Geopolitical Risk, LSI Exposure and Supervisory Assessment Framework

Geopolitical developments have become a persistent and structurally relevant factor shaping the operating environment of banks. Their prudential significance does not arise from the existence of a distinct “geopolitical” risk category, but from their capacity to amplify a wide range of established vulnerabilities, including credit deterioration, market repricing, liquidity stress, funding instability, operational disruption, and governance weaknesses. In this context, it is analytically more appropriate to refer to geopolitical uncertainty rather than geopolitical risk in a narrow sense. <br> <br> Geopolitical uncertainty is inherently cross-cutting, heterogeneous, nonlinear, and frequently transmitted through indirect channels. As a result, it does not fit neatly within the traditional banking risk taxonomy, but instead propagates through existing prudential categories. This feature is particularly relevant for Less Significant Institutions (LSIs), whose exposure is often not direct or cross-border, but embedded in domestic economic structures, sectorial concentrations, and operational dependencies. <br> <br> Against this background, the paper documents how the supervisory approach of the Banca d’Italia integrates geopolitical considerations within the standard prudential framework, rather than treating them as a separate supervisory silo. Evidence from recent supervisory cycles suggests that geopolitical uncertainty is reflected indirectly through its impact on governance, credit quality, provisioning adequacy, liquidity, operational resilience, and capital demand. <br> <br> The paper also develops an illustrative structural framework, inspired by contingent claims analysis, to represent analytically the main transmission channels through which geopolitical uncertainty affects bank balance sheets. The model highlights how such uncertainty simultaneously influences asset performance, volatility, funding conditions, and correlations, and provides a structured explanation for the different transmission mechanisms observed across LSIs and Significant Institutions (SIs). The contribution of the paper is therefore not quantitative measurement, but the provision of a consistent analytical framework to support supervisory assessment in an environment characterized by fundamental uncertainty. <br>