Geopolitical risk cuts bank lending by about 4 points
Sanctions trigger the sharpest response and financial separation
Fragmentation costs borrowers and lenders and shrinks diversification

A one standard deviation increase in a firm’s geopolitical risk is accompanied by a slowdown in the growth rate of cross-border bank lending to that firm of about 4 percentage points over a year. The finding comes from work by Bank of England staff, which combined confidential supervisory data on the largest exposures of British banks to individual overseas companies with a risk indicator derived from the companies’ own earnings calls. Risk is thus measured on a business-by-business basis and two companies in the same country and industry can be treated by banks in a completely different way. Anyone who receives cash flow from a risky geography pays, in other words, an additional discount on the value of their revenues. It remains to be seen how large this discount is, in which sectors it is applied more harshly and who ultimately bears its cost on a global scale.

Geopolitical Risk as a Discount on Cash Flow

Most geopolitical risk indicators are constructed from press coverage and assign the same value to each company in a country. The work of the Bank of England followed a different path, since it took advantage of what management reports in the earnings calls and matched it with the real credit relations of British banks, which pass through London, one of the largest international banking centers. The decrease of 4 percentage points remained stable even when companies in the same country, the same sector and the same quarter were compared, which leaves little room for the explanation that the general economic situation of a country is simply recorded. The calculation concerns the rate of increase in lending and not the interest rate, so the discount is not immediately observed. It is inferred from the behavior of banks, which in the face of greater risk lend less, i.e. implicitly ask for a higher price for each euro exposed.

For a bank, the value of a loan depends on whether the debtor’s cash flows actually reach the lender. When a company’s income comes from a jurisdiction that can be cut off from payment systems or subject to restrictions on the transfer of funds, the likelihood of a halt in repayment also depends on decisions of third countries, in which neither the debtor nor the lender has a say. The same revenue stream, with the same accounting figures, thus acquires less value for the lender and the lending is adjusted accordingly. The Bank of England’s sample is limited to British lenders, which is why the 4 percentage point estimate does not automatically carry over to German or Japanese banks, although the size of London as a center of international credit gives the finding a reach that is difficult to ignore by anyone who finances companies with revenues in many countries.

How Sector Sets the Size of the Discount

The largest reduction in lending was recorded in financial companies which is linked to how sanctions work, since they often target financial relationships or the trade flows that underpin them. Manufacturing companies followed with lower cross-border credit, which fits with the disruptions in trade and supply chains caused by tensions. At the opposite pole were mining and defense companies, where borrowing endured and in some cases increased, with the caveat that these changes were not always statistically significant. The direction has its importance, though. Energy and mining companies can benefit from the rise in commodity prices that accompanies tensions, while defense industries see demand strengthen when security concerns intensify and the lender that finances them receives almost reverse exposure to the same risk.

Figure 1: Lending to financial firms keeps falling across the horizon, while defence-related lending shows no clear decline.

The lender counts just as much as the debtor. Banks with a higher CET1 capital adequacy ratio and larger liquidity buffers cut significantly less funding to companies with increased geopolitical risk, while weak banks reacted more sharply. For the CFO of a company with revenues in multiple jurisdictions, the finding has practical content: the composition of the lender base affects the stability of funding as much as the industry in which it operates. A set of lenders with strong capital can withstand the tension, while reliance on a weak lender can disrupt funding at the time of crisis, before it has time to change anything in the fundamentals of the company itself.

Sanctions: the Harshest Form of Geopolitical Risk Short of War

On the scale of state coercion, sanctions are one step below armed conflict and banks react to them with particular intensity. The Bank of England’s study found that lending decreases more sharply when the debtor’s geopolitical risk is linked to sanctions. There are two sources of this risk. The company may itself be the recipient of sanctions, or it may indicate in its announcements that its supply chain or financial counterparties are exposed to them. The second possibility weighs more heavily on the analysis, because it shows that the sanctioning uncertainty also passes to companies that have not themselves been included in a list, as long as they recognize it as a risk to their activities.

The paper also measured how close the bank’s country and the borrower’s country are politically, based on voting standards at the United Nations. Banks reduced lending more when the borrower was in another geopolitical bloc than when they belonged to the same circle of allies and the difference became particularly evident after 2022. Geopolitical risk is thus changing the geography of credit, with flows moving towards borrowers politically closer to the bank’s headquarters.

From the above, it follows that sanctions are working, at least in terms of the goal of financial separation from the global network. Banks discount the risk before the borrower reaches the point of full cut-off, so the separation starts earlier than the official ban and also applies to those on the periphery of the measures. The conclusion has limits. The reduction in credit shows that the separation is being achieved and does not prove that the political purposes for which the sanctions were imposed are also being achieved, an issue that the work does not examine and that remains open.

The Global Cost of Financial Fragmentation

At the country level, the same paper found that rising geopolitical risk reduces cross-border borrowing and GDP, weakens equity prices and puts pressure on the exchange rate, while inflation tends to rise and monetary policy tightens. The decline in international credit is more pronounced in economies with rapid credit growth, indicating that geopolitical disruptions are amplifying pre-existing vulnerabilities. The International Monetary Fund had earlier quantified the mechanism, in its April 2023 Global Financial Stability Report: a one standard deviation increase in the geopolitical distance between two countries, comparable to the widening gap between the voting records of the United States and China at the United Nations since 2016, could reduce the bilateral cross-border allocation of portfolios and bank capital by about 15 percent. The same Fund warned that the burden falls disproportionately on banks with lower capital adequacy ratios.

Estimates for total costs vary widely and the IMF reports them as ranges. In a May 2024 speech, the IMF said that the loss of global output from trade fragmentation ranges from 0.2 percent, in a mild scenario with low adjustment costs, to 7 percent in an extreme scenario, while the fragmentation of foreign direct investment in a two-bloc world around the United States and China could cost about 2 percent. The same speech recalled that trade in goods now accounts for 45 percent of global GDP, compared to 16 percent at the beginning of the Cold War, making a new split cost much more than the previous one. These numbers refer to trade and investment and not bank lending, but lending is the channel through which businesses finance these activities.

A study published in the journal Economics of Transition and Institutional Change in 2026, with data from 47 advanced and emerging economies for the period 1990 to 2024, concluded that the exacerbation of geopolitical conflicts reinforces financial fragmentation and increases the vulnerabilities of the banking sector in the short term. A common objection is that cutting lending is simply prudent risk management and therefore does not constitute a loss. For the individual lender that avoids losses, the objection applies. Collectively, the IMF calculated that fragmentation reduces the potential for international risk diversification and can enhance macroeconomic volatility, so the cautious attitude of each lender individually does not necessarily create a safer system, since the diversification lost was security for everyone.

Figure 2: Extreme fragmentation raises volatility by up to about 8 points and diversification losses reach 38 to 54 percent of the autarky loss.

What Fragmentation Costs the Lenders

Lenders also pay and the bill is partly issued by the sanctions regime itself. Research by LexisNexis Risk Solutions estimated in 2023 that financial institutions spend a total of $206.1 billion annually on financial crime compliance, a category that includes sanctions monitoring. This is an estimate based on an executive survey, which does not isolate the part that is due to geopolitical reasons, which is why it is treated here as an order-of-magnitude indicator. The other side is the interruption of partnerships. According to the Financial Stability Board, the number of active correspondent banks decreased by 19.3 percent from 2011 to 2018. The causes are mixed, since the Financial Stability Board itself has mentioned the concentration of the sector, the limited profitability and the rules on money laundering or sanctions, so the entire reduction cannot be attributed to geopolitics. Any relationship that closes, though, means lost business and lost access to markets for the lender.

For the CFOs of companies with revenues in many jurisdictions, the findings lead to two specific moves, the dispersion of lenders among geopolitical blocs and the preference for banks with high capital and liquidity. References to sanctions in the company’s own publications warrant particular attention, because these are precisely the texts that lenders read. Banks’ risk managers have at their disposal a method of measurement per company, more detailed than national indicators allow. Researchers at the Bank of England suggest that geopolitical risk monitoring be integrated into macroeconomic surveillance and the IMF calls for stress tests, as well as sufficient capital and liquidity reserves for those who suffer the consequences.

The 4 percentage points with which the analysis began express the part of the cost that is most clearly seen, i.e. the loan that was not given to a particular company. The rest is spread among many recipients, from banks that lose customers and pay for compliance to economies that see risk diversification narrow. As the discount widens, so does the loss that the IMF estimated at about 15 percent of the bilateral capital allocation for each standard deviation increase in geopolitical distance. Whether the security purchased at this price offsets the damage cannot be judged with today’s figures.

This article reflects the analytical judgment of The Economy Editorial Board and does not constitute policy advice or the official position of any affiliated institution.

References

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