Geopolitical risk, banks' exposure and supervisory assessment framework

Geopolitical developments have become a persistent and structurally relevant factor shaping the operating environment of banks. Their prudential significance does not arise from the existence of a distinct 'geopolitical' risk category, but from their capacity to amplify established vulnerabilities, including credit deterioration, market repricing, liquidity stress, funding instability, operational disruption, and governance weaknesses. This reading is also consistent with the broader SSM and European supervisory approach, which frames geopolitical developments as cross-cutting drivers of existing prudential risks rather than as a new standalone risk category. In this context, it is analytically more appropriate to refer to geopolitical uncertainty rather than geopolitical risk in a narrow sense. Geopolitical uncertainty is inherently cross-cutting, heterogeneous, nonlinear, and frequently transmitted through indirect channels. It therefore does not fit neatly within the traditional banking risk taxonomy but propagates through existing prudential categories and affects both sides of banks' balance sheets. This feature is particularly relevant for less significant institutions (LSIs), whose exposure is often not direct or cross-border, but embedded in domestic economic structures, sectoral concentrations, borrower vulnerabilities, and operational dependencies. Against this background, the paper documents how the supervisory approach of Banca d’Italia integrates geopolitical considerations within the standard prudential framework, rather than treating them as a separate supervisory silo. Evidence from recent supervisory cycles suggests that geopolitical uncertainty is reflected indirectly through its impact on governance, credit quality, provisioning adequacy, liquidity, operational resilience, funding sustainability, and capital demand. The paper also develops an original structural framework, inspired by contingent claims analysis and by the Merton approach, but adapted to the specific economics of banking. Relative to the standard Merton model, the proposed framework introduces asset-class heterogeneity, liability-class dynamics, endogenous funding costs, and a payout structure that makes it possible to model banks while preserving analytical tractability. The contribution is therefore not measurement in a narrow sense, but a consistent analytical framework to explain how geopolitical uncertainty affects asset performance, volatility, correlations, funding conditions, distance to default, and equity values. Its main aim is to support supervisory assessment and structured scenario analysis in an environment of fundamental uncertainty.