There is a long list of geopolitical risks to which the financial sector is exposed: Donald Trump's erratic policies, trade conflicts, Russia's war against Ukraine and hybrid attacks against Western states, sanctions, supply chain disruptions, terrorism, cyber-attacks or disinformation campaigns. This list could go on and on.

Bundesbank board member Michael Theurer therefore speaks of „radical uncertainty“, and Claudia Buch calls on banks to prepare themselves for major inconveniences with a serious impact on their business. „We need to prepare for a prolonged period of ongoing geopolitical tensions, which will be characterised by great uncertainty and increased volatility,“ the Chair of ECB Banking Supervision comments.

This is because geopolitical risks are less predictable than conventional risks, highly uncertain in terms of their probability of occurrence and consequences, and their origin lies beyond the financial system. Banks' standard risk models have therefore reached their limits. It is not only institutions with international commitments or a presence in riskier regions that are vulnerable, but risks are being transferred to all corners of the financial system due to the high degree of networking in the financial sector, and the dependence on third-party providers such as cloud or IT security service providers.

Ralf Schuster, a geopolitical expert at Helaba, advises savings banks and commercial banks to build up the best possible overview. And geopolitics, which is about the question of what influence geographical factors have on politics, society and, in particular, markets, plays a significant role here. „Analysing countries in volatile global political times only from a macroeconomic perspective and managing your exposure accordingly may fall short of the mark," he says. "The danger here is to neglect geopolitical events.“

As examples, he cites exogenous shocks such as the war waged against Ukraine, which could set off negative chain reactions and cause losses even in previously stable markets. „Many players in the financial sector were also invested in Russia, with the result that they had to leave this market from one day to the next due to the war in Ukraine," he notes.

Schuster has worked in the banking sector for more than 40 years, five of them as a geopolitical strategist at the Landesbank. He describes himself as working on the frontier between finance and the real economy, having worked closely with German medical technology exporters for decades. He is therefore well aware from practical experience of how disruptions to supply chains and energy supply affect the economy as a whole. „We are currently seeing the consequences in the form of insolvencies and production relocations to other countries with more favourable location factors, such as cheaper energy," he says. "All of these negative effects on the real economy are caused by geopolitical events that the financial sector cannot escape.“

The banking supervisors speak of three transmission channels through which geopolitical events affect credit, market, liquidity and operational risks, and thus have an impact on individual banks or the financial sector. According to ECB Banking Supervision, the probability of a geopolitical event triggering a systemic crisis on its own is low. However, this could be the case if it hits existing weak points.

First, there can be a real economic channel through which, for example, restrictions on trade flows and supply chains exert pressure on companies. This increases credit risks, which goes hand in hand with higher provisions and defaults, and reduces banks' income and profits.

Geopolitical shocks can also unsettle investors, and cause risk aversion via the financial markets, as a second transmission channel. The consequences are potential price collapses and generally increased market volatility, falling valuations of assets held by banks, and more difficult or more expensive refinancing as investors demand higher risk premiums.

Wars, conflicts, cyberattacks and disinformation can have a damaging effect on banks via the third transmission channel, the security channel. Increasing digitalisation and threats from malicious actors, whether criminals or states exacerbate these risks, according to the supervisors. Banks could even be affected if cyberattacks or IT problems occur outside the financial sector, for example, if critical infrastructure such as the power supply is affected or central service providers fail. The best example of such a disruption is the US IT security provider Crowdstrike, where a faulty update in July 2024 resulted in global IT system failures across all sectors.

The hybrid warfare waged by Russia and other countries is also a growing geopolitical risk for banks. Examples include the sabotage of data and power cables in the Baltic Sea, or the disruption of supply routes to Europe due to attacks by the Yemeni Houthis on cargo ships in the Red Sea. Crises, wars and disruptions to supply routes also fuel inflation, with the possible consequence of rapid interest rate hikes by central banks. These can result in big losses on securities held by banks, as was observed in the course of the ECB's interest rate turnaround in mid-2022. „The coronavirus pandemic and the war in Ukraine were clearly inflation-driving factors,“ says Schuster.

How politicians and central banks react to geopolitical shocks, for example in the form of sanctions, trade barriers or adjustments to fiscal and monetary policy, can also have an impact on banks, according to the ECB. The effects that sanctions and reputational risks can have can be seen in the ban on banks with links to Russia in the wake of the invasion of Ukraine, such as the European subsidiaries of the Russian Sberbank and VTB.

For the financial sector, tense times are not only accompanied by cost increases to comply with regulations and sanctions but also by an increased risk of repatriation. „The financial sector plays a central role in implementation and is repeatedly confronted with transactions that serve to circumvent sanctions,“ says Schuster. This is an enormous feat that harbours risks that should not be underestimated.

According to him, the departments for sanction control, compliance and anti-money laundering in financial institutions are becoming increasingly important, as can be seen from the number of employees. „These are additional administrative costs that are due to the geopolitically unstable situation", he says. In addition, the financial damage caused by breaches of sanctions could run into millions or even billions.

According to Schuster, the fact that UK based HSBC divides the world into eastern and western markets, which in one case include Asia-Pacific and in the other North America and Europe, could become a kind of blueprint if the friction between the USA and China escalates. „If this conflict intensifies, it is to be expected that the world's major corporations will indeed start to run their businesses in the US and China as separate legal entities to avoid making themselves vulnerable. However, I doubt that all corporations will succeed in being strong enough in both regions to achieve the necessary stand-alone profitability.“

Even if the dispute between the two major powers so far has been more of a „preliminary skirmish“, Schuster believes it is unlikely that a complete decoupling will occur. „Complete decoupling does not work in this economically diversified world.“

The Geopolitical Risk (GPR) Index, developed by Dario Caldara and Matteo Iacoviello from the US Federal Reserve, looks at risks worldwide. It is based on the number of articles in ten Anglo-Saxon newspapers about negative geopolitical events. With a long-term average of 100, the current index value of 135 indicates increased risks but is still a long way from the highs seen at the beginning of the Ukraine war (298), the second Iraq War in March 2003 (418), or after the terrorist attacks in the USA in September 2001 (668).

The ECB supervisory authority uses this index to show the impact of corresponding risks on banks: According to this, a shock, i.e. a 20% increase in the Geopolitical Risk Index (GPR), leads to an increase in average risk costs of 7 basis points, and a deterioration in return on assets of 9 basis points.

Uncertainty on the financial market increases after a shock. This can be seen in the VStoxx volatility index, which rises by 1.5 index points, although the swing more or less evaporates after six months. Meanwhile, the Euro Stoxx 50 falls by around 1% in the wake of such a negative event. „You can't rule out all risks,“ says Schuster. „But of course you have to ask yourself what risks you want to take. Whether it makes sense to work with certain countries in the world that are not currently under sanctions, but could be in the future due to geopolitical events. This is a very complex challenge for the financial sector.“

ECB Banking Supervision requires banks to be able to assess how geopolitical risks can affect their business. In addition to dealing with this, they must strengthen their resilience both financially and operationally, according to Buch. „All banks, not just those that operate globally, need to be vigilant. They have to include geopolitical considerations in their risk management.“ Buch is aware that not every institution has the necessary resources or recognises the need for this and that monitoring such risks is costly.

For savings banks group geopolitics specialist Schuster, one thing is certain: „The banks must quickly build up geopolitical expertise, just as they have done in the areas of sanctions, compliance and money laundering. In my view, this is an absolute necessity.“

Even if the geopolitical scenarios that are played out by banks and supervisors and taken into account in financial stability reports and stress tests are generally negative, Schuster also points out the positive aspects: „Let's put it this way: geopolitical expertise can also earn you money.“

While anti-money laundering and compliance are necessary cost factors that primarily serve to avoid financial disadvantages for banks, geopolitical expertise can generate income if the right strategic conclusions are drawn early on to identify interesting markets and potential growth areas.

The globally active US banks are good at this. „They sit at the centre of power, so to speak. Close cooperation with governments and dialogue with current and former officials puts them in a position to pursue more sound and robust international strategies. This opens up more opportunities for them, including on the capital markets.“