Geopolitical risk and securitisation markets: edge of chaos
The war in Ukraine has shown how international corporations’ and investors’ risk-management systems have failed to properly identify, assess and manage two important factors. First are the probable effects arising from geopolitical events. Second are the downstream financial and economic knock-on consequences that have been set in motion in the short, medium and long term. A firm’s geopolitical risk exposure depends not just on its own direct exposure, but also on that of upstream firms (supply chains and counterparties) and downstream firms (clients).
Geopolitical risk is an emerging risk, characterised as ‘systemic’ in nature. These have the potential to cause a system-wide breakdown, or significant disruption, to economic, financial and security systems. They act as ‘threat multipliers’ by amplifying existing financial, economic and security risks. Greater geopolitical uncertainty could lead to disorder in global financial systems, at least in the short to medium term. This in turn could make a financial and economic crisis more likely.
In this volatile and interconnected world, geopolitical risks that amplify market, credit, and liquidity risks in the global securitisation markets can result in rapid transmission of adverse geopolitical shocks. This intensifies the causes of financial instability and triggers a potential widespread equity and bond market crash or bank runs. These may play out from a few hours to a few months. They either quickly fade away or morph into a major economic crisis. The 1980 Latin America debt crisis, the 1998 Russian bond default, and the 1997–98 Asian currency crisis are just a few examples.
The European Systemic Risk Board published a report in July 2022 entitled ‘Monitoring systemic risks in the EU securitization market’ According to the report, the global volume of securitisation products amounted to almost 11 trillion euros at the close of 2021. These include mortgage and residential-backed securities, collateralised loan obligations (CLOs), and collateralised debt obligations (CDOs). The US accounted for 9.8 trillion euros (87%), followed by the EU (6%), and the UK and China (2%). Over the last few years, observers have seen significant growth in the CLO market in the US and the EU. In Europe, CLO issuance reached a record high of 39 billion euros in 2021. In the US, CLO issuance also reached a record high of 164 billion euros. Globally, the largest volumes of CLOs are in the US.
During the prolonged low interest-rate environment, certain investment strategies were adopted by insurers in an attempt to boost investment returns. Property and Casualty (P&C) and Life insurers increased their exposure to alternative assets, such as securitisation products, commercial mortgage loans and private equity investments. And a significant portion was also invested in equities by P&C insurers. These investment strategies were adopted to hunt for yields and improve investment returns. But they came at the cost of:
Rising geopolitical competition across the world has exacerbated stressors on the critical resources underpinning state sovereignty and national security, including water, energy, food and employment. This heightened competition comes from the weakening of the international security apparatus, deepening mistrust between powerful countries, and the harms caused by climate change. And the amplification of existing inflationary pressures across the world as a result of the war in Ukraine has led to global shortages of fertilizers and grain, and soaring prices of oil and gas. This has weakened countries’ food security and increased the risk of social instability.
All these concurrent strategic risks have been exacerbated by rising public debt levels and heightened debt vulnerabilities in many countries. This weakens countries’ economic fundamentals and capacity to service and repay public debt, pushing the global system to the edge of chaos and threatening to unleash an economic tsunami. The tidal wave could come in the form of accelerating declines in corporate revenues and household disposable incomes. These declines would not only harm the credit risk of underlying obligors in the securitisation and global corporate and sovereign bond markets. They could also lead to widespread downgrades and defaults across all sectors of the economy. Large-scale downgrades and defaults have the momentum to send the economy into a downward spiral. They are the fuel that ignites a financial crisis.
As noted earlier, geopolitical tensions lead to a heightened perception of catastrophic consequences, such as disruption to global food, energy and medical supply chains. They also tend to lower consumer confidence and drive businesses to postpone hiring and investment decisions until the risk has subsided. This could last weeks if not months. They also create a discernible increase in financial stability risks across global financial markets. They act as amplifying triggers to the direct and indirect causes of financial and economic crises, like the bursting of speculative financial bubbles and bank runs. And they even amplify and drive monetary crises such as large-scale sovereign and corporate defaults and currency crises.
Overall, international corporations and investors should consider geopolitical risk as a primary risk class. Senior management should recognise that emerging geopolitical risks need explicit management, and should have a reasonable grasp of all the factors driving geopolitical instability. Effective enterprise risk-management systems should ensure ongoing review and improvements to existing risk frameworks. They can do this by creating an emerging geopolitical risk sub-framework to:
This is so that firms can minimise the strategic shocks and surprises associated with emergencies that arise from these types of risks. Included are those geopolitical risk events that are considered improbable or unlikely.
