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Author: Soumya Kuber |06/13/18

Financial Implications in the Age of Global Unrest

Certain geopolitical elements such as societal polarization, income inequality and the inward orientation of countries are spilling over into real-world politics as far as factors contributing to global risks are concerned. There has been a profound shift over the last couple of years where risk trends are having an impact on how economies act and relate to each other. In this article, we attempt to explore the gravity centers that shape financial services, especially in credit risk, through global risks.

Disorders such as cybersecurity threats, rising geopolitical tensions and biodiversity loss in economic organizations have been the pertinent driving forces that influence a nation’s economy. Such conflicts result in a significant decrease of investments, by reducing profitability; thereby, leading to several cascading effects such as:

1. Rising income and economic disparity

  • High levels of personal debt coupled with inadequate savings and pension provisions due to increasing income and wealth disparity
  • Automation and digitalization could plausibly lower the levels of employment & wages, and contribute to the increase in income and wealth at the top of the distribution

2. Domestic and international political tensions

3. Environmental threats

4. Cyber vulnerabilities

5. Prolonged period of historically low interest rates across the world

A recurring theme in popular literature on war is the claim that the prospect of an economic gain motivates small groups of potential profiteers to unleash political violence

Credit rating agencies and the financial meltdown

Credit rating agencies have been profoundly regarded as trusted arbiters of credit-worthiness and the ratings provided by them are considered as vital for risk management. Although, the common narrative has been that the rating values were conceded to the level where the issuers paid for them. The general consensus on the financial crisis was that the major credit rating agencies such as Fitch, Moody’s and Standard & Poor’s partook by assigning whimsically high ratings to mortgage-backed securities, mostly to the upper tranches of Collateralized Debt Obligations (CDO).

Credit rating agencies are singled out for requiring further regulation due to discrepancies in the Dodd-Frank Financial Reform Act. The root causes of the financial crisis attributed many of the failures in financial markets to the point that the major firms and investors relied upon the credit rating agencies from a risk management perspective, without fact checks in place. This view of credit ratings and the firms in the financial system represent a noteworthy turnaround. In the early formative years, the credit rating agencies were viewed as valuable agents in the system, a view that was underscored by the fact that regulators at all levels relied on them to manage risk-taking in markets. Substantial problems with credit ratings arose when government regulation became binding on a large investor class and restricted their possessions of risky assets.

A few statistics on global risks

  • As per the World Economic Forum (WEF) 2018, the focus primarily lies on environmental degradation, cybersecurity breaches, economic strains and geopolitical tensions. Conflicts around the world accounts for about $14 trillion a year for the global economy.
  • The Institute for Economics and Peace estimates that conflict and violence cost $13.6 trillion in 2015. Military spending ($5.6 trillion) and internal security ($4.9 trillion) accounted for more than two-thirds of the year 2016’s cost. Losses from conflict ($1 trillion), crime and interpersonal violence ($2.6 trillion) made up the remainder.

The implications of the above, percolate down to almost everything, particularly in the financial services industry. In addition to dealing with a multitude of isolated issues, globally, we have to constantly battle a growing number of systemic challenges, comprising of fractures and failures affecting the environmental, economic, technological and institutional systems on which our future rests. These global trends underscore the pressing need to develop more state-of-the-art approaches to deal with fragility, conflict and violence.

In countries like Afghanistan, Bangladesh, Burkina Faso, the Democratic Republic of the Congo, Nigeria and Uganda, there are constructive examples of enterprises making a transformation in frontline communities. They are harnessing public-private partnerships and involving the business sectors that are not only making a return on their investment, but also seeking to build stronger communities. It could be said that the growing economic bonds between nations in the form of trade or foreign direct investment could pacify relations, as the opportunity cost of relying on violence increases in line with strengthening commercial ties between these nations.

Cybersecurity risks in an interconnected world

Financial organizations and governments have been the prime targets of cyberattacks. In today’s day and age, with every company doing most of their business online, the threat is universal. In the years 2011 to 2014, energy companies in Canada, Europe, and the United States were attacked by the cyber-espionage group, Dragonfly. Several others like WannaCry ransomware, NotPetya, Meltdown and Spectre wreaked havoc, showing that vulnerabilities are not just limited to software, but to hardware too.

Naturally, financial institutions now consider cyber risk to be the biggest threat to their businesses as it is substantial, and the underlying vectors on which they are borne are changing swiftly. The recent Equifax breach is a great learning for organizations worldwide to take preventive actions in the future from such mishaps.

Organizations must stress upon their IT departments to prioritize changes they favor, such as a sales campaign and detailed reports at the cost of security measures like email encryption and multifactor authentication. They could potentially issue restrictions that come with cybersecurity measures, such as the extra efforts into data-loss prevention, and limitations on the use of third-party vendors in critical areas.

How global risks are interconnected

Political risk affects the bottom-line of business/economics as the international markets are more interconnected than ever before; an issue in one country flows down to other nations rapidly. The world is increasingly dependent on energy in states, troubled by considerable political risk. Global supply versus demand has obstinately been a struggle.

So, what does this mean for financial institutions, investments and assets? With diminishing returns on traditional investments and assets in the developed world, financial institutions are looking forward to the emerging markets for their increased returns. However, the political and economic instability of certain emerging markets means that investors and lenders need to take a cautious approach as today’s emerging market can easily become tomorrow’s failed state. Financial institutions have to be incredibly diligent when investing or lending in these territories to ensure they are not in breach of any sanctions.

Economic and political risk analysis

As global risks are getting progressively multifarious, systemic and cascading, an organization’s response should be integrated across the global systems. Economic risk analysis and political risk analysis address two fundamentally different questions. Economic risk analysis tells corporate leaders whether a particular country can pay its debt while the political risk analysis is concerned if a country will pay back its debt. With emerging markets like China & India, and other politically unstable countries figuring into companies' investment calculations, business leaders are inclined towards political risk analysis to measure the impact of politics on potential markets and minimize risks, to ultimately make the most of global opportunities. Political risk is usually influenced by the passage of laws, the foibles of government leaders, and the rise of popular movements. Such factors (usually hard to quantify) must constantly be pieced together into an ongoing narrative within historical and regional contexts.

Here are some of the strategies that financial institutions could possibly think of employing:

1. Risk analysis using data and analytics:

  • Risk analysis must be employed for a nation’s story as it develops.
  • Political analysis is more subjective and consequently more susceptible to bias than its economic counterpart.
  • Because of their very nature, political risk variables are harder to measure than economic variables. Politics, after all, is influenced by human behaviour and the sudden confluence of events, for which no direct calibrations exist. Different companies and consultancies will have different methods for measuring and presenting stability data.
  • Structural elements highlight long-term underlying conditions that affect stability and function as a baseline for temporal scores, which reflect the bearings of policies, events and developments.
  • Financial institutions can make use of advanced analytics to take preventive action using the temporal scores obtained from historical information.

2. Robotic Process Automation (RPA) to combat fraud and anti-money laundering (AML):

  • Combined with artificial intelligence (AI), RPA can be used to handle unstructured data that supports fraud/AML.
  • RegTech, an aspect of RPA, can help facilitate the delivery of regulatory requirements, thus allowing banks to cope with changes in regulations, efficiently.
  • Digital technology can be used for internal policing to ensure a bank’s highest standards are constantly being met (quality assurance). If banks combined RPA and AI, it can help them to monitor potential fraud, committed by customers or employees.
  • Proactively inform and engage customers in case of a potential foreseeable risk.

3. Counter risk and cyber threats: To strengthen cybersecurity measures, organizations must identify their strengths and weaknesses and establish a new model of governance for empowering the central team to oversee all cyber risk efforts across the enterprise. These programs in turn increase buy-in and speed up implementation, and also lead to substantial cost savings.

4. Regulations to exercise control: The European Union set the European Securities and Markets Authority, in order to keep a closer eye on rating agencies’ conduct. The Dodd-Frank Act of 2010, which instituted a multitude of financial reforms, necessitated the Federal Reserve, Securities and Exchange Commission (SEC) and Wall Street’s main regulator to constrict regulation of the agencies and to reduce references to ratings in their rules for banks and financial institutions.

In the light of the prevailing global unrest, regulatory authorities are accountable for political stability while administering financial markets. Preventing financial crises also means reducing the probability of a political disaster. For leaders of financial institutions, the complementary insights of political and economic risk analysts are indispensable.

Can we overcome these risk trends that are having a negative impact on the economy in the recent future? Share with us your comments at info@mindtree.com

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