Financial stability risks from geoeconomic fragmentation
Source: European Systemic Risk Board and European Central Bank. Financial stability risks from geoeconomic fragmentation. Original PDF, unchanged; available free from the publisher. No affiliation or endorsement.
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Contents Executive summary 2 1 Introduction 6 2 A framework for assessing geopolitical risks to financial stability 7 3 Assessing geopolitical risks to EU countries 11 3.1 Classification of geopolitical risk indicators 11 Box 1 Geopolitical risk: from US-centric indices to euro area tools 16 3.2 Selection of informative indicators 18 Box 2 Recommended indicators for geopolitical risks analysis 19 3.3 Current state of geopolitical risks 22 4 Transmission of geopolitical risk 26 4.1 Macro-financial transmission of geopolitical risk 26 4.2 Tail risks to macro-financial conditions in the EU 35 4.3 EU country findings 49 5 Financial market impact of geopolitical risks 53 5.1 Geopolitical risk and financial market spillovers 53 5.2 EU financial market reaction to US political risk shocks 58 6 Impact of geopolitical risk on euro area financial institutions 62 6.1 Impact of the Russian invasion of Ukraine on euro area banks 62 6.2 US economic policy uncertainty and euro area bank lending 72 6.3 Geopolitical shocks and euro area sectoral portfolio reallocation 75 Box 3 The UCITS sector in Luxembourg in the face of the Russian invasion of Ukraine 80 References 83 Annex 91 Financial stability risks from geoeconomic fragmentation Contents 1
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Executive summary Geoeconomic fragmentation and geopolitical risk have emerged in recent years as defining challenges for economies worldwide, profoundly reshaping the global economic and financial landscape. Heightened geopolitical tensions, trade frictions, and regulatory divergence have created a world where political and economic spheres are increasingly intertwined. These developments have transformed the nature of uncertainty faced by policymakers and financial institutions, as geopolitical shocks transmit through global markets, disrupt trade and investment flows, and potentially impact financial stability. This report examines the link between geopolitical and geoeconomic risks and financial stability. It introduces a comprehensive framework for regular monitoring of geopolitical risks, integrating a wide array of quantitative indicators with a rich empirical modelling foundation to evaluate the impact on the financial sector. The framework is conceived as an instrument for policymakers and financial authorities, enabling a systematic assessment of how geopolitical developments affect macro- financial conditions. The work makes three main contributions to risk monitoring. First, it establishes a monitoring toolkit for indicator-based analysis of geopolitical risks that can be readily integrated into existing financial stability frameworks. Second, it explores the macro-financial transmission of geopolitical shocks using state-of-the-art econometric models. Third, it draws on granular datasets to document how banks and non-banks adjust to geopolitical shocks and periods of elevated policy uncertainty. The framework categorizes geopolitical risks into five broad groups, each capturing facets and channels that can amplify macro-financial vulnerabilities and impact financial stability. The categories are: (i) military conflicts and wars; (ii) infrastructure vulnerabilities; including energy and digital systems; (iii) trade disruptions and sanctions; (iv) capital and financial risks; and (v) political or societal factors. Together, these dimensions shape the complex landscape of geopolitical risk. The framework also identifies the main channels through which these risks affect financial stability – financial, real-economy, and operational. This report focuses on the financial channel, where spillbacks occur through tighter financial conditions, higher risk premia, and financial market stress. As a result, financial institutions may face heightened credit, market, liquidity, or operational risks. Moreover, existing vulnerabilities and feedback loops can act as amplifiers, transforming localised disturbances into systemic risks with the potential to threaten financial stability. The empirical analysis relies on a broad set of 40 geopolitical indicators covering the five risk categories identified in the framework. These metrics include high-frequency market-based measures and slower-moving cyclical and structural indicators. Statistical and econometric selection criteria were used to identify the most relevant indicators for visual monitoring tools and econometric analysis. The geopolitical indicators heatmap (GEO heatmap) can be embedded in Financial stability risks from geoeconomic fragmentation Executive summary 2
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broader risk monitoring frameworks to support ongoing financial stability assessments. The monitoring tools used in the analysis confirm that the prevailing geopolitical risks have intensified in recent years, as captured by trends in geoeconomic fragmentation, geopolitical tensions and heightened policy uncertainty. Measures of policy uncertainty have especially surged during 2024 and 2025, driven primarily by a sharp increase in global economic and trade policy uncertainty. These developments have been accompanied by a 27% rise in trade disputes at the World Trade Organization between 2015 and 2024 combined with regulatory divergence. A significant dichotomy emerges between a measured rise of geopolitical risk and the impact for the economy and financial stability. While indicators of uncertainty have surged and model-based results indicate substantial downside risks for the real economy, measures of financial volatility have remained contained or quickly reverted after short-lived spikes. Growth-at-Risk (GaR) estimates – capturing real GDP growth at the lower tenth percentile – show that the inclusion of geopolitical indicators lowers expected growth outcomes compared with estimations without such risk factors. Since 2014, the contribution of geopolitical indicators to these dynamics has increasingly acted as a drag on GaR, reducing it by one to two percentage points. On the financial side, heightened geopolitical shocks and policy uncertainty tends to raise systemic stress, resulting in lower loan growth and tighter lending conditions. These results point to significant tail risks for the real economy from geopolitical sources. The transmission of geopolitical risks and economic policy uncertainty varies notably across EU Member States, reflecting differing levels of risk exposures and financial sector resilience. Based on the empirical evidence, economies with higher trade openness or higher public indebtedness appear more vulnerable to amplification effects. The evidence also shows that geopolitical risk can reduce financial integration and economic synchronisation within the euro area, amplifying output losses and financial stress. While heterogeneous exposure to geopolitical risk among EU Member States can partly explain these divergences, it suggests that reduced synchronisation and financial integration may compound the macro-financial effects of geopolitical shocks beyond their direct impact. To evaluate the resilience of financial systems, the empirical analysis is complemented with sensitivity analyses and macro-financial stress tests. These stylized scenario exercises illustrate how macro-financial variables and risks surrounding them evolve under simulated geopolitical shocks. In addition, they identify the contribution of the financial system as an amplifier of the dynamics and the benefits of stabilising financial stress to mitigate the effects. Taken together, the results highlight the stabilising role that a sound and well-capitalised financial system can play in limiting adverse macro-financial outcomes. Financial markets provide a critical lens through which to observe how geopolitical shocks propagate and affect interlinkages between market segments. Volatility spillovers between asset classes – bonds, commodities, Financial stability risks from geoeconomic fragmentation Executive summary 3
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equities, and exchange rates – spiked during major recent events such as the COVID-19 pandemic and the Russian invasion of Ukraine in 2022. These episodes illustrate how geopolitical shocks can break down established relationships between markets and significantly impact cross-market interconnectedness. An additional analysis focuses on the transmission of US political risk. It is based on prediction market data, which are designed to track the emergence of new geopolitical risks and to analyse their impacts across financial markets. The analysis shows that political risk shocks linked to US trade tariffs not only affect US equity prices and exchange rates but also spill over into euro area equity markets. A granular perspective on financial institutions confirms that both banks and non-banks adjust their behaviour in response to geopolitical shocks by reducing lending, especially across borders. The effect on lending was strongest among euro area banks with less capital headroom or large exposures to high-risk countries. Banks reduced both the probability of new lending relationships (by around 6%) and the average loan amount (by 9%). Similarly, spillovers from heightened US policy uncertainty led to a reduction in credit from euro area banks. On the liability side of banks’ balance sheets, market-based funding tends to decline in response to increases in economic and trade policy uncertainty and rising geopolitical risk, particularly as regards foreign-currency funding. For non-bank financial institutions, the shift towards domestic concentration following the Russian invasion of Ukraine was pronounced, with exposures to the rest of the world falling by 17%, compared with 7% for domestic exposures, driven primarily by investment funds, pension funds and insurers. This re-orientation towards domestic markets – as opposed to a rebalancing from higher to lower-risk cross-border exposures – reduces exposure to external shocks but may also constrain diversification and the system’s ability to mitigate risk. While this report provides a comprehensive assessment of the financial stability implications of geopolitical risk and geoeconomic fragmentation, certain gaps remain. The availability and comparability of geopolitical indicators vary considerably over time and across countries, suggesting the need for further efforts to build methodologically harmonised datasets and tailor monitoring frameworks to national specificities by selecting specific indicators for different countries. Moreover, new sources of risk are emerging rapidly, including digital fragmentation, cyber threats, and the societal dimensions of geopolitical shifts. Economic, financial, and regulatory divergence – whether through trade restrictions on critical materials, financial regulation of new instruments, or climate-related policy shifts – may further complicate the landscape. It could therefore be worthwhile to complement indicator-based monitoring with more elaborate scenario analyses involving specific risk materialisations, as they would enhance the capacity to anticipate emerging geopolitical and financial stability risks. By offering a structured, empirically grounded approach to understanding the financial stability implications of geopolitical risks, the monitoring toolkit presented in this report provides a foundation for future research and policy development. Policymakers and financial institutions can employ this framework to detect and categorize the main sources of risk in an evolving landscape of Financial stability risks from geoeconomic fragmentation Executive summary 4
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geopolitical risk to assess cross-market and cross-border spillovers, estimate the impact on financial institutions and calibrate macro-prudential responses. In an era of accelerating fragmentation and persistent geopolitical uncertainty, proactive risk management and strengthened cooperation across jurisdictions are essential to preserve financial stability and sustain economic resilience. Financial stability risks from geoeconomic fragmentation Executive summary 5
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