Major financial firms have always been reluctant to talk about geo-political risks, at least publicly. They have been comfortable in a globalised world where the growth of international trade and cross-border investment made the deep political fissures of the Cold War seem like a distant memory. This has left them ill-prepared for a new era of sustained geo-political turbulence.

Many did not even analyse the potential risks to their business thoroughly because they did not view some of the more cataclysmic risks – such as a war in Europe – possible, or because the issues raised are just too sensitive – such as with China and the threat it poses to Taiwan. The disruption caused to global trade and the international financial services sector by the Global Financial Crisis of 2008–09 seems like a bump in the road when compared to the huge craters being caused by the Russian invasion of Ukraine.

The immediate consequences with the massive spike in energy prices and the draconian sanctions are hard enough for many economies and businesses to swallow, but the effects are going to stretch far and deep beyond that. Resilience has become a popular concept for financial institutions to talk about but, all too often, it has been resilience to those risks that are more predictable and the impact of which can be quantified with a reasonable degree of certainty.

Those critical uncertainties, only visible in the far distance of horizon scanning exercises, were often passed over. Brexit provided a jolt to that complacency for firms with well-established cross-border business between the European Union and the UK but it was the COVID-19 pandemic that made boardrooms think harder about those risks it had previously pushed into the background as unthinkable.

Failure to prepare
Pandemics had long been on the list of major threats to society, economies and financial institutions but, if they are being honest, few western governments and businesses seriously explored the possible impacts and put in place robust contingency plans for a pandemic.

The huge public relations disaster of the way the insurance industry – especially in the UK – responded to business interruption insurance claims from businesses forced to close by lockdown measures, amply demonstrates how unprepared major business sectors were for a pandemic. That was one wake-up call. It may have had the bosses of the world’s financial institutions looking harder at what might be looming on the far horizons of business risks but it still did not elevate geo-political threats to the top of many boardroom agendas. It would be unfair to characterise all firms as blinkered when it comes to geo-political risks, says Oksana Antonenko, a Director at the Global Political Risk team at Control Risks. She told World Finance that regulators must also share some of the blame for overlooking these threats, by forcing firms to focus their risk management expertise elsewhere: “Financial regulation has not developed a sound, consistent, coherent and rigorous approach similar to that which firms were required to adopt after the global financial crisis. That introduced stress testing for financial risks but did not do the same for geo-political risks.”

Antonenko continued: “Unless there is a regulatory requirement to undertake this and regulators in the west require financial institutions to publish geo-political risks analysis they will not do so. They won’t get visibility and financial institutions will not talk. There were some requirements, especially in the US, to look at emerging risks but there has never been a clear definition of what these risks are.”

She also points to the perils of talking openly about geo-political risks, highlighting the loss of licences by some firms in Turkey when they voiced concerns about the reckless economic policies of Viktor Orbán’s government. Similarly, the silence from major financial institutions on the risks China poses is deafening. No one will talk about them. The fear of upsetting crucial client relationships is all pervading, and many firms cite genuine concerns for the safety of their staff in China or the families of London-based Chinese staff if they are seen to venture opinions that might be interpreted as hostile in Beijing.

Monitoring exposure
Russia’s assault on Ukraine has potentially changed much of this reticence. Now, financial firms are looking at their exposures to a wide range of geo-political hazards and, in particular, the risks of getting caught by suddenly imposed sanctions or enmeshed in social unrest ignited by growing internal tensions and economic pressures. The response of western liberal democracies to Russia’s invasion of Ukraine has surprised many in its strength and unity and has added to the volatility across the world’s financial markets.

Measuring, predicting and protecting against the consequences of that volatility is now a priority. “Many firms do now have teams embedded at a senior level and are now looking at these risks in a more rigorous fashion,” says Antonenko. There are many ways of looking at these threats and trying to make sense of them using the various scenario planning tools that academics have developed.

Plotting the risks on a matrix that maps both the critical certainties and critical uncertainties is one favoured tool for bringing out the threats – and the opportunities (see Fig 1). Those that are placed on the far left of the certainties matrix are the issues that should already be part of day-to-day business planning, strategy and delivery. Moving across the matrix are the issues surrounded by a higher degree of uncertainty. It is those that migrate to the top right hand corner – extreme uncertainty but with potentially high impact – that should attract the most attention but which are often put in the ‘too hard’ tray.

Potential for escalation
Other tools embody the notion of horizon scanning to draw out the major disruptive threats to their business. “Horizon scanning is vital in this area. In many ways the Ukraine crisis has been one of the key risks to watch since late last year. We certainly saw the potential for escalation,” says former BBC journalist and anchor Susannah Streeter, now senior investment and market analyst at financial firm Hargreaves Lansdowne.

Streeter adding: “Because the horizons are often further away it tends to be the current risks that concentrate minds and are pushed to the top of the agenda. We saw this with the pandemic. The risks to Europe were downplayed, even when it took hold in Italy. Countries didn’t move up to that emergency gear until it arrived in their own countries.”

Many scenario planning tools categorise each risk as is plotted on their matrix or across their horizon. This helps highlight the sort of knowledge and expertise needed to understand the issues. The most common categorisation is PESTEL (Political, Economic, Socio-demographic, Technological, Environmental and Legislative). This also makes it easier to see the potential connections, how one event can act as a trigger for another, something highlighted in a recent Informed Insurance report from leading corporate law firm DAC Beachcroft.

Looming large
In the context of Ukraine, this immediately connects energy conflicts, trade disputes and sanctions, terrorism and cyber-attacks with social unrest also looming large in this complex risk scenario. It also shows how dramatic geo-political events can quickly cut across other priorities, such as the fight against climate change and the development of broad environmental, social and governance (ESG) strategies, says Helen Faulkner, head of insurance at DAC Beachcroft: “Up until the Russian invasion of Ukraine the emphasis in insurer ESG strategies was firmly on the environmental aspects. Ukraine has not so much diminished that focus but brought the social and governance issues to the fore as well.”

Financial firms are looking at their exposures to a wide range of geo-political hazards

Faulkner explained: “Energy strategies are at the heart of the European response to the invasion as we all rush to disconnect our reliance on Russian gas and oil. This could either set back the shift away from fossil fuels, or accelerate it as nuclear energy and renewables enjoy increased government investment.”

Global supply chains have been sensitive to concerns about environmental sustainability and have been very focused on reducing their carbon footprints, especially following the COP26 Summit in Glasgow last November, which imposed new net zero targets on international transport by road, sea and air.

The war in Ukraine has forced firms to change priorities says Oliver Chapman, CEO of supply chain specialist OCI: “Everyone was trying to do their best on sustainability and reducing their carbon footprint. But their number one priority is to make sure their supply chain is secure and this means sustainability has taken a bit of a lower priority. It still matters, but if a business has to put more trucks on the road to keep its business going then that is what it will do.” The ‘S’ and ‘G’ parts of ESG will also come into sharper focus, according to Faulkner: “The social part of ESG is also important. How businesses treat refugees will be judged as much as how governments treat them.

From how easy financial institutions make it for refugees to get insurance cover and banking services, to offering them employment opportunities, will all come under the microscope of public opinion. Governance is also crucial as sanctions are extended and enforced. Most insurers and brokers have withdrawn from Russia but the complexity of international sanctions requires constant review and monitoring.”

Serious questions to be asked
Sanctions are one of the major hazards and have myriad consequences for financial institutions and the economies of the western liberal democracies that have implemented them. “It was a surprise to see such unity of purpose, especially how quickly the Europeans adopted sanctions that have damaged their own economies, especially in relation to energy costs,” says Antonenko. Further adding: “There is a serious question around how sustainable this will be over time. This could go on for months, if not years, and the price will be quite high for Europe.”

The price could be high for businesses that get it wrong too, warns Streeter: “It is the reputational risk that really worries firms. Even when governments haven’t necessarily imposed specific sanctions there is the court of public opinion holding firms to account. Some took longer than others to withdraw from Russia but the power of social media gradually impacted some major global brands and forced them to act.”

Nuanced positions are hard to sustain in the face of strong, often sharply polarised, public opinion, Streeter continues: “HSBC’s standpoint on the Hong Kong protests in calling for stability seemed to many to be supporting the authorities. It shows just how difficult it is to walk that tightrope.” Wherever you look, sanctions compliance is an issue, says Chapman. Many of his clients have complex international supply chains and feel very exposed to the potential risk of making a mistake by inadvertently dealing with a sanctioned entity.

“There has been a huge focus on due diligence. It is now important to look beyond your own suppliers and look at their suppliers and their suppliers’ suppliers. What we don’t know is how these will be implemented and enforced over time and what sort of fines and penalties could be issued for breaching them in some way,” said Chapman.

Antonenko agrees: “Compliance is very difficult. There are just hundreds and hundreds of people and firms on the sanctions lists. We are seeing over-compliance at the moment with banks being very cautious. One consequence could be that sanctions will encourage the rise of cryptocurrencies. They are certainly going to benefit from this.”

The crypto markets
At the moment, the price of bitcoin and other leading cryptocurrencies does not show much impact from the Ukraine conflict. Since the heavy build-up of Russian forces on Ukraine’s border started last November, the price of bitcoin has fallen by 50 percent with trading levels relatively low. The cryptocurrency markets are not exhibiting the sort of volatility you might expect if firms were switching to them, either to facilitate legitimate payments or find a way of getting round sanctions. Many of the key sanctions are financial, including the effective freezing of assets held abroad by Russia’s central bank and selected Russian commercial banks, and the exclusion of most Russian intermediaries from the SWIFT messaging system used to facilitate cross-border transactions among banks.

The tough sanctions imposed on the large foreign currency reserves Russia has built up caused many a sharp intake of breath across the international money markets, but perhaps were only to be expected once the major western economies and Japan started to move to isolate Russia financially. The freezing of the reserves is directly linked to the desire to limit Russia’s ability to finance its war against Ukraine. The Bank of Russia had accumulated more than $600bn of international reserves, including gold (see Fig 2).

This was a 50 percent uplift over five years and, in retrospect, is being seen as laying the ground for financing the expansionist policies of the Russian regime. This will be an area where sanctions could develop quickly. Economists Richard Berner, Stephen Cecchetti and Kim Schoenholtz, writing for the VoxEU research and analysis website, warn: “Sanctions trigger an arms race. Once in place, the target looks for paths to evade them, while those imposing sanctions work to increase their effectiveness. Put differently, sanctions are a game in which one party looks for leaks to exploit while the other works to plug the holes. Furthermore, an essential aspect of the arms race is that the two parties seek to demonstrate their resolve in an effort to convince the other side to concede.

Consequently, the most important aspect of effective sanctions arguably is a credible commitment to modify and update them as needed – that is, to do whatever it takes.” It is the ripples that are already spreading out further that will cause the most concern, as they bear all the signs of a financial contagion that could be hard to contain.

A problem exacerbated
One part of the international financial markets that has already felt the impact is the sovereign debt market. On April 12, Sri Lanka announced that it would suspend payments on the $35bn it owes the world. This is not solely a consequence of the Ukraine conflict. Its impact on energy and commodity prices quickly exacerbated an already shaky economy and a country beset with social unrest. Less than a month later, on May 9, the government fell.

This is where the shifting sands of geo-political power games start to have a serious impact on financial stability. During this century, many emerging economies have become heavily indebted to China. According to the World Bank, 60 percent of the poorest economies are in debt distress or at high risk of it and with interest rates rising across the world this could turn out to be a conservative figure. The problem here is that the prospects of co-operation between western lenders and China on debt restructuring is being diminished by the strains of the Ukraine conflict.

So nervous eyes are being cast towards South America, where serial defaulter Argentina is already sending up distress signals and the political instability already very visible in Venezuela, Chile and Colombia is already nurturing economic and financial crises. Colombia has been gripped by political unrest for over a year, when an unpopular attempt to reform taxation was a trigger for popular anger. Sri Lanka shows how social unrest can quickly escalate in major political and economic upheaval. Social unrest often leads to a chain-reaction with political authorities implementing tough, sometimes brutal, responses.

The issue is how much you are prepared to put at risk in terms of your balance sheet and shareholder funds

These, in turn, lead to calls for sanctions and for businesses to withdraw from countries. Antonenko said: “Social unrest will become more frequent in the second half of this year and into 2023, especially as the knock-on effects of the lack of harvests from Russia and Ukraine are felt. The potential for a crisis in the food chain is very high and it will be sustained. Commodity price pressures coming on the back of over-stretched public finances in the wake of the Covid pandemic mean that even developed economies will suffer, especially with higher inflation.”

With Ukraine being one of the world’s largest producers of wheat and cereal products and its last major port not in Russian hands, Odesa, blockaded, the prospect of a major crisis in the food chain is looming, says Streeter: “The big issue we have here is the commodity impacts which are adding to the inflationary concerns around the world. Emerging economies, such as Egypt that imports so much wheat, will come under severe pressure. Around the world we will see rising social unrest as prices rise.”

A wake-up call
Europe and the US will not be immune from the impacts of this, says Antonenko: “This could rekindle the populist movements we saw rise in the last decade. The signs are already there. It is really shocking that Le Pen got 42 percent of the vote in France. It is a wake-up call for all of Europe and the US.” All the while, China simmers in the background. Western concerns about its treatment of the Uyghur minority in Xinjiang and the suppression of democracy of Hong Kong may not be in the headlines now but they have not gone away as issues that have increased western antipathy to the current Chinese Communist party leadership.

It is the prospects of escalating tensions in the South China Sea and a Chinese invasion of Taiwan – the “reunification of the renegade province” as Chinese leader Xi Jinping calls it – that should cause the most concern. Predicting anything with China is notoriously hard, says economist George Magnus, an associate at the China Centre, Oxford University and author of Red Flags: Why Xi’s China is in Jeopardy. “The idea you can articulate exactly what might happen in five to 10 years is almost impossible. People will take a view and say the likelihood of a shooting war in the South China Sea is less than five percent and so I’ll back my 95 percent judgement that it will be okay. Good luck with that. It might turn out that way but nobody can be certain. The issue is how much you are prepared to put at risk in terms of your balance sheet and shareholder funds.”

Magnus continues: “They should be on the defensive if they say that because there is a strategically adversarial relationship between China and the rest of the world, the liberal democracies. You have to be pretty brave to say that it doesn’t matter.” It does matter, says Antonenko. China might be distracted as it struggles with the implications of its zero-tolerance policy toward Covid but it is a major player in the world’s response to the Russian invasion of Ukraine: “China has stayed neutral and has so far provided an avenue for Russia to bypass western sanctions. This will see China becoming increasingly dominant in the Russian economy.” Antonenko adds: “China is unlikely to change its own strategy and plans for Taiwan. It will continue to view Taiwan strategically, not opportunistically, although it will try to measure the likely western response. It sees the US distracted and committing resources to defend and later rebuild Ukraine.”

Major implications
The pictures of the destruction in major cities in Ukraine give an idea of what that rebuilding might entail. Estimates of the cost are very speculative at this stage but are already north of $700bn: by comparison the post-WW2 Marshall Plan cost $160bn at today’s prices. Financing this will have major implications for government debt, bond markets and infrastructure capacity and investments for decades to come. There are few causes for optimism that this might be a short-lived disruptive phase in the evolution of a globalised world, says Antonenko: “We need to acknowledge that the rest of the world beyond the G7 and EU are largely sitting on the fence in this conflict. This is not going to change so we are entering a new Cold War era with the world divided.”

Clearly, there is now a well-entrenched understanding that we are in an era of geo-political turbulence. There is no clarity on when or how we might arrive at a new system and a global settlement. This could take many years.