Widening the CRO lens to mitigate geopolitical risk

Geopolitical risk has been on risk managers’ radar for years but are financial institutions equipped to handle the escalation of conflicts? Reports suggest that the risk function has a long way to go, still.

“The most important [risk] is the geopolitics around Russia and Ukraine, America and China, relationships of the Western world. That to me would be far more concerning than whether there is a mild or slightly severe recession.” Jamie Dimon, CEO, JP Morgan Chase.

Escalating geopolitical tensions mean that CROs are dealing with huge levels of uncertainty, as the risk landscape grows ever more complex. Geopolitical risk has always existed as a second order consideration for banks to contend with, but today’s climate feels especially fragile. After Russia invaded Ukraine in 2022, US/China tensions have risen over Taiwan, trade wars have emerged bringing supply chain vulnerability into the equation, while in the Middle East, the risks of a regional war are rising in response to the Israel Palestine conflict.

These are powerful forces at work and require CROs to be on top of the details when it comes to state-sponsored cybersecurity attacks, financial crime compliance, energy market volatility and deglobalisation to name but a few.

Cyberattacks are often closely associated with geopolitical tensions and are seen as one of the top risks facing banks. CROs have always closely followed policy statements and announcements made by central banks but this remit has necessarily extended such that they must now be on top of key developments in international relations; how is a country’s political/leadership structure changing? And what impact could this have on FX, credit quality, corporate lending activities, trade finance?

An IIF report found that increased cyber attacks (cited by 69% of CROs), a global economic slowdown (67%) and increased market volatility (65%) were cited as the most likely manifestations of geopolitical risk.

The challenge of geopolitical risk is precisely because of its second order characteristics. As well as physical manifestations (i.e. cyber attacks), it has an indirect impact on credit, market and liquidity risks. Understanding how to build resilience in banks’ treasury departments, therefore, to limit the impact of shifting global power dynamics, is no small task for risk departments.

A recent report, Geopolitical Risk and Global Banking presented at a joint ECB-IMF-IMFER conference this July, noted that an increase in GPR (geopolitical risk) “increases credit risk of exposed banks yet banks appear limited in their willingness/ability to derisk in foreign operations in response to GPR”.

Given the unpredictable and damaging impact of geopolitical uncertainty, banks that are not agile enough to anticipate, and respond quickly to emerging risks, open themselves up to multiple points of vulnerability. This in turn can lead to serious reputational risk.

Not to mention financial risks.

Citigroup, which had been trying to sell its Russian retail operations when Ukraine was invaded, put aside $1 billion in loan-loss reserves to absorb potential losses as high as $3 billion. Goldman Sachs incurred a net loss of approximately $300 million on investments in Russia and Ukraine.

No CRO can ever anticipate what could happen in the future. There are no risk tools or financial models to turn to. Knowing exactly how much political upheaval could impact the bank’s balance sheet is impossible to quantify. Nevertheless, political instability exposes banks’ customers to threats that may not have previously existed. As such, CROs must contend with:

Qualitative analysis:

What is the risk exposure to a particular country or region based on a subjective analysis of available data?

Limited historical data:

Unlike traditional financial risks, geopolitical risks often lack reliable historical data for modelling.

Speed of escalation:

Oftentimes, geopolitical tensions erupt like Black Swan events: unexpected and highly impactful. Having the right risk systems and processes in place that allow CROs to make fast decisions is vital.

One available solution is to build and/or implement political risk tools to track and report on evolving global matters. This is where AI tools could have a significant role to play, given the ability for large language models to scan and monitor huge data sets.

A report by McKinsey – Knowledge Partner for RiskMinds International 2024 – notes that rising geopolitical tensions are testing the resilience of global organisations and challenging existing growth strategies, with business leaders faced with asking, ‘What is the future of the global corporation? Do we need to fundamentally shift strategies and structure?’

Last year, there were 183 active conflicts. The risk of nuclear weapon use is higher than it has been in decades. Global cooperation on peace and security is declining. It is a troubling backdrop for banks to continue to do business safely and securely.

Financial fragmentation is affecting banks’ ability to execute cross-border investments and maintain international payment systems without disruption. While sanctions and financial restrictions can lead to increased debt rollover risks and funding costs, drive up interest rates on government bonds, and disrupt supply chains and commodity markets; harming emerging economies who rely on commodities to generate growth.

As noted last year in an IMF blog, the stress of geopolitical impact on the real economy reduces the profitability of banks and diminishes their “risk-taking capacity”.

If different competing economic blocs emerge more strongly in the coming years it will require CROs to bolster their geopolitical risk assessment frameworks to enhance scenario planning and stress testing capabilities. Indeed, the topic of scenario planning will be discussed on the panel “The New CRO Agenda” at RiskMinds International 2024 in November.

In Asia Pacific, the rapid digitisation of its financial services industry has led to increased cybercrime and financial crime. Using AI and enhanced data analytics capabilities in their risk systems is one mitigation approach to reduce financial crime risk – with money laundering the key focus.

Other options for CROs to consider in an attempt to stay on the front foot include:

• Enhance crisis preparedness and management strategies i.e. establish proper protocols and conduct regular crisis simulation exercises
• Explore ways to diversify the bank’s operations and supply chains as much as possible
• Improve stakeholder communication by developing consistent messaging across internal and external channels, for different scenarios
• Continuous learning by having CROs work in different geographies and areas of the organisation to build a wider skillset and help broaden their understanding of geopolitical risk

Discuss these pressing matters with CROs and senior risk leaders at RiskMinds International.