FRM Exam Part II · Global Financial Stability Report, April 2025, Chapter 2 (Geopolitical Risk)

Policy Implications and Risk Management for Geopolitical Risk

Updated 11 October 2026 · Fact-checked

This topic covers how financial institutions, regulators and central banks prepare for geopolitical shocks. The core tools are scenario analysis and stress testing, adequate capital and liquidity buffers, and monitoring of exposures and transmission channels. To answer questions, identify the shock, map it to a channel, then pick the matching tool.

Understand Policy Implications and Risk Management

Geopolitical risk is the risk that wars, sanctions, trade restrictions, terrorism or political tension disrupt economies and markets. It is hard to model because events are rare, unique and often outside historical data. That is why the policy advice leans on judgement-based tools, not on VaR alone.

The broad message of the IMF's April 2025 Global Financial Stability Report chapter is that geopolitical risk can raise asset price volatility, change investor behaviour and strain financial institutions. Institutions and authorities should therefore assess the exposure before the shock arrives. Treat this as a summary of themes, not a list of exact thresholds. The exam tests the logic, not memorised numbers.

The main risk management tools are these:

Scenario analysis: build plausible, severe geopolitical stories (for example an energy supply disruption or a sanctions episode) and trace their effect through market, credit, funding and operational risk.
Stress testing: apply the scenario shocks to portfolios, capital and liquidity to see the losses and whether limits and ratios hold.
Buffers: capital and liquid assets that absorb losses and funding outflows. Basel capital buffers and liquidity ratios such as the LCR support this.
Monitoring: track exposures by country, sector, counterparty, supplier and currency, with indicators and triggers that prompt action.

For supervisors and central banks, the same logic applies at system level. They run system-wide stress tests, look for common exposures and interconnections, check that banks and non-bank institutions hold enough buffers, and prepare liquidity support and crisis coordination. Macroprudential tools can be adjusted when vulnerabilities build up.

A good answer links the tool to the weakness. Unknown or unmodelled shock: scenario analysis and reverse stress testing. Loss absorption: capital buffers. Funding run: liquidity buffers and contingency funding plans. Hidden concentration: exposure monitoring and limits. Cross-border spillover: international coordination.

Key formulas to remember

Risk-management chain: Shock → transmission channel → exposure → tool; Use this to match any geopolitical question to the correct response.
Stress test capital check: Post-stress capital ratio = (Capital − stress losses) ÷ Risk-weighted assets; Simplified. Real tests also adjust RWA and revenue. Compare the result with the minimum plus buffers.
Liquidity Coverage Ratio: LCR = Stock of high-quality liquid assets ÷ Total net cash outflows over 30 days ≥ 100%; A standard Basel liquidity buffer test. It is a regulatory minimum, not a geopolitical scenario by itself.
Reverse stress test: Start from failure outcome → find scenario that causes it; Works backwards. Useful where history gives no guide to a rare event.

How to solve Policy Implications and Risk Management questions

Use this method for any question on geopolitical risk policy and management.

1Read the scenario and name the shock: conflict, sanctions, trade barrier, political instability or similar.
2Identify the transmission channel: asset price fall, volatility, funding stress, credit losses, supply chain, cyber or operational disruption.
3Identify who is asking: a bank risk manager, an asset manager, a regulator or a central bank. This sets the tool set.
4Match the weakness to the tool: unmodelled shock to scenario analysis, loss absorption to capital buffers, outflows to liquidity buffers, concentration to monitoring and limits.
5Check whether the question asks for a forward-looking tool (stress test, scenario) or a backward-looking one (historical VaR). Prefer forward-looking for geopolitical events.
6Eliminate options that overstate certainty, such as claiming a model can predict geopolitical events or that one buffer removes all risk.
7Choose the option that is specific, links shock to channel and tool, and fits the actor's role.

Quickest way: Shock-to-tool matching

When to use it: Use when you have about a minute per question and the options list different risk management responses.

Underline the weakness in the stem: unknown, loss, funding, concentration or cross-border.
Map it: unknown to scenarios, loss to capital, funding to liquidity, concentration to monitoring, cross-border to coordination.
Reject options that rely only on historical data or promise prediction.
Pick the remaining option that names the right actor and tool.

Common mistakes in Policy Implications and Risk Management

Relying on historical VaR to measure geopolitical risk.
VaR is the familiar tool from earlier topics.
Fix: Remember geopolitical events are rare and regime-changing. Use scenario analysis and stress testing, with VaR as a complement.
Treating stress testing and scenario analysis as identical.
They are used together and the words overlap.
Fix: Scenario analysis builds the story and its transmission. Stress testing applies the shocks to portfolios, capital and liquidity to measure results.
Choosing capital buffers for a funding run problem.
Capital is seen as the universal safeguard.
Fix: Capital absorbs losses. Liquid assets and contingency funding handle cash outflows. Match the buffer to the risk.
Stating that policy can eliminate geopolitical risk.
Options sometimes use absolute wording that looks reassuring.
Fix: Policy aims to reduce vulnerability and improve resilience. Be wary of words like eliminate, guarantee and prevent.
Ignoring non-bank institutions and cross-border links.
Students focus on banks only.
Fix: Include asset managers, insurers and funds, and remember international spillovers and coordination between authorities.
Monitoring only direct country exposure.
Direct lending to a country is the obvious exposure.
Fix: Also monitor indirect channels: counterparties, supply chains, commodity dependence, funding currencies and third-party providers.

Worked examples

Example 1

A global bank worries that a regional conflict could disrupt energy supply and trigger sharp market moves for which it has little historical data. Which tool is most suitable to assess the impact? A) A 99% one-day historical VaR B) A scenario-based stress test covering market, credit and funding effects C) The bank's current LCR alone D) Last year's credit rating review

Show the solution

Shock: energy supply disruption from conflict. Little history exists.
Weakness: an unmodelled, rare event affecting several risk types.
Option A is backward-looking and covers a normal 99% one-day range, so it misses extreme events.
Option C measures a 30-day liquidity position under a standard regulatory stress. It does not assess market and credit effects.
Option D is a static review and not forward-looking.
Option B builds a plausible severe scenario and traces market, credit and funding effects.

Answer: B. A scenario-based stress test is the right tool for a rare shock with no usable history.

Example 2

A bank has CET1 capital of $20 billion and risk-weighted assets of $200 billion. A geopolitical stress scenario produces losses of $5 billion. Assuming RWA stays unchanged and no revenue offsets the losses, what is the post-stress CET1 ratio, and what does it tell the risk manager?

Show the solution

Current ratio = 20 ÷ 200 = 10%.
Post-stress capital = 20 − 5 = $15 billion.
Post-stress ratio = 15 ÷ 200 = 7.5%.
The fall is 2.5 percentage points.
Compare 7.5% with the minimum plus applicable buffers. If buffers sit above 7.5%, the bank would be drawing on them, which triggers restrictions and management action.

Answer: The post-stress CET1 ratio is 7.5%, down from 10%. The result shows how much of the buffer the scenario consumes and whether management actions, such as reducing exposures or raising capital, are needed.

Exam tips

Expect applied scenarios. Name the shock and channel first, then the tool.
Prefer forward-looking tools (scenario analysis, stress tests, reverse stress tests) over historical methods for geopolitical shocks.
Watch absolute wording such as eliminate or guarantee. Those options are usually wrong.
Match the buffer to the risk: capital for losses, liquidity for outflows.
Remember the system view: regulators and central banks monitor interconnections, run system-wide stress tests and coordinate internationally.

Practice questions from Global Financial Stability Report, April 2025, Chapter 2 (Geopolitical Risk)

Policy Implications and Risk Management: frequently asked questions

What does the IMF GFSR April 2025 recommend on geopolitical risk?

The chapter's themes are to assess exposures with scenario analysis and stress testing, hold adequate buffers and monitor vulnerabilities. For the exam, focus on these themes and the logic behind them, not on exact figures.

How can central banks and regulators address geopolitical risk?

They monitor system-wide vulnerabilities, run stress tests, make sure institutions hold sufficient capital and liquidity, and prepare crisis tools. They also coordinate with other authorities because shocks spill across borders.

Why is VaR not enough for geopolitical risk?

VaR depends on historical data and a confidence level, and geopolitical shocks are rare and often break past patterns. Scenario analysis and stress testing capture severe, specific events that VaR can miss.

What is the difference between scenario analysis and stress testing?

Scenario analysis develops a plausible narrative and its transmission across risks. Stress testing applies shocks from that narrative to portfolios, capital and liquidity and measures the outcome.