For Banks, There Is No Escape From Geopolitical Risk

We live in an increasingly volatile world. Think of it as a return to the norm. After the devastation of two world wars, the U.S. led the creation of a new, rules-based geopolitical order that held sway for several decades. While there was certainly conflict—and a Cold War that constantly threatened catastrophe—we also managed to avoid outright global warfare while raising living standards for millions.

But now, we appear to be returning to the bad old days. Historian Odde Arne Westad argues that today’s environment parallels the period leading up to World War I, when structural forces fueled competition between Britain, an established power, and Germany, a rising challenger. Now, we see a similar dynamic as nations compete for influence: the U.S. (an established power) and China (a rising one) are the main contenders. Russia is likely to lead its own sphere of influence, while the Franco-German alliance could emerge as another power center. The U.K. may align with the U.S., Australia, Canada, New Zealand, and Japan, while India could spearhead a non-aligned bloc.

These nations could pursue cooperation based on shared goals, but history teaches us that when there are several competing powers, there will be conflict, making it harder to stem crises. As the world enters a riskier era, it’s crucial for banks to stay aware of how geopolitical events may impact them.

Geopolitical Risk Is Coming for Your Bank

Let’s look at one example: Do you know how exposed your institution’s lending portfolio would be should China invade Taiwan? Taiwan is home to an estimated 90% of the world’s microchip production capacity. Remember how the pandemic crippled the chip supply chain and drastically reduced automobile production? An invasion of Taiwan could disrupt semiconductor supply on a whole different level. If you are a regional bank in a hotbed for car production, say Michigan or Tennessee, your commercial loan portfolio likely includes various auto and auto-related manufacturing companies that are dependent on microchips. If a Chinese invasion cuts off chip supplies, your borrowers could miss loan payments because they cannot access materials they need to produce and sell their products.

Of course, that’s just one of many examples of how events half a world away can hit home. (This RMA Journal article notes top geopolitical risks for banks as of August 2024.) All banks should be aware of the critical components their borrowers need, and which ones do not have alternative suppliers.

It’s important to remember that geopolitical risks can emerge not only from conflicts between countries, but also from those within a country. After a failed coup, the Soviet Union dissolved from within as various regions emerged as independent countries. Yugoslavia also dissolved from within. And the U.S. is currently so politically polarized that effective governance is being compromised by the red/blue state divide.

The Importance of Including a Qualitative Approach  

Potential economic impact must be viewed through a wide lens. The decision for risk managers is what risks to accept, reduce, or avoid, using all available information. Unfortunately, our traditional ways of managing risk, heavily weighted toward quantitative models, are not sufficient for the scale, speed, or considerable tail risk of today’s interconnected world. More qualitative analysis is required because risk can come from factors well outside of models.

Fortunately, there are frameworks and approaches that can be used to produce the qualitative analyses, and related judgments, required to optimize the management of geopolitical risk. One approach is to recognize when a cognitive bias could be clouding an analysis of geopolitical risk. Just as human behaviors, emotions, and motivations are drivers of geopolitical conflict, our own biases and emotions can prevent us from recognizing related risks. In my RMA book “Risk Appetite, Culture, and Conduct” I stress the importance of the following:

• Self-awareness: Know yourself and your frame of mind when making critical decisions.
• Bias-awareness: Biases exist, but by being aware of them we can become better critical thinkers and decision-makers and counteract our own blind spots.
• Different information sources: Look for information from a wide range of sources to get multiple perspectives.
• Devil’s advocate: Seek out and speak with people who have different opinions to challenge perceptions and conclusions.

Because geopolitical risks are among the strategic risks that can prevent your organization from realizing its goals—risks that also include legal and regulatory environments, technology and marketplace disruption, and environmental changes—gaming out geopolitical scenarios in the same way you analyze other strategic risks can be beneficial.

It also helps to remember that geopolitical risk can influence other strategic risks. For example, if tensions between China and the U.S. continue to rise, what does that mean for global efforts to address climate change, another risk to your bank?

DePaul University professors Mark I. Frigo and Richard J. Anderson have identified principles for managing strategic risk that include:

• Strategic risk management is a process for identifying, assessing, and managing both internal and external events and risks that could impede the achievement of strategy and strategic objectives.
• It is a primary component and necessary foundation of the organization’s overall enterprise risk management process.
• It requires a strategic view of risk and consideration of how external and internal events or scenarios will affect the ability of the organization to achieve its objectives.
• It is a continual process that should be embedded in strategy setting, strategy execution, and strategy management.

Further ideas on geopolitical and other strategic risks are included in this 2019 RMA Journal article and in RMA's Emerging Risk Model.  

Banks require operating models that offer the flexibility to adapt to changing circumstances and seize new opportunities. History is replete with examples of species and empires that disappeared because they failed to evolve. Similarly, about 86% of the companies on the original Fortune 500 list from 1955 no longer exist. Many of these once high-performing, well-respected firms failed to implement strategies that could have mitigated or capitalized on disruptions to their business models. Geopolitical risk is a factor that no one can ignore, and its impact can strike closer to home than many might expect.

Further reading:

Geopolitical Risks on the Rise: Practical Advice for Banks (rmahq.org)

The Risk Management Association Emerging Risk Model

Strategic Risk Management: A Primer

Joe Iraci writes and teaches on banking and financial topics and recently retired from a position with J.P. Morgan Wealth Management. He is a member of RMA’s editorial advisory board and can be reached at jiraci63@gmail.com.