How Geopolitical Crises Could Pose a Financial Systemic Threat

WASHINGTON — Central banks' highly accommodative monetary policies in recent years have heightened the possibility that a geopolitical crisis in the Ukraine and elsewhere could eventually pose a systemic threat, according to a new paper by Federal Financial Analytics.

The paper argues that global policymakers have been understandably focused on the causes of the financial crisis in trying to anticipate new threats, but need to be more aware of the potential fallout from a different kind of calamity.

"The Ukraine situation is a sobering reminder of how geopolitical events fought over issues like national borders, ethnic solidarity, and resource allocation can quickly explode into currency, commodity, and cross-border financial crises," writes Karen Shaw Petrou, the managing partner of Federal Financial Analytics. "To date, none of these factors have been reflected in stress testing or all of the prudential standards imposed on big banks in the wake of the financial crisis because repairs are focused on the causes of the crisis, all of which were financial, not geopolitical."

She argues that global financial markets are more vulnerable than ever because of highly accommodative monetary policy from the U.S. and other central banks. Such policies, she says, have helped to distort investment patterns and encourage unusually large holdings in obligations subject to geopolitical risks and to counterparties with concentrated exposures.

"Since the 2008 crisis, central banks — especially the Federal Reserve — have engaged in unprecedented accommodated policy," Petrou writes. "This has driven interest rates down to zero, or on a real basis, into negative territory. Investors have thus chased the yield in an array of venues, many of them in emerging and peripheral markets particularly prone to geopolitical risk."

While Federal Reserve Board officials have kept a close eye on the Ukraine crisis, they have yet to see much of a threat.

"It's something I'm watching really carefully for potential implications for growth," said Federal Reserve Bank of Richmond President Jeffrey Lacker on March 4 in New York. "So far commodity markets seem to absorb the news reasonably well."

That same week San Francisco Fed President John William said he didn't see any risks to the economy — at least for now.

"Ukraine is a very small economy," Williams said to reporters after a speech in Seattle, according to Bloomberg News. But "you've got to be thinking, what are the implications if this gets much worse, or if this starts to spill over to other regions."

In trying to prevent the systemic threat, the Fed has focused on using counter-cyclical fixes to slow down asset-price bubbles. But shocks can turn rapidly systemic if geopolitical risk happens to hit an interconnected market or counterparty of a certain size and complexity, Petrou says.

What complicates matters even further is that much of the financing attached to geopolitical risk falls outside of current body of regulation, namely asset managers and other non-banking institutions.

"The shift from bank lending to capital-market structures has increased geopolitical risk in non-bank entities exempt from capital, liquidity, resolution and similar safeguards," Petrou writes.

She offers a series of first steps that cross-border financial institutions, boards of directors, governments, and financial regulators can take into account for such financial stability risks.

For example, firms that operate globally should map geopolitical risk against concentrated exposures and add such risk to their stress testing scenarios.

Boards of directors, she writes, should question senior management, especially their chief risk officers about what exposures are correlated to financial risks. Questions should include how such exposures could be defined and mitigated.

Financial regulators also should take steps to adjust recovery and resolution plans to take into account geopolitical episodes a well as consider the effect such risks could have not only on large banks, but also on financial-market infrastructure and non-bank institutions.

Finally, Petrou outlined several outstanding questions stakeholders should be able to answer to sufficiently address geopolitical risk. Those include:

• How resilient is the financial-market infrastructure — e.g., central counterparties — to geopolitical risk if major counterparties will not honor obligations due to geopolitical dictates from their home or host governments?
• What is the extent to which non-banks can handle geopolitical risk given their exemption from most capital, liquidity, and operational-resilience requirements? For example, what would happen if an asset-management firm had significant emerging-market product offerings it felt compelled to support under stress?
• Are capital requirements the right way to mitigate geopolitical risk? If not, what about other mitigants, for example insurance?