Geopolitical Risks and Bank Stress Tests

Given elevated geopolitical risks, it merits revisiting key findings from recent Federal Reserve and European Parliament research that suggests stress tests are evolving from recession tools into geopolitical shock absorbers. For years after the global financial crisis, bank regulation revolved around a relatively stable set of assumptions: recessions were cyclical, shocks were largely economic, and stress tests could be built around gross domestic product (GDP) declines, rising unemployment, and falling asset prices.

That framework is now under significant strain.

These recent analytical works signal a quieter but more consequential shift in global banking supervision, and one that bank regulators need to focus on. Geopolitical risk, once treated as a background uncertainty, is increasingly being embedded into the architecture of stress testing and capital adequacy frameworks.

The result is not yet a wholesale rewrite of bank regulation. But it is something more subtle—and arguably more important: the gradual transformation of geopolitical instability into a financial variable.

Europe’s view: Fragmentation is Now a Serious Risk to Banks

The European Parliament study by Thorsten Beck, Brunella Bruno, and Elena Carletti argues that geopolitical shocks differ fundamentally from traditional macroeconomic downturns. They are multi-channel, persistent, and capable of destabilizing financial systems through funding markets, trade flows, and operational networks simultaneously.

The report states that “major geopolitical shocks raise funding costs, weaken bank stability, and disrupt financial infrastructure.” It further noted that “banks reallocate rather than withdraw—cutting cross-border lending but maintaining affiliate activity.” This implies risk redistribution rather than risk elimination. The paper identifies three primary transmission channels through which geopolitical shocks reach bank balance sheets: financial markets (uncertainty-driven funding cost spikes and mark-to-market losses), the real economy (supply chain and trade disruption that weakens borrower repayment capacity), and the safety and security channel (cyberattacks and infrastructure disruption that threaten operational resilience). Crucially, these channels do not operate independently — they interact and amplify one another, creating feedback loops and systemic spillovers across borders.

Drawing on 120 years of bank-level data from 17 countries, the paper quantifies the solvency threat: a two-standard-deviation increase in geopolitical risk is associated with a decline of approximately 0.2 percentage points in the capital-to-asset ratio. The relationship is non-linear — moderate geopolitical risk has limited solvency effects, but extreme shocks erode capital ratios meaningfully. This non-linearity is precisely why conventional stress test scenarios, calibrated to historical recessions, may systematically underestimate geopolitical tail risk. On the supervisory response, the paper argues that releasable capital buffers (which can be released during stress to preserve credit supply), scenario-based supervision, and reverse stress testing are the priority tools. Hybrid approaches that combine supervisory frameworks with banks’ own granular assessments of geopolitical exposure are described as “especially valuable given the inherently unpredictable nature of geopolitical risk.”

_{Source: Synthesized from Beck, Bruno & Carletti (European Parliament, 2025) and Niepmann & Shen (Federal Reserve, 2025)}

The Federal Reserve: Geopolitical Risk Enters Modeling Architecture

The Federal Reserve research by Friederike Niepmann and Leslie Sheng Shen reflects a parallel evolution. Stress testing increasingly incorporates global shocks affecting energy, funding markets, and sovereign risk.

Using confidential FFIEC 009 data on U.S. banks’ foreign claims and FR Y-14Q loan-level data from Federal Reserve stress tests, Niepmann and Shen construct both country-specific and bank-specific geopolitical risk indices. Their core finding is striking: banks reduce cross-border lending to countries with elevated geopolitical risk but continue lending to those markets through foreign affiliates—a pattern that is unique to geopolitical risk and does not appear in response to conventional macroeconomic or sovereign risk.

The explanation lies in liability structure. In cross-border lending, the U.S. parent bank is fully liable for any losses. Affiliate operations—branches and subsidiaries funded at least partly by local deposits—create an asymmetry: if a government expropriates a foreign affiliate, local depositors absorb part of the loss, reducing the parent’s net downside. Geopolitical risk, unlike standard macroeconomic risk, specifically heightens expropriation risk. The authors point to Citigroup, which more than three years after Russia’s 2022 invasion was still winding down its Russian operations, while Raiffeisen Bank International and UniCredit continued to operate Russian subsidiaries despite mounting regulatory pressure to exit.

Perhaps the most policy-relevant finding is that geopolitical risk abroad reduces domestic credit supply. U.S. global banks reduce commercial and industrial (C&I) lending to domestic firms when foreign geopolitical risk rises—a spillover driven by capital requirements applied at the consolidated level. As foreign geopolitical risk increases consolidated risk-weighted assets, the regulatory capital constraint tightens for the parent, squeezing domestic lending. Critically, better-capitalized banks adjust less, underscoring that balance sheet strength is not merely a buffer against direct losses but a buffer against the propagation of foreign shocks into home-country credit markets. The authors also find that these spillovers are “driven more by perceived threats than realized events,” meaning uncertainty itself—not just actual conflict—is the primary transmission channel.

The deeper shift: geopolitics as a financial variable

What is emerging is not just greater attention to geopolitical risk, but its institutionalization inside financial regulation.

Three structural implications stand out:

• Stress testing is becoming geopolitical by design

Scenarios increasingly assume conflict-driven energy shocks, sanctions regimes, and trade fragmentation.

• Capital is becoming geographically sensitive

Exposure is increasingly evaluated not just by asset class, but by political alignment and jurisdictional risk.

• Financial stability is tied to global order

The assumption of frictionless global capital flows—central to post-crisis regulation—is weakening.

^{Sources: Niepmann & Shen (Federal Reserve, Aug. 2025); Beck, Bruno & Carletti (European Parliament, Nov. 2025)}

Concluding Thoughts

Geopolitical risk is becoming a structural input in banking regulation. Stress tests are evolving from recession tools into geopolitical shock absorbers, and capital frameworks are being recalibrated for a fragmented global system.
What these two papers establish, taken together, is that geopolitical risk is not merely a scenario to add onto an existing stress testing framework. It is a structurally different kind of risk: harder to model, faster to propagate across borders than traditional country risk, capable of reducing domestic credit supply through regulatory capital channels even in countries far from any conflict, and most dangerous at the tail — precisely where stress tests are supposed to be most rigorous. Capital buffers must be both adequate and releasable, scenario design must incorporate geopolitical extremes, and, as the European paper makes plain, effective responses require close coordination within the EU and with international partners. Geopolitical risk, by definition, does not respect national supervisory boundaries.

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