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

Transmission Channels of Geopolitical Risk to Financial Institutions

Updated 11 October 2026 · Fact-checked

Geopolitical shocks reach financial institutions through five channels: credit losses on exposed borrowers, higher or less available funding, market liquidity strain, sanctions and compliance effects, and market volatility that cuts asset values. Banks feel it mainly through loans and funding. Nonbank institutions feel it through asset prices, redemptions and leverage.

Understand Transmission Channels to Financial Institutions

A geopolitical shock is an event such as war, sanctions, trade restrictions or political tension that changes the outlook for economies and markets. It does not hit a financial institution directly. It travels through channels. Your job in the exam is to name the channel and say who is exposed.

The first channel is credit. A shock raises borrowers' costs or cuts their revenue. Firms in affected countries or sectors, such as energy importers or exporters to a sanctioned country, default more. Banks with direct loans or cross-border claims take losses. Higher expected losses raise provisions and cut capital.

The second channel is funding and liquidity. When uncertainty rises, lenders pull back. Wholesale funding gets dearer, and foreign currency funding, especially USD, can become scarce. Market liquidity also falls, so bid-ask spreads widen and assets are harder to sell without a price drop. Institutions that depend on short-term funding are most at risk.

The third channel is sanctions. Sanctions freeze assets, block payments and make some counterparties off-limits. Banks face direct losses on frozen exposures, higher compliance and operational risk, and disrupted settlement. Institutions linked to sanctioned entities through correspondent banking or trade finance are hit hardest.

The fourth channel is market volatility. Geopolitical stress moves equity, bond, commodity and FX prices together. Investors reprice risk and may sell risky assets. Banks see trading losses and lower collateral values. Nonbank financial institutions (NBFIs) such as asset managers, insurers, pension funds and hedge funds see portfolio losses and, for open-ended funds, investor outflows. Leverage and liquidity mismatch can force sales that amplify the shock. Banks and NBFIs are also linked, so stress in one can spread to the other.

Key formulas to remember

Channel map
Shock → credit | funding | market liquidity | sanctions | volatility → balance sheet loss or liquidity strain
Use this to classify any scenario. Name the channel first, then the institution type.
Bank vs NBFI emphasis
Banks: loans, deposits, wholesale funding. NBFIs: asset prices, redemptions, leverage.
A rule of emphasis, not an absolute. Both types face all channels to some degree.
Amplification loop
Price fall → margin calls or outflows → forced sales → further price fall
Strongest where leverage or liquidity mismatch is high.

How to solve Transmission Channels to Financial Institutions questions

Use this method for any question on how a geopolitical event affects financial institutions.

  1. 1Identify the shock: war, sanctions, trade restriction, political tension or general uncertainty.
  2. 2Identify the institution: bank, insurer, pension fund, asset manager, hedge fund or investor.
  3. 3Match the shock to the main channel: credit, funding, liquidity, sanctions or volatility.
  4. 4Check the institution's vulnerability: direct exposure, reliance on short-term or foreign currency funding, leverage, or liquidity mismatch.
  5. 5Look for second-round effects: forced selling, outflows, or links between banks and NBFIs.
  6. 6Pick the answer that names the correct channel and the right institution type, and drop options that are too absolute.

Quickest way: Channel and Institution Match

When to use it: Use when a multiple-choice question asks which channel or institution is most affected.

  1. Underline the key word: loans, funding, sanctions, redemptions, volatility.
  2. Map it: loans = credit; funding or USD = funding; frozen assets = sanctions; open-ended fund outflows = NBFI liquidity.
  3. Eliminate options that put the wrong institution on the channel.
  4. Reject options with always or never unless the text says so.

Common mistakes in Transmission Channels to Financial Institutions

  • Treating geopolitical risk as only a credit risk problem.

    Credit losses are the most familiar channel for bank exposure.

    Fix: Always scan for funding, liquidity, sanctions and volatility channels as well.

  • Assuming NBFIs are not affected because they are not banks.

    Banks get most regulatory attention.

    Fix: NBFIs are exposed through asset prices, redemptions and leverage, and can pass stress back to banks.

  • Confusing market liquidity with funding liquidity.

    Both use the word liquidity.

    Fix: Market liquidity is how easily assets sell without price impact. Funding liquidity is the ability to raise cash to meet obligations.

  • Treating sanctions as only a legal matter.

    Sanctions seem to be a compliance topic.

    Fix: They also create credit losses on frozen exposures, operational risk and payment disruption.

  • Saying direct exposure is the only route of contagion.

    Students look at country exposure tables alone.

    Fix: Indirect routes count: common asset holdings, funding markets and links between banks and NBFIs.

Worked examples

Example 1

A global asset manager runs an open-ended bond fund holding mid-sized emerging market corporate bonds. A regional conflict escalates, spreads widen and investors redeem. Which channel is most relevant, and why can the shock amplify?

Show the solution
  1. The shock is a conflict and the institution is an NBFI, an asset manager.
  2. Spreads widening is a market volatility effect, which cuts portfolio values.
  3. Redemptions are an NBFI liquidity strain, because the fund offers daily or frequent redemption but holds less liquid bonds.
  4. To meet redemptions the fund must sell bonds in thin markets, which pushes prices down further and can trigger more redemptions.

Answer: Market volatility and liquidity mismatch. Redemptions force sales in illiquid markets, creating an amplification loop.

Example 2

A bank has a large correspondent banking business and trade finance loans to firms that trade with a country that is newly sanctioned. Identify the channels through which the bank is affected.

Show the solution
  1. The shock is sanctions and the institution is a bank.
  2. Credit: trade finance borrowers lose revenue or access to payments, so default risk rises.
  3. Sanctions: frozen assets or blocked payments may create direct losses on exposures.
  4. Operational and compliance: the bank must screen transactions and may face disrupted settlement and compliance costs.
  5. Funding: if the bank relies on foreign currency funding from counterparties wary of the exposure, its funding costs may rise.

Answer: Credit, sanctions (including compliance and operational effects) and possibly funding. The most direct channels are sanctions and credit.

Exam tips

  • Questions are usually case-style. Name the channel in your head before reading the options.
  • Distinguish bank-specific channels (loans, deposits, wholesale funding) from NBFI-specific ones (redemptions, leverage, asset prices).
  • Watch for second-round effects such as forced sales and bank-NBFI links.
  • Be wary of absolute wording. Exposure depends on business model, leverage and funding mix.

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

Transmission Channels to Financial Institutions: frequently asked questions

How does geopolitical risk reach banks?

Mainly through credit losses on exposed borrowers, higher or scarcer funding, sanctions effects and trading losses from volatility. Banks with heavy cross-border lending or short-term foreign currency funding are more exposed.

How do sanctions affect financial stability?

Sanctions can freeze assets, block payments and raise compliance and operational costs. They can create credit losses and disrupt settlement. If exposures are large or concentrated, stress can spread to counterparties.

How is NBFI exposure different from bank exposure?

Banks are hit mostly through loans and funding. NBFIs are hit mostly through falling asset prices, investor redemptions and leverage. Both can be affected by all channels, and stress can pass between them.

Is geopolitical risk the same as market risk?

No. It is a source of shocks that can show up as credit, market, liquidity or operational risk. The exam expects you to identify the channel.