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

A bank holds a portfolio of corporate loans to firms in a country that becomes the focus of a sudden rise in geopolitical tensions. The bank's credit risk team expects the shock to affect the portfolio mainly through firms' cash flows and borrowing conditions. Which outcome best describes this credit channel of transmission?

Geopolitical stress raises default probabilities and credit spreads because borrowers face weaker cash flows and tighter financing. This increases expected credit losses and loan loss provisions. Higher spreads do not immediately compensate on existing loans, and collateral values tend to fall rather than rise in stress.

  1. AHigher default probabilities and credit spreads, leading to greater expected losses and provisionsCorrect
  2. BLower expected losses because higher spreads compensate lenders immediately
  3. CUnchanged expected losses because geopolitical risk affects only equity markets
  4. DA fall in loan loss provisions because collateral values rise with uncertainty

Explanation

Geopolitical stress weakens borrower cash flows and tightens financing, raising default probabilities and spreads and therefore expected credit losses and provisions. Higher spreads do not offset losses on existing loans already booked, and collateral values generally fall, not rise, in stress.

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