The following analysis appeared in Le Monde as "Condition de prêt des banques : « Pourquoi un risque géopolitique à l’étranger peut affecter le marché domestique »" on Jan.12, 2024.

How do geopolitical events in Russia, China, and the Middle East impact bank lending in advanced economies like the United States? And how do financial institutions respond?

These questions have become increasingly important to policymakers and business executives in the wake of a series of geopolitical shocks, including Russia’s invasion of Ukraine, escalating tension between China and Taiwan, and conflict in the Middle East. My research “Geopolitical Risk and Global Banking” (joint with Friederike Niepmann from the Federal Reserve Board) shows that when risk increases as a result of foreign geopolitical events, domestic lending by U.S. banks is consistently and negatively impacted: Banks significantly tighten domestic lending standards and reduce lending to domestic firms.

But why does foreign geopolitical risk spill over to the United States through its banks? Our research uncovers some key reasons: The rising geopolitical risk increases the credit risk of banks which have exposure to the affected countries. And when banks move to satisfy capital requirements and lower that exposure, reducing domestic lending is often the easiest way to go.

Surprisingly, banks often continue lending in countries where geopolitical risk rises

Our research reveals that foreign geopolitical events directly impact the overall loan portfolios of the exposed banks. In particular, we document a sharp increase in the average probability of default on loans to Russian and Ukrainian borrowers after Russia annexed Crimea in late 2013 and invaded Ukraine in early 2022. This effect is evident across a database of geopolitical events and has a significant impact on the aggregate credit risk of exposed banks.

Capital requirements limit the risks banks are allowed to take on, and banks must respond to increases in credit risk by reducing the overall exposure of their portfolio. We might expect banks to reduce their exposure to the countries where geopolitical risk rises. But, surprisingly, we find that the exposed banks continue a significant portion of their foreign lending.

This foreign lending takes two forms: They can lend locally from their foreign branches or subsidiaries, or they can lend across borders, such as from their home country offices. Our analysis shows that, while banks tend to reduce lending from offices outside of countries where geopolitical risk is increasing, their lending through local operations in these countries persists or even increases. Why?

Some anecdotal evidence from events following Russia’s invasion of Ukraine in 2022 may help shed light on this paradox.

Divesting foreign assets can be too costly, even where geopolitical risk is high

When Russia invaded Ukraine, several large global banks, including UniCredit, Societe Generale, Citigroup, and Raiffeisen Bank International (or RBI), were running significant operations in Russia. Societe Generale sold its Russian subsidiary soon after the invasion (and booked a loss from the sale). But the other global banks have divested much more slowly.

UniCredit, Citigroup, and RBI still own their Russian subsidiaries. Citigroup is gradually winding down its subsidiary and selling its portfolio, but UniCredit and RBI continue to operate their Russian subsidiaries more or less as usual. Reportedly, the banks are looking for opportunities to sell their Russian subsidiaries. But any sale needs Vladimir Putin’s approval and could come at a hefty cost for the bank, especially if the foreign operation generates a major revenue stream for the bank. For instance, RBI, which runs the 10th largest bank in Russia, earns around 40% of its group revenue in Russia, so its capital would take a significant hit if it walks away.

It’s an example of the significant frictions and difficult tradeoffs banks face for divesting assets in foreign operations. Rising geopolitical risk makes it much more difficult to find a buyer and sell at a reasonable price. The larger a foreign subsidiary is in relation to a bank's other operations, and the more important its revenues are for the bank, the more challenging it is for the bank to absorb losses from a sale.

But these banks still must satisfy capital requirements. They still need to offset the increased credit risk from the geopolitical event. So, much of the reallocation instead comes from reduced domestic lending in their home markets, where it is easier to reallocate investment. Our results show that the more local exposure a bank has in countries affected by geopolitical risk, the more it reduces its domestic lending in response. As a result, turmoil that seems far away can have a big impact on our local economies.

Leslie Sheng Shen is a senior economist at Federal Reserve Bank of Boston in the United States. The views in this article are solely the responsibility of the author and should not be interpreted as reflecting the views of the Federal Reserve Bank of Boston or any other person associated with the Federal Reserve System.