Geopolitical Risk and Global Banking 
Geopolitical risk has become a top concern for policymakers and businesses, yet the financial and international mechanisms through which it affects economies are not well understood. This paper addresses this gap by analyzing how global banks respond to rising geopolitical risk and the resulting spillover effects. More specifically, it examines how U.S. global banks manage geopolitical risk through their foreign operations and how these actions spill over into domestic credit supply. For their analysis, the authors use established and newly constructed geopolitical risk indexes and confidential Federal Reserve supervisory data covering nearly four decades of U.S. bank lending activities.
Key Findings
- Geopolitical risk significantly increases U.S. banks’ credit risk. Despite this heightened risk, these banks continue lending through their foreign branches and subsidiaries while reducing cross-border lending. This asymmetric response is unique to geopolitical risk, as banks do not adjust their foreign operations in a similar way in response to broad economic and sovereign risks.
- U.S. global banks’ foreign adjustments to geopolitical risk have implications for domestic credit supply. Banks exposed to geopolitical risk abroad reduce lending to U.S. firms, with the contraction most pronounced when the risk originates in countries where those banks operate through local affiliates.
- These patterns can be explained by a simple model in which geopolitical risk—through the possibility of expropriation or restrictions on profit repatriation—interacts with differences in funding structures across foreign operations. U.S. banks’ foreign affiliates rely on local funding, which limits parent-bank losses under such shocks and makes divestment less attractive. By contrast, cross-border lending is funded domestically and remains directly exposed to geopolitical risk. This asymmetry in net exposure explains why banks retrench from cross-border lending while maintaining affiliate-based operations—and why affiliate exposure, in turn, amplifies spillovers into domestic credit supply.
Implications
The paper’s findings reveal the potential real and distributional consequences of geopolitical risk transmitted through global banks. Constrained firms may respond to reduced credit supply by cutting investment and employment. At the same time, credit reallocation can generate amplification effects, as firms with better credit access may shift to smaller domestic lenders, crowding out more marginal borrowers such as small and medium-sized enterprises. In this way, geopolitical shocks may propagate through the domestic credit system not only via direct exposure but also through general equilibrium effects in financial intermediation.
Abstract
How do banks respond to geopolitical risk, and is this response distinct from other macroeconomic risks? Using U.S. supervisory data and new geopolitical risk indices, we show that banks reduce cross-border lending to countries with elevated geopolitical risk but continue lending to those markets through foreign affiliates—unlike their response to other macro risks. Furthermore, banks reduce domestic lending when geopolitical risk rises abroad, especially when they operate foreign affiliates. A simple banking model in which geopolitical shocks feature expropriation risk can explain these findings: Foreign funding through affiliates limits downside losses, making affiliate divestment less attractive and amplifying domestic spillovers.