Financial institutions who globalised their market footprint in the last three decades now operate in an increasingly antagonistic geopolitical environment. Surveys show that leaders and board members across the financial sector are aware of global geopolitical volatility.

Key areas to be aware of

Deteriorating US-China relations top the risk list, with trade wars, sanctions and financial and geo-economic measures in key industry sectors like technology, financial services and strategic commodities. Concerns about Hong Kong, and increasingly militarised disputes over Taiwan and maritime sovereignty in the South and East China Seas drive this.

In the Middle East, new tensions drive the kind of volatility long associated with the region. The politics and fiscal arrangements of the Eurozone remain unsettled, added to post-Brexit dynamics between the UK and the EU and the emergence of acute tensions between NATO and Russia over Ukraine – the latter raising Central Bank concern over any shocks to the financial resilience of EU and UK financial institutions implementing new rounds of financial sanctions directed at Russia.

Elsewhere, concern has risen in recent years about domestic politics in the US. Meanwhile, some states in Asia, Africa and Latin America remain characterised by political and socio-economic challenges long associated with financial institutions’ Emerging Market portfolios.

Geopolitical risk is a challenge across much of the global economy. While this was apparent before 2020, Covid’s long-term macroeconomic and fiscal impacts will exacerbate this.

The relationship to ESG

These factors cut across the ESG landscape too. China and Russia’s lower profile attendance at COP26 shows geopolitics disrupting multilateral decarbonisation efforts, while climate change will exacerbate transnational disputes about access to resources like water or generate destabilising migration flows.

Other factors mean geopolitics increasingly underpins ESG dynamics. For instance, a recent US government report concluded that:

"Competition will grow to acquire and process minerals and resources used in key renewable energy technologies. China is in a strong position to compete; it currently controls more than half the global processing capacity for many of these minerals ……. including rare earths for wind turbines and electric vehicle motors; polysilicon for solar panels; and cobalt, lithium, manganese, and graphite for electric vehicle batteries."

Nevertheless, the same surveys show majorities of FS boards and CROs are not confident in their own capabilities to anticipate and manage the business impacts from geopolitical conditions.

In part this is because financial institutions have often approached external challenges through the concept of operational risk, functionally separate from other risk disciplines, and typically defined in regulatory rulebooks as “the risk of loss resulting from inadequate or failed internal processes, people or systems or from external events."

Even where credit, country or market risk teams incorporate political factors into their risk models, therefore, there exists a neat theoretical division between external risks outside a firm’s direct control and internal financial risks from business practice that firms can mitigate directly. The more recent emergence of ‘non-financial risk’ as a discipline reinforces this. This has also been recognised by regulators themselves. In their 2021/2022 business plan, the Prudential Regulation Authority stated that the Prudential Regulation committee would “… maintain and build on our risk identification and horizon scanning processes, identifying new and crystallising risks such as geopolitical risks arising from international tensions, and those resulting from Covid-19. This includes continuously developing our frameworks for identifying key risks and ensuring that they remain in line with the PRC’s risk tolerance."

Adapting risk management 

The experience of Covid-19 shows the limitations of this segmentation. The pandemic and lockdowns not only increased operational and cyber challenges from the shift to home-working but quickly caused unprecedented macro-economic impacts, an increase credit and market risk, and placed stress on capital and liquidity positions.

Geopolitics can present a similar range of direct and indirect impacts for financial institutions. This doesn’t mean risk architecture needs wholesale redesign. But it does mean that holistic, interconnected internal approaches are essential, crucially driven by the kind of geopolitical expertise that a CRO would not traditionally have regarded as a core skills-set. This can be used to support first line management teams - who are unlikely to be geopolitical experts either - as much as to drive up the quality of risk identification, monitoring and coordination.

It also means bringing to bear financial risk management capabilities such as stress-testing that may not have been used in relation to geopolitics before, as is happening on climate risk , and as the PRA rulebook already require UK firms to do but where this is now increasingly relevant as the geopolitical environment becomes less stable.

Greater integration between risk and sustainability functions is key, given the nexus described above, as is internal coordination with teams that may be outside risk, such as legal, compliance or procurement, who also deal with business impacts from geopolitical developments.

There are also clear implications for boards and board risk committees, partially set out below. This is an agenda that many boards are unfamiliar with, but where enhanced governance approaches can be facilitated by a clearer emphasis on identifying the direct and indirect business impacts of geopolitical issues, leveraging their risk committees for detailed consideration of complex geopolitical challenges and upgrading board/BRC skills-sets.

Internal audit functions can support enhanced governance by validating whether risk function approaches adequately keep up with increasing geopolitical instability. Knowing what a good Geopolitical Risk Framework looks like, while not a traditional part of an FS audit team’s repertoire, will become increasingly important.

As the geopolitical environment becomes more ‘competitive’ – the euphemism used by diplomats and political analysts to describe the trajectory of the geopolitical environment over the next two decades – the financial sector is increasingly affected. This is not all downside. Geopolitics can also generate commercial opportunities for agile financial firms, opportunities which a holistic geopolitical risk framework can support boards, internal audit and risk functions in considering.

Is the board ready?

In 2019, Frédéric Visnovsky, Deputy Secretary General, Autorité de Contrôle Prudentiel et de Résolution (ACPR) stated that the board should be in a position to consider several questions:

• Who is in charge in the organisation to identify, assess and monitor relevant geo-politic and geo-economic risks?
• Do we have a robust framework?
• How do I make sure that our team is fit for purpose here?
• How do I make sure that the strategic decision-making processes across the organization are incorporating both these new risks and opportunities?
• What are the risk appetite frameworks and stress testing around geo-political and geo-economic challenges?
• And do the above cover funding and liquidity interconnections across the Banking group
• How does this affect the bank’s financial model, business model and operating model?
• Does the board have the visibility? Do you have access to the right directors or committees?
• Does the board have the right people around the table?
• Should the shareholder structure be a dimension of analysis when assessing the bank’s exposure to geo-political and economic risks?

About the author

Derek Leatherdale is Managing Director of GRI Strategies Ltd and Associate Director at the Risk Coalition, with whom he is the co-author of 'The Extra G - ESG Squared: principles-based guidance for geopolitical risk oversight and its integration with ESG issues for boards, risk committees and risk functions'.