ECB urges banks to improve geopolitical risk assessments

ECB finds banks can model geopolitical shocks but gaps remainThe Central Bank of Cyprus (CBC) on Friday highlighted the results of the European Central Bank’s (ECB) thematic reverse stress test on geopolitical risks, which assessed how 110 euro area banks under direct ECB supervision would respond to severe geopolitical scenarios. The exercise, which forms part of the ECB’s broader supervisory focus on geopolitical risks for 2026 to 2028, examined banks’ ability to identify and assess potential threats in an environment of heightened global uncertainty. The ECB asked banks to design their own plausible geopolitical scenarios based on their individual risk profiles, with each scenario required to result in a 300-basis-point reduction in their Common Equity Tier 1 (CET1) capital ratio. Unlike traditional stress tests, where banks are assessed against a common scenario, the reverse stress test focused on how effectively banks could analyse the ways geopolitical developments could affect their own business models. The ECB said banks were generally able to develop meaningful stress scenarios that reflected their specific vulnerabilities, but the exercise also identified areas where improvements are needed. These included the level of detail and sensitivity of risk assessments, the consistency between scenario descriptions and their impact on solvency and liquidity, the realism of proposed mitigating actions and the way banks assess the interaction between capital and liquidity pressures. The CBC said the findings would contribute to the ECB’s ongoing supervisory discussions with banks and could inform qualitative assessments under the Supervisory Review and Evaluation Process (SREP). The exercise will not result in changes to Pillar 2 guidance or leverage ratio Pillar 2 guidance. The ECB said geopolitical risk has become a major area of supervisory attention because it can affect both financial and non-financial risks across the banking sector. Banks developed a broad range of scenarios covering military conflicts, trade disruptions, energy and supply chain shocks, economic sanctions, macroeconomic instability and cyber incidents. The scenarios reflected banks’ individual business models and risk profiles, while also requiring institutions to assess three main transmission channels through which geopolitical risks could affect their operations. These channels included financial market effects, impacts on the real economy and safety and security risks, including physical threats, cyber risks and hybrid threats. Most banks identified the real economy channel as the main route through which geopolitical shocks could affect them, followed by financial market impacts. In scenarios involving military conflicts and cyberattacks, safety and security risks were considered particularly important drivers of potential disruption. The ECB found that credit risk and pressure on profitability were the most common ways geopolitical stress translated into capital losses. Loan impairment losses were frequently highlighted as a major source of pressure, particularly for banks exposed to sectors vulnerable to geopolitical developments such as manufacturing, energy and transport. For banks with significant trading activities, lower fees and reduced trading income were also identified as factors contributing to capital erosion. The ECB said banks’ liquidity positions generally remained above regulatory minimum requirements under the stress scenarios. However, it found that several banks showed only limited changes in liquidity indicators despite the significant capital deterioration assumed under the scenarios. The ECB said this highlighted the need for further improvements because solvency and liquidity pressures are often closely connected during periods of crisis. Supervisors will follow up with the banks concerned to strengthen their stress-testing frameworks. The exercise also examined non-financial risks, with cyber incidents and disruption caused by third-party service providers emerging as the most significant threats identified by banks. The ECB said banks should incorporate operational resilience and cyber risk considerations into their stress-testing frameworks alongside traditional financial risks. A key feature of the reverse stress test was the requirement for banks to explain the management actions they would take under a severe geopolitical scenario. These included raising capital, selling business lines, cutting costs and adjusting dividend payout ratios. The ECB said the proposed actions were generally realistic and relevant to the specific scenarios developed by each bank. However, supervisors identified cases where assumptions appeared overly optimistic, including expectations that loan portfolios could be sold or that capital could be raised at favourable prices during highly adverse market conditions. The ECB said it would continue discussions with affected banks as part of its ongoing work on capital and recovery planning. It also stressed the important role of bank boards in ensuring that scenario analysis and contingency planning are properly incorporated into decision-making. The ECB said the reverse stress test replaced an annual stress test that banks would otherwise have been required to submit as part of their internal capital adequacy assessment process, helping to reduce compliance costs while maintaining supervisory oversight. The findings will now be used as part of the ECB’s continued dialogue with banks and may contribute to qualitative assessments under the SREP process. The exercise does not involve adjustments to banks’ Pillar 2 guidance or leverage ratio requirements.