Anxiety in financial markets about a contested US Presidential election result after polls have closed next month remind us that global politics are more volatile now than at any point since the Cold War. Geopolitical unpredictability is on the rise across continents, and most especially in the US-China relationship, where the advent of Covid-19 and China’s role in Hong Kong are driving a Sino-sceptic bipartisan consensus in Washington that will endure whoever is President after 3 November.
Financial Institutions (FIs) must contend with the macroeconomic impacts of this. But they, and their corporate and investment banking clients, are also in the front line in other ways, not just in China, but in facing collateral impacts in third countries and across sensitive global industry sectors.
Ongoing concerns about Eurozone fragility, Brexit, the oil price shock compounding the Middle East’s perennial political uncertainty, and Covid-19’s impacts on financial and political stability in emerging markets are also issues for global FIs.
Industry concern has been rising for several years. In a 2019 survey, geopolitics was identified as a top risk by global financial services (FS) CROs, with 80% saying they expected material business impacts from geopolitical volatility to increase markedly over the next decade. But the geopolitical impacts of Covid-19, particularly between the US and China, have accelerated this. For instance, in its interim report, HSBC noted that financial performance in the first half of 2020 had been “heavily impacted” by geopolitical risk.
Nevertheless, geopolitics typically resides on the fringe of mainstream FS risk management. Partly this reflects an FI’s inability to control external forces, with even the most effective lobbying efforts rarely able to dial down policy-making instincts in opposing capitals at the same time.
Does this mean FIs are powerless to anticipate and manage the business impacts of volatility?
Not according to UK regulators. The PRA and FCA explicitly require firms to account for geopolitical factors in their ICAAP calculations, while the Bank of England has previously expressed concern about financial stability risks from US-China and an Italian banking crisis driven by political factors.
Internal adaptation in response to a new external environment can go further, however.
I set up a Group Geopolitical Risk function at a G-SIB (globally systemically important bank) to bring structure and analytical expertise to managing the many ways in which geopolitics affected global operations. These included differing impacts across global business units, and across Second Line functions dealing with credit and market risk, stress-testing and capital/liquidity adequacy processes, as well as operational and other non-financial risks.
Internal approaches had been uncoordinated. Some teams did not account for political risk factors in their work. Where others did, they developed different, often conflicting, methodologies to measure it. Geopolitics was on the ‘risk register’, but no single team owned the issue or was responsible for bringing the coordination and analytical expertise necessary for a holistic and forward-looking approach. Senior management faced inconsistent internal advice on risk levels and mitigation, often when under pressure considering unexpected political instability in key markets.
How did a geopolitical risk function change this? It led the authoritative, forward-looking and dynamic political risk assessment process that guided the bank’s strategic response to the Arab Spring and Eurozone debt crisis, for instance, allowing mitigation plans to be aligned across the First and Second Lines, and ensuring proportionate risk management measures in markets where there were fears unrest would spread.
It meant guiding the bank’s long-term investment strategy in South Korea, long before many recognised that North Korea’s missile and nuclear development would force greater confrontation with the US. It meant working with the Corporate Bank and Trade Finance business to guide strategic approaches to client selection several years ahead of peer FIs realising the consequences emerging US-China tensions would have on tariffs, supply chain resilience or on sensitive industry sectors like tech and telecoms globally.
It also meant pioneering the integration of geopolitical factors into stress-testing on issues like Hong Kong’s stability, or the regional macroeconomic consequences of a spike in tension in the South China Sea, as well as leading work to improve the tools and methodologies used by risk teams to capture political factors in their work.
Integrating this framework in other FIs is not conceptually difficult, but it requires a structured approach to do so successfully. It works best when driven by a clear governance framework, using agile assessment expertise to drive enterprise-wide risk and impact assessment processes, and leveraging ERM frameworks to ensure consistent risk reporting and mitigation recommendations to senior management.
This involves giving responsibility to a single team, equipped with proper analytical expertise, to drive cross-functional work on geopolitical issues. This can often leverage existing internal resources but, properly empowered, this capability can lead work needed to identify where, when and how external political developments can affect business performance to support strategy and risk planning.
In a world with political instability in every continent, taking these steps can help FIs get ahead of geopolitical volatility, ensuring financial resilience in the face of downside risks, and support exploitation of the market opportunities that volatility can create.
FIs often ‘muddle through’ on geopolitical risk. This was fine in a different era. But as global volatility becomes entrenched in the international landscape, it is more important than ever for FIs to adapt their approaches to risk management.
Derek Leatherdale is Managing Director of GRI Strategies Ltd, which works to embed more effective internal approaches to political and geopolitical risk management and strategy in multinational firms.