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ECB Proclaims, Geopolitical Risks Can Trigger a Systemic Crisis

“Recent history suggests that adverse geopolitical events alone are unlikely to cause a systemic crisis, although they may act as a trigger for systemic distress if they interact with pre-existing vulnerabilities” says the introduction to the regular Stability Review issued by the European Central Bank.

After analyzing channels through which geopolitical risks affect financial stability, and the impact on banks and non-banks, the authors of the report conclude that:

“Geopolitical shocks may act as a trigger for systemic distress if they interact with pre-existing vulnerabilities. In particular, financial instability could arise if a combination of different factors materializes, such as (i) a very large shock, (ii) other sources of amplification, and (iii) strong contagion.

“Geopolitical risk can have adverse implications for the resilience of financial institutions. Several academic and policy studies, as well as the empirical evidence reported in this special feature, suggest that the materialization of geopolitical risk could have negative effects on the soundness of euro area banks and non-banks. Geopolitical risk could result in significant outflows and falling returns from investment funds, among other things. Equally, geopolitical risk could lead to declining bank stock prices, widening CDS spreads and greater funding costs and provisioning needs for banks, which in turn would weigh on their profitability.”

However, instead of recommending what is feasible i.e. to reduce geopolitical risk (defined as “the threat, realization and escalation of adverse events associated with wars, terrorism and tensions among states and political actors that affect the peaceful course of international relations"), the report suggest to do what is unfeasible, i.e. reduce the vulnerability of the system (through capital adequacy, liquidity management etc).