April 2025
Rising tension
Recent months have witnessed dramatic shifts in global politics and the relations between world powers. Across the world both governments and businesses are having to adapt to a level of geopolitical uncertainty not seen for many years.
Claudia Buch has named improving banks’ resilience to geopolitical shocks as a priority ever since she was first nominated as European Central Bank (ECB) Supervisory Board Chair. Over the past year she has repeatedly referred to geopolitical risk as a key driver (along with environmental risk and digitalisation) of a new risk environment facing European banks. Then in September 2024 Buch set out the ECB’s conceptual framework for understanding the impact of geopolitical shocks on the financial system. This set out how by affecting the real economy, financial markets and/or banks’ own physical and cyber infrastructure, a trade disruption, crisis or conflict could affect multiple financial and non-financial risks that banks must manage (including credit, market, liquidity and operational risk).
Growing priority
Geopolitical risk then duly became a central theme of the ECB’s latest supervisory priorities, unveiled in December. The ECB’s first priority, on balance sheet and operational resilience, included a supplementary ‘special focus’ on incorporating geopolitical risk management. This set out a range of activities through which supervisors will assess banks’ resilience including a targeted benchmarking of how banks factor geopolitical risk into their risk identification and risk appetite frameworks. In addition, the ECB added a geopolitical element to many of its standard areas of supervisory focus: for example promising reviews of how banks incorporate geopolitical risk into their IFRS 9 valuation models and their IT outsourcing plans.
Also trailed in ECB supervisory priorities was that geopolitical risk would be an important part of the 2025 EU-wide stress test. For this year’s exercise, the adverse macroeconomic scenario, published in January, is based on a hypothetical geopolitical crisis resulting in a sharp contraction in global trade as well as a deep recession. As geopolitical shocks frequently spill over into energy markets, the scenario also includes significant increases in oil and gas prices, and a particularly pronounced knock-on impact on the ability to repay of borrowers in energy-intensive manufacturing and transport sectors.
Alongside the main stress test, the ECB also announced that it will conduct an ‘exploratory scenario analysis’ on a sample of 15 banks. This exercise will test their ability to model counterparty credit risk under various (presumably geopolitically driven) stress scenarios. This will allow the ECB to test banks’ scenario planning and modelling capabilities. It will also provide more information on banks’ exposures to non-bank financial institutions including private credit funds, an area the ECB has previously noted remains largely opaque.
Implications for banks
The increasing ECB focus on geopolitical risk means banks need to invest in improving their scenario analysis capability. ECB supervisors will expect banks to work through the impact of potential geopolitical scenarios as part of business planning, capital and liquidity planning (ICAAP/ILAAP) as well as their operational risk and business continuity planning.
Scenario analysis will need to be a cross-divisional exercise, bringing in experts from across the organisation to assess the different risk factors and pathways set out in the ECB framework. The process, and assumptions made, will need to be thoroughly documented. Management bodies will have an important role in determining key parameters and assumptions and ensuring effective coordination.
Banks cannot, of course, be expected to predict what geopolitical crises will occur when, or precisely how governments and markets will react. But by analysing plausible scenarios they can better understand where both their strengths and fragilities lie. That in turn can help them both to mitigate their vulnerabilities and develop contingency plans should the worst occur.
