Steering a bank through geopolitical rapids

12 January, 2023Derek Leatherdale

Bank boards need to reassess their understanding of the impact that geopolitical risk can have on both their business and their clients, says Derek Leatherdale, Managing Director at GRI Strategies and Visiting Scholar at The London Institute of Banking & Finance.

Financial services firms exist to manage risk and, to do that, they have three lines of defence. That sounds robustly martial – and straightforward. The reality is that banks sit within a flow of capital and information that has many more, and more fluid, geopolitical dimensions than compliance textbooks tend to suggest.

That is because geopolitics exposes banks both to so-called ‘upstream’ risk – i.e. forces beyond their control – and to ‘downstream’ risk. The latter can be strategic, financial, operational, or reputational, and include threats to clients’ interests. And all of this is multifactorial and hard to quantify.   

Geopolitical risk is about more than credit and sanctions

Over most of the past thirty years, political risk in banking has effectively been shorthand for credit risk in sovereign lending. Analysts built political stability measurements into their quantitative country risk models, with higher risk numbers typically associated with emerging markets, rather than mature developed economies.

More recently, political risk has been synonymous with sanctions risk, as Western governments have ramped up sanctions in response to geopolitical concerns. Again, it seemed relatively easy to define.

However, neither a set of numbers, nor a list of sanctions, can now capture the increasing magnitude and velocity of geopolitical instability. There are wide-ranging 2nd and 3rd order impacts across large parts of the global economy.  Geopolitical risk covers many interrelated challenges that can touch almost all aspects of a bank’s activities. This heightened geopolitical risk flows from the increasingly antagonistic way that governments use foreign policy to achieve domestic political objectives.

Banks have no direct control over geopolitical risk but, for several decades, that was a limited problem. In the years immediately after the end of the Cold War, the vicissitudes of diplomacy had little bearing on increasingly globalised banking business models. It seemed reasonable to assume that the world was moving gradually in one direction – globalisation – and that disruptions on the way were no more than localised bumps in the road. That has now changed. The greater use of geo-economic policy measures in pursuit of national security objectives is biting financial services in many ways.

Banks as weapon and shield

One of the basic challenges for bank boards tackling geopolitical risk is cognitive: geopolitics can be seen as something that only happens in far-off places, or in war zones.

But financial services firms are on the front-line of geopolitical risk because governments have been weaponizing the sector. And that weaponization is not just about relations between financial institutions. There’s a wider use of geo-economic tools for national security purposes, such as tariffs and the use of investment restrictions, all of which can directly and indirectly affect the performance of banks.

Weaponising financial services is not new, of course. The Bretton Woods agreement at the end of WWII could be seen in that light and the Bank of England was founded in 1694 to help finance a war with France.

The Chinese would say the US are weaponizing the dollar, aimed at China. There’s a fascinating set of questions about how this will evolve as countries like China and Russia and, to some extent, countries like Iran, look at alternatives to the dollar. That could mean alternatives both in terms of currencies and in terms of payment systems.

It’s quite clear that SWIFT, the financial messaging service, makes it very easy to weaponize international payments, from a US point of view. Substitutions for SWIFT are being considered in Moscow and Beijing.

Wielding financial services to meet political ends can have unintended consequences. If policymakers use the financial system too aggressively, they might blunt its utility as a source of intelligence on, for example, Iranian nuclear activity or sanctionable activity by Russia, because that they accelerate the process of creating alternatives.

The moment of greatest risk

Between the fall of the Berlin Wall in 1989 and the global financial crisis of 2008, Western financial institutions tended to put geopolitical risk on the back burner.

At that time, many assumed that the global geopolitical order was essentially uni-polar and that politics had dropped away as an issue.

A whole generation of management teams and boards didn’t really focus on geopolitics.

They may not always have believed in “the end of history” – the phrase famously coined in 1992 by Francis Fukuyama and taken to mean that all countries would end up as liberal democracies. But they did believe in unfettered globalisation and that has served them well – until now.

Because boards could afford to pay a little more than lip service to geopolitical issues, geopolitical expertise was a stepchild among the risk functions in financial institutions. It tended to languish in a risk register, or to be parked in a ‘strategic & emerging risks framework’ where it gathered dust until a review was scheduled.

Now, the future of globalisation is in question and geopolitics as a live risk topic is back. That means re-tooling bank risk functions so that they can provide the support and internal analytical expertise banks increasingly need.

Related content

See our Centre for Governance, Risk, and Regulation