighted by asset-side geographical exposure shares divided by total assets. Moreover, to make levels more comparable across banks, we standardise the country-level GPR indices by transforming them into z-scores based on historical time series going back to 1985 (where available) before weighting them. Panel a: standard deviations for the GPR index are calculated in respect of the long-term average of the series (1985-2023). Panel b: darker colours indicate a higher average exposure-weighted GPR index for the country’s significant institutions.
*) Caldara, D. and Iacoviello, M., op. cit.

Geopolitical risk events can have an adverse impact on bank credit default swap (CDS) spreads and stock prices. Bank-level estimations show that there is a positive and statistically significant relationship between the bank-level GPR index and the CDS spreads of euro area banks. By contrast, stock prices are affected negatively. More specifically, the estimated coefficients suggest that a 1 standard deviation increase in the bank-level GPR index is significantly associated with an increase in CDS spreads of 38 basis points and a decline in stock prices of around 6% (Chart A.6, panels a and b). These results are driven primarily by weakly capitalised and less-profitable banks. The finding is consistent with the theory of geopolitical risk triggering risk aversion, causing investors to sell assets and demand a higher return for bearing the risk associated with certain banks, especially those perceived as less resilient to adverse shocks due to their weaker solvency and profitability.

The funding and liquidity positions of banks could also come under strain, undermining their stability.[13] Geopolitical tensions triggering a rise in risk aversion could lead to reduced funding (including cross-border credit), a higher cost of funding and greater recourse to short-term funding. These effects could also result in heightened rollover risk and potential liquidity stress. Empirical evidence shows that there is a positive and statistically significant relationship between the bank-level GPR index and the bond yields of euro area banks. A 1 standard deviation increase in the bank-level GPR index is associated with an increase of 7 basis points in bond yields (Chart A.6, panel c). This result is also driven by weakly capitalised and less-profitable banks.

Chart A.6

Greater market reaction to geopolitical risk for weakly capitalised and less-profitable banks

a) CDS spreads

b) Stock prices

c) Cost of funding

(basis points)

(percentages)

(basis points)

Sources: Eurostat and ECB (GFS, ICP, MNA), ECB (RTD, supervisory data), Bloomberg Finance L.P., LSEG, S&P Dow Jones Indices LLC and/or its affiliates, Caldara and Iacoviello*, Ahir et al.** and ECB staff calculations.
Notes: Coefficient estimates indicate the effect on the dependent variable of a 1 standard deviation shock to the bank-level GPR index. Based on panel regressions on a sample of 34 significant institutions for CDS spreads, 31 institutions for stock prices and 37 institutions for cost of funding, from Q1 2015 to Q3 2023. The regressions control for lagged bank-level characteristics (equity/asset ratio, cost of risk, cost/income ratio, return on assets, total loans/deposits ratio) as well as the World Uncertainty Index[14] and country-level macroeconomic variables (real GDP growth, inflation rate, stock market index, one-year sovereign bond yields). Regressions control for bank fixed effects and time (quarter) fixed effects. The regressions also include a dummy for Greek banks in the period 2015-16. All coefficient estimates are statistically significant at levels of least 10%, except where shaded. For the sub-sample analysis, banks with an equity/asset ratio above the median are considered highly capitalised (with high profitability) while banks with an equity/asset ratio below the median are considered to have low capitalisation (low profitability).
*) Caldara, D. and Iacoviello, M., op. cit.
**) Ahir, H., Bloom, N. and Furceri, D., op. cit.

Banks may respond to geopolitical risk by raising lending rates and reducing risk by adjusting exposures and decreasing lending. Both credit supply and credit demand may be dampened by adverse macroeconomic developments caused by geopolitical risk. On the credit supply side, greater uncertainty may make banks less willing to lend to non-financial corporations and households.[15] On the credit demand side, households and corporations may be reluctant to take out loans or invest in times of elevated uncertainty. That said, the empirical evidence on the effect of geopolitical risk on bank lending is mixed. Some studies suggest that geopolitical risk is not associated with a reduction in overall bank lending.[16] The effects on bank lending may also vary across sectors, as lending to households tends to be domestically focused while corporate lending may be targeted more towards export-oriented sectors. It may also be used to fund overseas investment or trade finance, and as such may be more exposed to foreign geopolitical risk. Banks’ efforts to reduce exposure to those sectors most affected by geopolitical risk could act as headwinds to economic activity in these sectors. For instance, international trade could be curtailed if banks decided to limit the availability of trade finance or increase its cost.[17]

Chart A.7

Geopolitical risk negatively affects bank profitability (especially for smaller and weakly capitalised banks) and asset quality (especially for smaller banks)

a) Return on assets

b) Cost of risk

(basis points)

(basis points)

Sources: Eurostat and ECB (GFS, ICP, MNA), ECB (RTD, supervisory data), Bloomberg Finance L.P., LSEG, S&P Dow Jones Indices LLC and/or its affiliates, Caldara and Iacoviello*, Ahir et al.** and ECB staff calculations.
Notes: Coefficient estimates indicate the effect on the dependent variable of a 1 standard deviation shock to the bank-level GPR index. Based on panel regressions on a sample of 71 significant institutions from Q1 2015 to Q3 2023. The regressions control for lagged bank-level characteristics (equity/asset ratio, cost of risk, cost/income ratio, return on assets (ROA), total loans/deposits ratio) as well as the World Uncertainty Index and country-level macroeconomic variables (real GDP growth, inflation rate, stock market index, one-year sovereign bond yields). Regressions control for bank fixed effects and time (quarter) fixed effects. For regressions with the ROA as the dependent variable, the ROA is omitted as an explanatory variable. Similarly, for regressions with the cost of risk as the dependent variable, cost of risk is omitted as an explanatory variable. All coefficient estimates are statistically significant at levels of at least 10%, except where shaded. For the sub-sample analysis, banks with an equity/asset ratio (total assets) above the median are considered highly capitalised (large) while banks with an equity/asset ratio (total assets) below the median are considered to have low capitalisation (small).
*) Caldara, D. and Iacoviello, M., op. cit.
**) Ahir, H., Bloom, N. and Furceri, D., op. cit.

The macroeconomic consequences of geopolitical risk could weaken bank asset quality. Slower economic growth could weaken the ability of borrowers to repay loans, thus leading to higher provisioning and more non-performing loans. For instance, there was a sharp increase in the average probability of default for bank loans to Russian and Ukrainian borrowers after Russia invaded Ukraine in 2022. Bank-level estimates show that increases in geopolitical risk result in weaker asset quality, measured by the cost of risk. The estimated coefficient suggests that a 1 standard deviation increase in the bank-level GPR index is associated with a 7 basis point increase in the cost of risk (Chart A.7, panel b). The asset quality results are driven by the increase in the provisions of smaller banks, which are generally less diversified internationally and have less opportunity to spread their risk if their domestic market is exposed to geopolitical risk.

Higher funding costs, weaker lending and a deterioration in asset quality arising from geopolitical risk could undermine bank profitability. A higher cost of funding could squeeze banks’ net interest margins, while lower loan volumes could reduce interest income. Loan losses and valuation losses on asset holdings could also weigh on profitability.[18],[19] Bank-level estimates show that a 1 standard deviation increase in bank-level geopolitical risk is significantly associated with a decline in bank profitability, measured by return on assets, of 9 basis points (Chart A.7, panel a). This result is driven by weakly capitalised and smaller banks, as they would likely experience higher funding costs and a more marked deterioration in asset quality in times of heightened geopolitical risk.

Conclusions

Recent history suggests that geopolitical shocks alone are unlikely to cause a systemic crisis, but the latest developments call for heightened vigilance.[20] The major geopolitical risk events of recent decades, such as the 9/11 attacks, did not immediately trigger financial crises, even in the countries directly affected by the events. In this context, recent history may not be a good guide to the severity of future shocks. Geopolitical shocks may act as a trigger for systemic distress if they interact with pre-existing vulnerabilities. In particular, financial instability could arise if a combination of different factors materialises, such as (i) a very large shock, (ii) other sources of amplification, and (iii) strong contagion.

Geopolitical risk can have adverse implications for the resilience of financial institutions. Several academic and policy studies, as well as the empirical evidence reported in this special feature, suggest that the materialisation of geopolitical risk could have negative effects on the soundness of euro area banks and non-banks. Geopolitical risk could result in significant outflows and falling returns from investment funds, among other things. Equally, geopolitical risk could lead to declining bank stock prices, widening CDS spreads and greater funding costs and provisioning needs for banks, which in turn would weigh on their profitability.

Policy authorities need to monitor geopolitical risk and assess its possible consequences for financial stability. Assessing these risks will enable policy authorities to enhance their ability to identify vulnerabilities, better understand how geopolitical events might propagate through the financial system and draw up possible policy responses in advance. This would facilitate a swift and coordinated policy response when needed and strengthen the overall resilience of the financial system.

Financial institutions should apply a combination of risk management strategies and business diversification to address geopolitical risk. First, institutions need to have robust capital adequacy and liquidity management frameworks in place to withstand shocks, including those arising from possible geopolitical risk events. Institutions should also set up dedicated teams or utilise specialised services to continuously monitor geopolitical developments. Such a proactive approach would allow them to anticipate risks and adjust their strategies accordingly. They should regularly assess their resilience to geopolitical risk by carrying out dedicated and thorough assessments and stress tests. Additionally, they could purchase political risk insurance to protect themselves against losses resulting from geopolitical events. Finally, financial institutions should develop robust contingency plans so that they can respond swiftly to unexpected events and minimise disruption to their operations.

  1. See Caldara, D. and Iacoviello, M., “Measuring Geopolitical Risk”, American Economic Review, Vol. 112, No 4, April 2022, pp. 1194-1225. The GPR index is constructed by counting the number of newspaper articles related to adverse geopolitical events as a share of the total number of newspaper articles at a monthly frequency. The global GPR index is based on one Canadian, three UK and six US newspapers.

  2. For more on this topic, see “Global Financial Stability Report: Safeguarding Financial Stability amid High Inflation and Geopolitical Risks”, International Monetary Fund, April 2023.

  3. See Góes, C. and Bekkers, E., “The impact of geopolitical conflicts on trade, growth, and innovation”, Staff Working Papers, ERSD-2022-9, World Trade Organization, July 2022.

  4. See the box entitled “Geopolitical risk and oil prices”, Economic Bulletin, Issue 8, ECB, 2023; Caldara, D., Conlisk, S., Iacoviello, M. and Penn, D., “Do Geopolitical Risks Raise or Lower Inflation?”, mimeo, 2023; and Smith, S. and Pinchetti, M., “The transmission channels of geopolitical risk”, Bank of England, Bank Underground, 4 April 2024.

  5. For reference, the Russian invasion of Ukraine in 2022 was an event of roughly 5 standard deviations for the global GPR index.

  6. In the event of a war, governments may close financial markets − making it impossible to trade financial assets in the normal venues or exchanges − impose debt moratoria or suspend currency convertibility, while also seizing or requisitioning real or financial assets. Such extreme scenarios are not considered here. See Ferguson, N., “Earning from History? Financial Markets and the Approach of World Wars”, Brookings Papers on Economic Activity, Vol. 2008, Spring 2008, pp. 431-477.

  7. Caldara, D. and Iacoviello, M., op.cit., find that the S&P 500 index falls by almost 5% after 12 months in response to a 2 standard deviation shock to the GPR index, with considerable diversity across industry lines.

  8. For instance, the Russian invasion of Ukraine triggered a large initial market reaction, yet many euro area financial markets recovered most of their initial losses after around a month.

  9. The classification is based on the response of the stock prices of different industry sectors to geopolitical shocks and is taken from Caldara, D. and Iacoviello, M., op. cit.

  10. Caldara, D. et al., op cit., find that government debt and spending, including military expenditure, rise significantly after geopolitical risk materialises.

  11. The notes to Chart A.6 explain how the bank-level GPR index is constructed.

  12. On average, 65% of euro area significant institutions’ asset exposures are domestic and the remaining 35% are foreign. Foreign exposures are divided into intra-euro area (40% of total foreign exposures) and extra-euro area (60% of total foreign exposures).

  13. See Phan, D.H.B., Tran, V.T. and Iyke, B.N., “Geopolitical risk and bank stability”, Finance Research Letters, Vol. 46, Part B, 2022, and Banna, H., Alam, A., Alam, A.W. and Chen, X.H., “Geopolitical Uncertainty and Banking Risk: International Evidence”, SSRN Working Paper, No 4325966, 2023.

  14. See Ahir, H., Bloom, N. and Furceri, D., “The World Uncertainty Index”, Working Paper Series, No 29763, National Bureau of Economic Research, 2022.

  15. See Ashraf, B.N. and Shen, Y., “Economic policy uncertainty and banks’ loan pricing”, Journal of Financial Stability, Vol. 44, 2019.

  16. See Demir, E. and Danisman, G.O., “The impact of economic uncertainty and geopolitical risks on bank credit”, The North American Journal of Economics and Finance, Vol. 57, 2021, and Niepmann, F. and Shen, L.S., “Geopolitical risk and Global Banking”, mimeo, 2024.

  17. See Niepmann, F. and Schmidt-Eisenlohr, T., “No guarantees, no trade: How banks affect export patterns”, Journal of International Economics, Vol. 108, 2017, pp. 338-350.

  18. Geopolitical risk could also increase the operational risks faced by banks. For instance, banks may be affected by the imposition of financial sanctions or legal requirements to seize foreign assets, while the risk of state-sponsored cyberattacks may increase.

  19. Hampered profitability could in turn contain bank capital accumulation, which would then lead to a lower supply of credit, dampening economic activity.

  20. See also Baron, M. and Dieckelmann, D., “Historical Banking Crises: A New Database and a Reassessment of their Incidence and Severity”, in Schularick, M. (ed.), Leveraged: The New Economics of Debt and Financial Fragility, University of Chicago Press, 2021, pp. 209-226.