2019 is a year of big changes. The UK’s imminent exit from the European Union is less than 2 months away and at the moment, there is no deal in place. We are also expecting to see the US-China trade war unfold, so there are new geopolitical risks around every the corner. Paolo Petrone, Senior Manager, Risk Consulting, PwC UK, and Ajay Raina, Director, Risk Consulting, PwC UK, take a look at the losses financial institutions have suffered over the past few years, and advise on how to be better prepared and what to keep an eye out for.
Geopolitical risk is a growing concern for financial institutions due to the wide-ranging impacts to their portfolios and business models from increasingly more interconnected and frequent events, such as Brexit, cyber-terrorism and trade-wars. In this blog, we explore the changing nature of geopolitical risk and the challenges financial institutions face in managing it. Finally, we provide a view on areas for investment for building and delivering an effective organisation response.
Geopolitical risk and its changing nature
Geopolitical risk was traditionally associated with foreign policy issues, such as trade and conflicts, and often limited to developing economies and to single events.
This is now changing; domestic issues, environmental events and international policy are greatly interrelated. One example is how mass-migration deeply influenced domestic policy in the developed world. Another is how trade tensions and tariffs impacted commodity prices and car manufacturers globally throughout the North American Free Trade Agreement (‘NAFTA’) renegotiations in 2018.
While geopolitical risk is becoming more complex, financial institutions also face multiple concurrent events impacting their businesses. Events often develop over several months, resulting in greater uncertainty, such as Brexit and the US-China trade tensions.
The impact for financial institutions
Financial institutions, and in particular Global Systemic Financial Institutions (‘GSFIs’), are vulnerable to geo-political events given their key role of facilitating economic activities across sectors and jurisdictions:
- Direct impacts: GSFIs are impacted by geopolitical risks directly through their portfolios. In 2016, US banks observed an increase in defaults of shale producers after Saudi Arabia increased oil output in 2015. Similarly, 2017 ended in record re-insurance losses due to a series of major hurricanes and earthquakes globally.
- Changes to operating conditions: Geopolitical events can also deeply affect operating models, requiring financial institutions to revisit investment as well as their legal entity footprint as in the case of Brexit and the introduction of sanctions against Russia.
- Indirect and secondary impacts: IT infrastructure and supply chains, with the move to digital and cloud, are more vulnerable to cyberattacks and natural disasters.
In addition, financial regulators, including the Prudential Regulatory Authority (‘PRA’) and the European Central Bank (‘ECB’), are looking to ways to assess financial institutions’ resilience, by focusing on outsourcing and resolvability and by stress testing the impact of geopolitical risks on portfolios.
Traditional risk management approaches and the challenge of geopolitical risk
Traditionally, financial institutions relied on historical analysis and expert-based inputs to assess likelihood and implications of geopolitical events, with the magnitude of impacts to portfolios generally assessed through scenario analysis and stress testing. We note four main limitations in those traditional approaches:
- Limited early warning: responses are often ex-post the events, resulting in sharp re-calibration of risk appetite and limits, with assets disposed at discount and mid-term changes to business plans.
- Lack of precedent: Emerging trends like climate change, the rise of nationalism, cyber terrorism and social media manipulation have limited historical precedents to infer impacts to portfolios.
- Complex interactions: While focus is placed on identifying trends and the macro-economic impacts of events in isolation (e.g. ageing population, rise of artificial intelligence (‘AI’), U.S.-China trade tensions), these often manifest simultaneously and with clear feedback-loops.
- Skills and capacity: Financial institutions remain resource-constrained by continuous regulatory change programmes. Geopolitical threats are therefore competing for limited senior management capacity against such programmes, limiting ability for investment in building capabilities to respond to geopolitical events.
What can financial institutions do to be better prepared?
We believe financial institutions need to invest in deepening their understanding of dynamics of underlying geopolitical events and increase their organisational flexibility and skills to identify and respond to threats. Areas for investment include:
Identification of drivers of change
A comprehensive set of drivers of geopolitical events, state and non-state actors involved, environmental, socio-economic and technological factors should be identified to support analytical approaches.
Alternative data and emerging technologies
The wide availability of digital data (e.g. satellite imagery, consumer spending, social profiles) and advances in AI and machine learning have made it possible to access near real time information to help identify evolving trends, interconnections and likelihood of outcomes.
Organisational Skills and Expert Networks
Financial institutions need to continue investing in broadening skills and form agile and cross-discipline talent-pools that provide the best combination of business, political, social and technological insights.
Crisis Management and resilience capabilities
Readiness should be regularly tested through dedicated fire-drills and structured scenarios. Crisis management playbooks should also aim at mitigating business continuity risks of geopolitical events.
More agile governance mechanisms
Effective response to emerging risks is likely to be multi-layered and require more agile governance to provide both short term (e.g. cutting country limits) and long term decisions to mitigate impact while preserving strategic optionality.
In the coming months, we will provide deep-dive analysis on each of the above topics, highlighting relevant frameworks, tools and methodologies. For any questions and comments, please reach out to the authors.
Paolo Petrone, Senior Manager, Risk Consulting, PwC UK
Ajay Raina, Director, Risk Consulting, PwC UK