Reporting and Governance

Before Covid-19 senior management teams of systemically important financial institutions spoke increasingly of their concern over levels of geopolitical volatility, but the fall out from the pandemic will likely make matters worse. By Derek Leatherdale, managing director at GRI Strategies Ltd

"(b) the broader risk of a firm’s business model or strategy proving inappropriate due to macroeconomic, geopolitical, industry, regulatory or other factors;" This is the Prudential Regulation Authority’s rule book definition of ‘business risk’ as it applies to Internal Capital Adequacy Assessment (ICAAP) processes carried out by regulated entities.  

But this consideration has taken a back seat as systemically important financial institutions (SIFIs) grapple with the business impacts of Covid-19 and managing the risks from providing emergency liquidity to businesses. 

As lockdowns start to ease, geopolitics will return, while there are also important lessons to draw from the way the financial sector manages its response to what are dubbed by regulators and industry as ‘external’ or ‘non-financial risks’. 

Perhaps most clear is that the political fallout from Covid-19 will exacerbate the factors behind the sharp increases in geopolitical volatility over recent years, often substantially so. 

US-China relations will top this list. Regardless of who wins the next US presidential election, Covid-19’s origins are already driving an even more strident Sino-phobic narrative in US public opinion and policy-making circles. It is not hard to sketch out scenarios in which, having demanded and failed to get reparations from China, for instance, US legislators or policy-makers turn to other economic response measures that seek either to punish China or reduce US economic dependency.

Financial institutions operating in both the US and China may feel this most acutely, but banking operations in other developed markets, or with key industry sectors like technology and telecoms, will also face increased collateral exposures. 

Deteriorating US-China relations will spill over into other parts of Asia too. This will take in more intense military competition in the South China Sea or around Taiwan, and a US political system less likely, for instance, to tolerate efforts to suppress protests in Hong Kong that they perceive to be directed by Beijing.  

Elsewhere, the eurozone is emerging from Covid-19 with even starker disagreement among members over the role of fiscal burden-sharing than after the debt crises and festering sense of latent banking crisis first emerged nearly a decade ago. It is also probable that Eurosceptic political figures in Italy will leverage what has been a sharp negative turn in Italian public sentiment towards the EU. 

Meanwhile the impacts of low oil prices on political and fiscal stability in key markets must now be taken into account by financial institutions, perhaps most especially in the Middle East, while the strains of Covid-19 and the concurrent capital outflows call into question assumptions of political stability underpinning the operations of international banks in many emerging markets. 

Rise of non-financial risk

But the Covid-19 experience also illustrates a deeper set of issues that carry across to how financial institutions deal with external macro risks, of the kind a choppier geopolitical environment will certainly pose in future. 

SIFIs 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”. 

The idea of ‘Non-Financial Risk’ has also grown in recent years. Together these create a neat division on paper between risks that originate externally, are not financial and for which mitigation options are limited and essentially defensive, against internal financial risks originating from business practice that an institution is in a position to mitigate more effectively. 

Covid-19 shows the limitations of this segmentation. What started as a non-financial external risk quickly presented a series of issues around capital and liquidity adequacy, and credit and market risk. These directly affect institutional balance sheets, whether as a result of the sharp downgrades to macroeconomic projections or the need to expedite lending at scale to new corporate clients. 

What do these linkages tell us about SIFI responses to future geopolitical volatility? Not necessarily that risk architecture needs wholesale rethinking, but that external/non-financial risks can quickly lead to a host of internal and financial impacts. Anticipatory and holistic approaches that bridge this gap are essential, bringing to bear financial risk management capabilities such as stress-testing in dealing with external risks. This will be especially so in contending with the geopolitical context that follows Covid-19. 

We opened by quoting the PRA on what factors should appear in ICAAP processes. Readers will note pandemics are not listed. 

Nevertheless, that banks have been able to support businesses in extraordinary economic circumstances without calling into question their own solvency is partly because of the extra capital they hold as a result of post-financial crisis reform. 

This is more a happy by-product than the stated intent of those reforms, however, and regulators might understandably now consider whether to add pandemics to the list of issues relevant to ICAAP. 

In the post-Covid world geopolitics will loom larger than before, with the potential for shocks to undermine systemic stability. They, and SIFIs, could therefore go further. The risk management lessons of Covid-19 offer industry and their regulators important insights into how they might do so. 

A Speakers’ Corner is an area where open-air public speaking, debate and discussions are allowed. The original and most noted is in the north-east of Hyde Park in London

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