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Outline how being exposed to geopolitical risk shapes how well banks and non-bank financial firms hold up, through share valuations, credit supply and flows into investment funds.

FRM® Part II · Current Issues in Financial Markets · Global Financial Stability Report, Chapter 2 · FRM2.CI.4.f

The idea

Financial firms exposed to geopolitical risk are weakened through three channels. First, share valuations. Banks with greater exposure see lower price-to-book ratios and weaker equity returns, especially if they have low capital, weak profitability or heavy wholesale funding. Second, credit supply. Losses and higher risk weights reduce capital, so a bank holding its target capital ratio must shrink its risk-weighted assets, which tightens lending. The size of the required cut in risk-weighted assets is given by the following formula. Asset cut = loss ÷ target ratio. Third, non-banks. Investment funds, particularly open-end and emerging market funds, face investor outflows. Funds meet redemptions first from cash, then by selling assets, and fire sales amplify price falls. The exam point is that capital buffers and liquidity buffers decide resilience, and that outflows net of cash are what force asset sales.

Formulas

Cut in risk-weighted assets to restore a capital ratio

ΔRWA = L ÷ k

L
the loss to capital
k
the target capital ratio

Assumes no new capital is raised. A small loss forces a much larger cut in lending because it is divided by the ratio.

Asset sales forced by fund redemptions

forced sales = redemptions − cash

redemptions
investor withdrawals
cash
cash held to meet them

Funds pay first from cash, so only outflows net of cash force sales. Zero if cash covers redemptions.

A practice question

From the question bank, with the reason each wrong option is wrong.

How does exposure to geopolitical risk typically affect bank credit supply?

  1. Banks tighten lending and reduce credit growth. - correct
  2. Banks expand lending to take advantage of higher risk premia.Why not: Reverses the sign; exposed banks protect capital and cut credit.
  3. Credit supply is unchanged because loan contracts are fixed.Why not: New lending and renewals are flexible and respond to the shock.
  4. Banks shift entirely to unsecured consumer loans.Why not: An unsupported claim; banks generally tighten across lending categories.

Losses, higher risk weights and funding costs constrain bank capital, so exposed banks reduce credit supply and lending growth.

A harder one

Which statement best describes the effect of geopolitical risk exposure on investment funds?

  1. Funds see inflows because investors treat all funds as safe.Why not: Reverses the pattern; risk-off investors withdraw from exposed funds.
  2. Funds exposed to affected regions, particularly open-end and emerging market funds, tend to experience investor outflows. - correct
  3. Closed-end funds see forced redemptions while open-end funds do not.Why not: Reverses the mechanism; open-end funds face redemptions, closed-end funds trade at discounts instead.
  4. Outflows affect only bank-affiliated money market funds.Why not: Too narrow; outflows affect a wide range of funds, especially emerging market ones.

Exposed investment funds, particularly open-end and emerging market vehicles, face outflows that can force asset sales and amplify price declines.

The hardest tier

Which bank is most vulnerable to geopolitical shocks?

  1. A bank with high capital, stable deposit funding and diversified exposures.Why not: This bank has strong buffers and diversification, so it should be the most resilient.
  2. A bank with high capital but concentrated exposures to the affected region.Why not: Capital provides a buffer against losses, so this is less vulnerable than the thin-capital bank.
  3. A bank with thin capital but stable deposits and no exposure to the region.Why not: Lacking exposure and relying on stable funding limits vulnerability to this shock.
  4. A bank with thin capital, heavy wholesale funding and large exposures to the affected region. - correct

Resilience depends on capital, funding stability and the size of exposures. Weak capital, runnable wholesale funding and concentrated exposure combine to give the highest vulnerability.

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