Geopolitics and financial stability: a plan beats no plan − speech by Carolyn Wilkins

Introduction

There is no better place to speak about geopolitical risks to financial stability than at a leading provider of credit ratings for global capital markets. Rating agencies provide assessments across a range of geopolitical risks and apply these to their evaluations of creditworthiness.^{footnote [1]}

The risk managers here today will probably agree that “It does not do to leave a live dragon out of your calculations if you live near one.”^{footnote [2]} This wise principle is from the Hobbit, in which Bilbo Baggins was referring to actual dragons; here I’m referring to a broad set of geopolitical risks to the financial system, which are the dragons that we too often leave out of our calculations.

Remember the idea of the “Great Moderation” popularised in the early 2000s? It was a kind of “watchful peace” that many economists believed would be characterised by a long period of macroeconomic stability.^{footnote [3]} This period ended rather brutally in 2008 with a global financial crisis (GFC). It cost the UK around one million jobs at the time, and the UK economy took five years to get back to the size it was before the recession.^{footnote [4]}

Today, the belief that has been severely shaken is that global economic integration would support long-lasting geopolitical stability.^{footnote [5]} We’re seeing increased trade restrictions, including some in the name of national security, creating the risk of fragmentation of global trade. At the same time, the uniting power of some post World War II international institutions is under pressure.

It’s not surprising that a recent Bank of England survey found that geopolitical risk and cyber-attacks are the most frequently cited risks among financial institutions (FIs).^{footnote [6]} Many boards of directors are factoring into their calculations a range of geopolitical risks to their institutions, including the effects of increased regulatory and trade restrictions, and more-extreme scenarios like cyber warfare or actual physical warfare.

It’s critical that financial institutions and authorities don’t repeat the errors made leading up to the GFC, and work together to mitigate the potential impact of geopolitical risks along three lines:

• Resilience: In the current case, both financial institutions and governments need to have financial and operational resilience in line with the elevated geopolitical risk environment.
• Diagnosis: Easier said than done because potential future geopolitical events are numerous and entail considerable uncertainty. We must therefore focus on the scenarios that expose the most important vulnerabilities in the financial system. This entails getting a deeper sense of economic, financial and operational interdependencies than we have today.
• Preparedness: A plan beats no plan when it comes to dealing with the scenarios that matter the most. Preparedness covers a lot of ground, from testing recovery and resolution plans so that they are robust in a deteriorating geopolitical environment, to war-gaming system-wide cyber events.

The shadows cast by wide-ranging geopolitical dragons are long, darkening the lives and livelihoods of many people in many countries. Given my role on the Financial Policy Committee (FPC), these remarks will have a narrower focus: on mitigating the financial and operational fallout from “wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations”.^{footnote [7]}

Resilience: financial and operational strength

Let’s turn to my first point on financial and operational resilience.

When it comes to geopolitical risks no financial system or economy is an island. We can see in these measures of geopolitical risks (Chart 1) that country-specific indices tend to track the global index. This is particularly the case for events with global spillovers, such as the Gulf War, 9/11 and the Russia/Ukraine War. And as you would expect, they do deviate at times for country-specific events such as the terrorist attacks in London and Paris.

Geopolitical threats create financial stability risks because they increase the chances of downside tail-risk scenarios, which require substantial financial and operational resources to withstand.^{footnote [8]} The UK is home to banks with very large foreign operations and, the UK celebrates its large, open international financial centre. While these features provide considerable economic benefits, they also contribute to vulnerabilities in the face of geopolitical risk.

Financial stability concerns also come into play because empirical studies show that geopolitical threats are a headwind to growth, and they tend to be inflationary. The potential for stagflation presents policy makers with difficult trade-offs and makes it more difficult for financial institutions and governments to build resilience.

Clearly the first line of defence for the financial system is for FIs to protect themselves. Given the current geopolitical landscape, regulatory standards for FIs must remain up to the task. We benefited greatly during COVID from post-GFC regulatory reforms in that banks were resilient enough to be part of the solution. And we saw from the failures of Silicon Valley Bank and Credit Suisse in 2023 the unfortunate result of inadequate regulatory and supervisory expectations.^{footnote [9]} Regulation is not costless, yet done right it supports stable growth over time.^{footnote [10]}

Resilience isn’t just about financial institutions at an individual level. Governments also must have the financial capacity to meet any financial contingencies should a risk crystalise, and operational capacity to lead on system-wide operational resilience issues.

The FPC that I sit on is of the view that global sovereign debt risks are material. There has been a long-term upward trajectory in public debt-to-GDP ratios across major economies in recent decades, with further increases projected (Chart 2). The International Monetary Fund (IMF) projects that average global public debt will approach 100% of GDP by 2030, with China and the US largely driving the increase.

As we set out in the Bank’s November FSR, heightened concern among market participants about the sustainability of public debt outside the UK could spill over to the cost of debt service for the government, households and businesses within the UK. It is important that banks and other financial firms factor these risks into their internal risk management and stress testing.

Recently we’ve seen orderly movements in global yields as one would expect given news that markets consider relevant to the global outlook. At the same time, there have been spikes in yields in a number of individual countries in recent years, including the UK, that indicate the dragons of market discipline are alive and well.

Chart 2: Sovereign debt (percentage of GDP)

• Sources and methods: IMF and Workspace from LSEG (based on IMF Oct 2024 World Economic Outlook and Fiscal Monitor). Chart shows total gross general government debt on an internationally comparable basis. Separately published country measures can use different methodologies.

Operational capacity and resilience are critical too, as was apparent in the stress in UK government bond markets in Autumn 2022. In this case, there were deficiencies in systems and processes that impeded the ability of smaller pension fund trustees to respond promptly to the stress event.^{footnote [11]} In a geopolitical operational scenario – FIs, governments, and central banks will all likely be called on to respond, and they need to be ready.

So how much financial and operational resilience are we talking about? Given the sheer number of scenarios there are to contemplate and the extreme uncertainty around the probability of any one of them happening, it’s impossible to know exactly. And, the geopolitical risk indices I showed earlier are not much use as early warning indicators.

Diagnosis: focus on scenarios that matter most

This leads to my second point. Instead of trying to guess which exact threat might materialise (e.g. which countries will start a conflict and when), we should instead focus on the types of scenarios that pose the most serious threats to financial stability. To do this well, we need to develop a better understanding of economic and financial interdependencies. This approach is akin to a “reverse” scenario analysis in which understanding vulnerabilities allows one to spot the scenarios worth really assessing and mitigating against.

The first place to start is to map out the transmission channels of generalised geopolitical risks to the financial system. As you can see from work done by Claudia Buch and our European Central Bank (ECB) colleagues, these channels are numerous and complex (Figure 1).^{footnote [12]} In routine stress testing exercises for banks, authorities typically focus on financial market and real economy channels. What’s different about geopolitical risks is that they can also open safety and security channels that could work to amplify the ultimate financial and economic impacts. Imagine during key moments of the GFC if we had also been dealing with widespread disruptions in operations from a cyber-attack or mass diffusion of fake information.

Unfortunately, mapping out the transmission channels only gets you so far because the speed and strength of transmission of any shock depends on knowing considerable detail about interdependencies in the financial system and the economy. For instance, we know from Bank of England work that risks in mainland China would have a much stronger impact on the UK financial system if they were to spread to Hong Kong.^{footnote [13]}

So what kind of analysis might have flagged the importance to economic and financial outcomes of European energy security that stemmed from a high degree of dependence on Russia? While it may have been impossible to accurately predict the Russian invasion of Ukraine and ensuing sanctions, looking at key economic dependencies in Europe would have highlighted countries highly dependent on Russian gas, such as Germany. A type of reverse scenario analysis would have accounted for the fact that energy markets are regional, and so we would have also expected energy prices to spike in all of Europe in the face of particular risks. Estimated effects on the UK would have accounted for domestic issues, including how energy is priced. Hindsight is 20-20, but the approach of identifying key interdependencies within and across borders may have helped identify which scenarios to investigate more fully. This analysis not only helps to quantify the amount of resilience needed, it also could highlight critical dependencies that lead to mitigating actions such as building in redundancy.

Translating this to effects on the financial system is the next layer and requires extensive knowledge of financial linkages and interdependencies. In this regard, we need to improve on our assessment methods and data, particularly with regards to non-bank financial institutions. The Bank just made an important step forward with its System-wide Exploratory Scenario (SWES). This work was undertaken with more than 50 FIs, ranging from banks, to hedge funds and insurance companies, among others. Importantly, the scenario in question assessed the consequences of a sharp shock to global financial markets due to a sudden crystallisation of geopolitical tensions. I encourage you to read a recent speech by my colleague, Lee Foulger, as it has an excellent overview of the findings.^{footnote [14]}

What I’d like to emphasise is that stress tests, reverse scenario analyses and other forms of “diagnosis” should not always be about raising more capital or other regulatory requirements. The SWES certainly wasn’t.

Instead, it explored how the initial shock to global financial markets might cascade through the financial system. It drew on vulnerability mapping to identify the most important threats to core UK markets and estimated where collective actions might amplify or reduce the impacts.^{footnote [15]}

Participants in the exercise gained a better understanding of how others might behave during stressed financial market conditions, learning where their priors fell short. We saw that some previous actions have helped to increase gilt market resilience, such as those taken to increase the resilience of liability driven investment (LDI) funds after the severe stress in 2022. We also learned that resilience of repo, money market funds and corporate bond markets was critical to ongoing functioning, and therefore worth monitoring.

I’d also like to emphasise a technical point with respect to identifying vulnerabilities worth focusing on. Financial stress tests are usually calibrated using a historical distribution of stresses more typically driven by demand shocks, while geopolitical events may tend to work more through supply channels. This is important because the most recent desk-based exercise conducted by the Bank showed that the supply shock scenario in the exercise was costlier to the banking system than the demand shock scenario.^{footnote [16]} Policymakers concerned with assessing whether the system has adequate resilience should bear this distinction in mind.

I’ve spoken a lot about financial and economic channels, but geopolitical threats can work through operational channels as well. Not surprisingly, individual FIs are testing the resilience of their important business services (IBSs) through tools such as the CBEST^{footnote [17]} or STAR-FS threat-led penetration tests^{footnote [18]}, alongside other internal testing, in which they can assess how their IBSs withstand cyber attacks.^{footnote [19]}

While this work is essential, it’s only the starting point. Operational events, geopolitical or not, have the potential to have system-wide effects across a wide range of sectors, and even across borders.^{footnote [20]} That’s why the National Cyber Security Centre’s (NCSC) work is crucial to enhancing the UK’s cyber resilience and addressing the global nature of cyber threats.^{footnote [21]} The NCSC works in collaboration with government departments, the intelligence community, regulators and the financial services industry and has produced cyber security guidance and frameworks and set out an assessment of the latest threats and risks in its annual report.

For its part, the Bank of England, in partnership with the Financial Conduct Authority and HM Treasury work with industry to ensure tools are in place to respond to operational disruption. This includes collaboration with industry to develop sector resilience and response capabilities through the Cross Market Operational Resilience Group (CMORG), along with regular exercises to test the ability of firms and the sector to respond to disruption, cyber stress testing, and the new critical third parties’ regime. And the latest UK sector exercise “SIMEX 24” set out to test the sector’s ability to respond to a major infrastructure failure that would require a total shut down and restart of the sector.

Preparedness: robust response when risks crystalise

This line of thinking leads to my third point, which is to be prepared.

Think about when the UK left the EU with a withdrawal agreement on 31 January 2020. It entered an 11-month transition period, during which the UK and EU negotiated the terms of their future relationship, including on cross-border trade in financial services. In advance of the UK’s withdrawal, the FPC put in place a checklist of actions that would mitigate risks to financial stability that could arise if no further trade arrangements were implemented by the end of transition period.^{footnote [22]} For instance, the list considered measures to mitigate risks to businesses and people as basic as access to cash or other payments methods.

In this case, we knew the date that the transition period would expire, but in most other cases there is a lot more uncertainty along many dimensions. That’s why we should consider taking a page from the cyber play book and consider multiple day scenarios or war games where we act in real time with partial information that is revealed only over time. The Bank’s cyber stress testing with individual firms and collectively often follows this kind of approach.^{footnote [23]} The Bank is also taking steps towards war-gaming in other stress exercises. For example, in the SWES, the scenario was designed to play out over two weeks, and the SWES itself ran over two rounds. My Bank colleagues called this a ‘stress test meets war game’ approach that allowed us to better gauge how an actual stress might play out.

Given the UK is a global financial centre, it’s also important to consider recovery and resolution plans for FIs in the context of geopolitical risks. There may be situations in which key expectations end up no longer holding, and that may require additional work. For instance, asset sales may well form a part of any plan. In the case of a geopolitical event, markets may not be functioning well, regardless of whether other FIs are under stress. Even if markets are functioning well, access to assets in all jurisdictions in which the FI operates may be restricted through capital controls or other mechanisms. In the context of Russia’s invasion of Ukraine, we saw that globally active banks faced challenges in divesting their foreign assets.

Another expectation is that there is effective cooperation between the home and host authorities, ensuring readiness to execute effective cross-border resolutions for financial institutions that operate in multiple jurisdictions. This certainly was the case in the failure of Credit Suisse, where the relevant home and host authorities had made extensive preparations to co-ordinate an effective cross-border single point-of-entry resolution of the Credit Suisse group as an executable alternative. Cooperative arrangements between different national authorities should continue to help ensure effective resolution mechanisms for financial institutions that operate in multiple jurisdictions.

But cooperation itself can be a casualty of geopolitical tension and fragmentation of financial regulation. That’s why the Bank is providing strong support to these arrangements through continued international testing of resolution plans and other work promoting regulatory cooperation.

Conclusions

Let me conclude by saying that there is a broad set of geopolitical risks to the financial system that, like live dragons, should not be left out of our calculations.

At a minimum, we should preserve the hard-won resilience that has been built in the UK since the GFC, and that supports the UK as a sound international financial centre. Building on the SWES and other work, we should develop a deeper sense of the most important vulnerabilities in the financial system that stem from economic, financial and operational inter-dependencies. This work can help identify which geopolitical events might be the most problematic for financial stability and which pose less risk. It’s also important that not all “diagnostic” work is about capital or increased regulatory requirements.

Winston Churchill once said that “plans are of little importance, but planning is essential.” System-wide contingency planning is the essence of preparedness. While we may not be able to predict the exact nature of any particular shock, we can help ensure more general resilience by considering relevant and plausible scenarios. This is why the Bank is working with other authorities to develop robust responses in many financial and operational areas should geopolitical risks crystalise.

Thank you, and happy to answer questions.

I’d like to thank Andrew Bailey, Nathanaël Benjamin, Ben Biggs, Sarah Breeden, Robert Edwards, Lee Foulger, Jeremy Franklin, Julia Giese, Bernat Gual-Ricart, Jon Hall, Andrew Huddart, Kishore Kamath, Rebekah Leather, Amy Lee, Jeremy Martin, Maighread McCloskey, Grellan McGrath, Jamie Mckerchar, Ben Mitchell, Raakhi Odedra, James Owen, Aaron Schroeder-Willis; Alex Tapp and Thomas Wise for their help in preparing this speech.

Views expressed here are my own, and do not reflect those of my FPC or other Bank of England colleagues.