The interconnected nature of risks in a complex banking world

The web of interconnections shaping today’s banking and shadow banking systems is no longer a neat lattice but an opaque, evolving maze. Each innovation in credit markets, derivatives, and liquidity transformation brings sophistication, but also fragility. Complexity is the paradox of modern finance: It creates opportunity, yet it breeds risks that can cascade with startling speed when confidence falters. Shadow banking underscores this duality - expanding credit access and deepening liquidity, while simultaneously concentrating vulnerabilities in structures with limited regulatory backstops. The events of March 2020 reminded us that stress in the so-called shadows can destabilize the very core of the financial system.

This complexity is not abstract. It manifests through anchor risks that weigh daily on economies and markets: Geopolitics, climate change, trade wars, rising debt burdens, pandemics, and cyber threats in the wake of digitalization. These forces do not remain at the periphery, they permeate financial systems in tangible ways, through supply chain disruptions, liquidity pressures, shifts in monetary policy, and ultimately in the trajectory of global growth. Leaders today cannot afford to view risks in silos. The challenge is not to simplify the maze, but to cultivate risk fluency: the ability to see how risks converge, anticipate their spill-over effects, and embed resilience into both balance sheets and strategy.

Complexity as contagion

Banks are no longer narrow intermediaries between savers and borrowers, they are networked platforms plugged into markets, asset managers, hedge funds, fintech’s, and third-party service providers. Risk does not remain isolated in this structure; it migrates. Outsourcing of critical functions, from cloud technology to payments processing, has created a new dimension of third-party dependency risk. A failure or cyber event at a single vendor can paralyze market infrastructure as surely as a default in the interbank market. In today’s environment, financial contagion can just as easily come through an outsourced algorithm as through a balance sheet exposure.

Shadow banking: A double edged sword

Shadow banks - money market funds, private credit vehicles, and securitization structures - are indispensable for financing growth, particularly as traditional banks retreat under tighter regulation. But they also carry fragility. Their reliance on short-term funding makes them highly vulnerable to “runs,” and unlike traditional banks, they lack reliable central bank backstops. March 2020 showed how stress in shadow finance, from commercial paper to ETFs, forced systemic intervention. Shadow banking risks are not peripheral, they sit at the heart of market stability.

Climate as a systemic catalyst

Climate risk is no longer a long-dated issue, it is a present-day financial risk multiplier. Physical risks such as floods, droughts, and heatwaves increasingly impair asset values, disrupt supply chains, and stress insurance balance sheets. Transition risks - from regulatory shifts to stranded asset exposures do add another layer of uncertainty. For banks, insurers, and investors alike, climate risk is not just an ESG concern but a central driver of credit risk, liquidity risk, and even sovereign risk. Emerging markets that are commodity-dependent or reliant on fragile grids are particularly exposed, where climate shocks quickly become fiscal and financial shocks.

Risk amplifiers in complex systems

Several categories of risk are directly born of complexity:

1. Opacity Risk – Interwoven contracts make true exposures difficult to map. Diversification can quickly prove illusory in stress
2. Interdependency Risk – Shared counterparties across banks, brokers, and funds mean one failure can trigger domino effects
3. Liquidity Mismatch Risk – Shadow entities borrow short and lend long, creating fragility under redemption
4. Regulatory Arbitrage Risk – Loopholes push risks outside supervisory sightlines, where they accumulate unchecked
5. Third-Party & Cyber Risk – Outsourcing and digitisation have created a new layer of systemic risk, where a single service disruption can ripple through the global system

The new geography of risk

Globalisation ensures that shocks rarely remain local. Stress in Chinese property markets, or dislocations in U.S. private credit, can transmit instantly through swap markets, offshore dollar funding, and cross-border holdings. Emerging and frontier markets are particularly vulnerable: Reliant on external capital, commodity-linked revenues, and policy credibility. Sudden stops in capital flows, dollar liquidity shortages, and commodity price volatility remain the core risks, but today, climate shocks and geopolitical realignments are amplifiers. For frontier economies, where fiscal capacity is thin, a climate disaster or external funding squeeze can spiral quickly into systemic instability. Paradoxically, some of these same markets are redefining what “safe haven” means, with countries demonstrating policy stability and fiscal prudence attracting capital even as traditional anchors wobble.

Shadow liquidity and hidden leverage

Hidden leverage magnifies fragility. Collateral re-use, synthetic credit exposures, and derivatives multiply the velocity of capital. These practices improve efficiency in normal times but accelerate instability in stress. The U.K. pension fund crisis of 2022, where liability-driven investment strategies buckled under rising gilt yields, is a vivid reminder of how complexity masks leverage until volatility lays it bare.

Navigating complexity: Toward resilience

The goal is not to dismantle complexity, it is intrinsic to global finance, but to manage it with foresight:

• Transparency: Market participants and regulators must have better visibility into shadow exposures, derivatives, and third-party interconnections
• Macroprudential Tools: Supervisors need systemic instruments to monitor leverage and flows beyond banking
• Liquidity Backstops: Shadow institutions that provide essential credit intermediation may require conditional backstops
• Cross-Border Coordination: Global risks demand global solutions. Fragmented regulation fuels arbitrage
• Climate and Cyber Resilience: Climate-adjusted stress tests and robust cyber defences must be integrated into systemic oversight

Conclusion: Complexity as a risk class

The complexity of the financial system is its strength and its vulnerability. It enables efficient capital allocation, but it also creates nonlinear risks capable of sudden eruption. Complexity itself must be treated as a distinct risk class, managed through vigilance, transparency, and foresight.

In an interconnected world, risk does not disappear, it migrates, mutates, and multiplies. Third-party dependencies, climate shocks, and vulnerabilities in emerging and frontier markets all illustrate how diverse risks converge in real time. Those who develop true risk fluency - able to navigate the maze rather than simplify it- will not only weather volatility but also define the next generation of resilient finance.