Geopolitics and Fragmentation Emerge as Serious Financial Stability Threats

Concerns about global economic and financial

 have intensified in recent years amid rising geopolitical tensions,
strained ties between the United States and China, and Russia’s invasion of

Financial fragmentation has important implications for global financial
stability by affecting cross-border investment, international payment
systems, and asset prices. This in turn fuels instability by increasing
banks’ funding costs, lowering their profitability, and reducing their
lending to the private sector.

Effects on cross-border investment

Geopolitical tensions, measured by the divergence in countries’ voting
behavior in the United Nations General Assembly, can play a big role in
cross-border portfolio and bank allocation, as we write in an analytical chapter of the latest
Global Financial Stability Report

An increase in tensions between an investing and a recipient country, such
as between the United States and China since 2016, reduces overall
bilateral cross-border allocation of portfolio investment and bank claims
by about 15 percent.

Investment funds are particularly sensitive to geopolitical tensions and
tend to reduce cross-border allocations notably to countries with a
diverging foreign policy outlook.

Financial stability risks

Geopolitical tensions threaten financial stability through a financial channel. Imposition of financial restrictions, increased
uncertainty, and cross-border credit and investment outflows triggered by
an escalation of tensions could increase banks’ debt rollover risks and
funding costs. It could also drive-up interest rates on government bonds,
reducing the values of banks’ assets and adding to their funding costs.

At the same time, geopolitical tensions are transmitted to banks through
the real economy. The effect of disruptions to supply chains and
commodity markets on domestic growth and inflation could exacerbate banks’
market and credit losses, further reducing their profitability and
capitalization. The stress is likely to diminish the risk-taking capacity
of banks, prompting them to cut lending, further weighing on economic

The financial and real-economy channels are likely to feed off one another,
with the overall effect being disproportionately larger for banks in
emerging markets and developing economies, and for those with lower
capitalization ratios.

In the longer run, greater financial fragmentation stemming from
geopolitical tensions could also roil capital flows and key economic and
financial market indicators by limiting the possibilities for international
risk diversification, such as by reducing the number of countries in which
domestic residents can invest.

How to curb risks

Supervisors, regulators, and financial institutions should be aware of the
risks to financial stability stemming from a potential rise in geopolitical
tensions and commit to identify, quantify, manage, and mitigate these
threats. A better understanding and monitoring of the interactions between
geopolitical risks and more traditional ones related to credit, interest
rate, market, liquidity, and operations could help prevent a potentially
destabilizing fallout from geopolitical events.

To develop actionable guidelines for supervisors, policymakers should adopt
a systematic approach that employs stress testing and scenario analysis to
assess and quantify transmission channels of geopolitical shocks to
financial institutions.

Other steps include:

In response to rising geopolitical risks, economies reliant on external
financing should ensure an adequate level of international reserves, as
well as capital and liquidity buffers at financial institutions.

  • Policymakers should strengthen crisis preparedness and management
    frameworks to deal with potential financial instability arising from
    heightened geopolitical tensions. Cooperative arrangements between
    different national authorities should continue to help ensure effective
    management and containment of international financial crises, including
    through development of effective resolution mechanisms for financial
    institutions that operate in multiple jurisdictions.
  • The global financial safety net—a set of institutions and mechanisms that
    insure against crises and financing to mitigate their impact—must be
    reinforced through mutual assistance agreements between countries. These
    would include regional safety nets, currency swaps, or fiscal
    mechanisms—and precautionary credit lines from international financial
  • In the face of geopolitical risks, efforts by international regulatory
    and standard-setting bodies, such as the Financial Stability Board and the
    Basel Committee on Banking Supervision, should continue to promote common
    financial regulations and standards to prevent an increase in financial

Ultimately, policymakers should be aware that imposing financial
restrictions for national security reasons could have unintended
consequences for global macro-financial stability. Given the significant
risks to global macro-financial stability, multilateral efforts should be
strengthened to reduce geopolitical tensions and economic and financial

This blog is based on Chapter 3 of the April 2023 Global Financial Stability Report,“Geopolitics and Financial Fragmentation: Implications for Macro-Financial Stability.”

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