This time last year, with Covid restrictions lifted in most areas and the global pandemic still visible in the metaphorical rearview mirror, firms were optimistic about the year ahead. But then Russia’s tanks crossed the border with Ukraine, and all hell subsequently broke loose. Tensions between Russia and the West have been almost at breaking point, with thousands killed, a European energy crisis and the threat of nuclear war dragging geopolitical risk into the fore.
The following 12 months exposed the fragility of global systems and the extent to which our civilisation relies upon them, weaponising everyday essentials such as gas and food and fracturing global political relations. “We’ve shifted into a disordered multipolar world where everything is a weapon: energy, data, infrastructure, migration,” EU foreign policy chief Josep Borrell said in December. “Geopolitics is the vital word, everything is geopolitics.”
Russian sanctions: the current situation
As political relations between Russia and the West, and also the US and China become increasingly strained, curbs put in place to limit trade and financial transactions with these countries are also increasing. Since Russia invaded Ukraine 12 months ago, the list of sanctioned entities has grown steadily. According to the Economist Intelligence Unit (EIU) 131 countries currently oppose Russia’s invasion of Ukraine, including several historically ‘neutral’ countries such as Switzerland, Sweden and Finland. “The countries opposing Russia account for only 36% of the world’s population,” says the EIU. “Around two-thirds of people live in countries whose governments are either neutral or Russian-leaning. China and India, which together account for around one-third of the global population, skew the results. The Chinese government, classified as Russia-leaning by the EIU, has avoided direct condemnation of Mr Putin’s actions and is unlikely to stand with the West. India’s government, classed as neutral, has increased its engagement with the Russian government.”
Beijing is seen by many as a supporter of Moscow, but has so far avoided making any specific moves that could deepen divisions between China and the West. The Chinese government is trying to position itself as a neutral actor that could help negotiate peace in Ukraine, however a top Chinese diplomat, Wang Yi recently said its relationship with Russia is “rock solid,” further fuelling sentiments that it is Russia-leaning.
Pick a side: US/Europe vs China/Russia
Why do we find ourselves in such a politically divided world? “The tendency for the world to fragment dates to before the [second world] war,” says Economist, author and global forecasting director of the EIU, Agathe Demarais, “but there has been a double shock of pandemic, then war, which accelerated it.” A recent poll by the European Council on Foreign Relations (ECFR) suggests that conflict in the Ukraine has helped consolidate the notion of “The West”, with European and American citizens sharing many views on global issues. “Europeans and Americans agree they should help Ukraine to win, that Russia is their avowed adversary, and that the coming global order will most likely be defined by two blocs led respectively by the US and China,” says the ECFR. In contrast, citizens in China, India, and Turkey are more inclined to support a quick end to the war even if Ukraine had to surrender their territory to the Russians.
“Russia isn’t in a position to negotiate with China, which will take whatever it wants from Russia without giving Russia what it wants,” says Demarais. “There are clearly two blocs, one American, one Chinese along with its allies and Russia. Will Europe become a third bloc or not, or will it be aligned with the Americans?”
Prioritising geopolitical risk
The Chartered Institute of Internal Auditors (CIIA) and Airmic have published a report providing advice for businesses on navigating geopolitical risk. The report warns that geopolitical risk is set to worsen and urges firms to break down silos between boards, internal audit and risk management in order to have a clearer, more realistic view of the actual risks presented by geopolitical events. “Geopolitical risk is a strategic risk that does not sit in a silo and should not be viewed as a standalone risk,” it says. “In our increasingly interconnected world, geopolitical events exacerbate and interlink with existing business-critical risks. For example, supply chains, cybersecurity, legal and compliance, reputation, and financial stability.”
Geopolitical risk has been ranked highly by senior executives in annual risk surveys for several years, however according to the CIIA’s research, it is the risk that internal audit spends the least time auditing. Addressing this disparity might involve awkward conversations, says the ICAEW (Institute of Chartered Accountants in England and Wales). “Internal audit and risk professionals must speak up and say the unthinkable on geopolitical risk and potential scenarios: they should do this even if this risks them being unpopular with the board. The bigger risk is of senior management or the board turning around and saying: ‘Why didn’t anyone see this coming?’.”
Firms must also think about what is at the core of geopolitical risk, i.e. human decision making. “With Russia’s invasion of Ukraine happening on the back of the pandemic, there is the danger of organisations making long lists of all the things that could possibly go wrong in geopolitics,” says the CIIA report. “But geopolitics is not a game of predicting the future. Some political observers have been chided for advising organisations that Russia had no rationale to invade Ukraine, but geopolitics is predicated on human behaviour – of leaders and citizens – which does not always go to script.”
For firms, the conflict in Ukraine provides both regulatory and operational challenges, particularly for banks with actual physical branches or offices based in Ukraine. The Ukrainian government has taken measures to keep its banking system working under martial law and the country’s central bank is optimistic. “The banking system was strong and operated with no functional limitations during the whole war [last year], regardless of very big ground and air operations,” said Governor of the National Bank of Ukraine, Andriy Pyshnyy. “We stopped the outflow of capital, implemented a fixed exchange rate, and took several other necessary anti-crisis measures. And almost all banks – not only systematically important banks – continued operations. This is a big advantage for Ukraine.”
The central bank is currently working on a project known as Power Banking. “This includes the creation of one network of branches of systematically important banks in Ukraine,” explained Pyshnyy. “We are talking about over 1,000 branches in 200 cities and villages. These branches are expected to function as one network. We are developing operational solutions to support this network, even under blackout conditions, with backup electricity, connectivity, and cash. Nothing comparable has ever been implemented anywhere in the world.” The Ukrainian banking system is currently working with some administrative restrictions, including on capital flows, which had to be implemented to ensure macroeconomic stability. “As the economy recovers, we will review all these processes and go back to market mechanisms,” says Pyshnyy. International banks operating in Ukraine include Deutsche Bank, ING and Crédit Agricole, among others.
Exiting Russia: the cost
Exiting Russia does not come without challenges. HSBC recently announced it will take a loss of US$300m on the sale of its Russian business, which it plans to sell to local lender, Expobank. The deal is still pending regulatory approval, which may never come – Deputy Finance Minister Alexei Moiseev said last year Russia would block the sale of foreign banks’ Russian businesses until Russian banks abroad were able to function properly. Many other European banks have reported heavy losses from exiting Russia. “The few western lenders that retain a significant presence in the country – most notably Austria’s Raiffeisen Bank International AG and Italy’s UniCredit SpA – are attracting increased regulatory scrutiny and facing criticism that their operations are indirectly supporting the war effort,” said S&P Global Market Intelligence in a recent report on the topic. “Meanwhile, Russia’s weakening economy and ostracisation on the global stage has negatively impacted domestic banks’ profits and diminished their regional presence. Sberbank of Russia and VTB Bank PJSC, once two of Europe’s largest banks by assets, have been forced to withdraw from neighbouring European markets such as Hungary, Croatia and Serbia amid an increasing package of global sanctions.”
China and Taiwan: lessons learned from Ukraine
When Russia invaded Ukraine, suddenly the threat of China taking military action in its claim for Taiwan as Chinese territory became very real. There is also growing tension between the US and China over the freedom of navigation in the South China Sea, worsened by the presence of several Chinese “spy balloons” seen in the US, with one very recently shot down off the coast of South Carolina.
For businesses, the most immediate threat is that of sanctions. In a case study included in the CIIA/Airmic report, an anonymous organisation said their biggest concern was that sanctions on China would be even more impactful than the sanctions on Russia. “The UK’s sanctions regime on Russia during the Ukraine crisis has gone beyond what we have ever seen, in terms of how deeply the professional services sector has been drawn into that,” they said. “We worry about how much more far-reaching the impact would be of such a sanctions regime potentially applied to China.”
There is also the complicated issue of whether firms should withdraw all activities from a region that is viewed by the West as hostile because it’s the “right thing to do” from a reputational viewpoint. The Airmic report gave the following example: “A mining company exited China because it wanted to ‘do the right thing’ in view of reports about China’s human rights violations, among other issues. However, its credit rating was subsequently downgraded by the international rating agencies, because of how its financial outlook worsened as a result of exiting the lucrative China market.” China’s integration with the global economy is far more ingrained than Russia’s was, so the impact of exiting the region would be considerably greater.
War: an opportunity for criminals
We’ve already witnessed a significant increase in ransomware cases with origins in Russia. This type of cyber warfare is a particular cause for concern for the banking sector because it is such an enticing target for cybercriminals. The pandemic exposed weaknesses in network security in all sectors as the world quickly adopted remote working as the norm and cyber gangs, including state-sponsored actors, moved quickly to take advantage of those weaknesses.
Cyber attacks in Ukraine itself tripled last year and as of January 2023, Ukraine had registered more than 5000 cyber-attacks on state institutions and critical infrastructure since 2014 when the Ukrainian peninsula of Crimea was illegally annexed by Russia.
For firms to remain resilient in the face of this growing threat, they need to understand their true vulnerability – and that being geographically removed from a conflict does not eliminate exposure, particularly in a digital world. Talking to Cybercrime Magazine, EY partner Neal Pollard, an expert in cyber security and cyber conflict said “there’s been talk for a long time about cyber being another battle space… and there’s an expectation that as countries go to war, that cyber will be part of that conflict.” Pollard highlights the extent of the exposure of the world to global cyber-related risks, with the World Economic Forum estimating 70% of new value created in the economy over the next 10 years will come from digitally enabled platform business models. The way businesses must address this risk is to better understand the human behaviour behind cyberattacks, which is something organisations are getting better at doing, argues Pollard. “With the creation of cyber threat intelligence as a discipline, larger corporate programs have cyber threat intelligence programs so that engineers understand that you’re not fighting robots; you’re fighting criminals – humans behind keyboards. And that should help inform your defences,” he says.
Financial institutions also need to be mindful of sanctioned individuals looking for ways to bypass curbs on their deposits. The US Financial Crimes Enforcement Network (FinCEN) has recently warned US banks to look out for Russian oligarchs using the commercial real estate market to circumvent sanctions: “Commercial real estate transactions routinely involve highly complex financing methods and opaque ownership structures that diminish transparency in a way that can allow bad actors to hide illicit funds in commercial real estate investments,” it said in a statement. “Additionally, the relative stability of the US commercial real estate market and the high value of commercial real estate properties can provide illicit actors with a way to generate a steady income and store large amounts of wealth.”
Risks to physical assets: recovering leased assets in sanctioned countries
Aircraft leasing companies based in Europe who supply planes to Russia have been facing huge challenges with recovering planes located in the region since the invasion of Ukraine.
The estimated value of aviation assets currently in Russia stands at an estimated US$5bn. European sanctions prevent the sale, transfer, supply or export of aircraft or aircraft components to Russia. Leased aircraft are categorised as “supply” and therefore must be removed from Russia by the end of March 2023, according to latest sanctions. “If those lessors are given only one month to terminate leases and recover the aircraft from the customers to a storage location outside of Russia, that will be a significant logistical challenge perhaps made even greater, if not impossible, by the increasing airspace restrictions,” Rob Morris, head of consultancy at Ascend by Cirium, told the Financial Times.
Aviation insurance underwriters are dealing with billions of dollars worth of claims from aircraft lessors with planes stranded in Russia. Several insurers are facing lawsuits from aviation companies looking to claim for assets they have been unable to retrieve from Russia due to airspace restrictions. This has been a shock for underwriters as this would historically have been a very small part of their business, but could now result in huge losses.
According to S&P Global Market Intelligence, insurers are struggling to calculate the true cost of the Ukraine war a year after the conflict started. “Exposures far removed from the war itself have been unearthed, while insurers are unable to count the cost of claims across their political risk, marine and aviation business lines. Those covered by the political violence market, such as physical damage to buildings, are also proving difficult to quantify.” says S&P. The challenge insurers face is resolving a claim when clients aren’t able to retrieve their assets and a loss adjuster cannot be sent to assess the physical damages in-person.
S&P says in the fourth quarter of 2022, Lancashire Holdings increased its provision for potential losses to US$65.8m after setting aside US$22m for direct claims in the first quarter. Swiss Re AG increased its Ukraine war reserve across its property and casualty reinsurance and large global commercial insurance businesses to US$334m, up from US$283m in the first quarter.
Aviation lessors will be looking at other areas of potential geopolitical risks in response to the impact of the Ukraine conflict and applying appropriate caution. “Clearly the tension between the US and China is a point of key focus and concern,” John Plueger, chief executive of Air Lease Corp told the Airline Economics conference in January. He also said there was “much more” concern in the aviation industry about the impact of geopolitical risk. “China and Taiwan are very active markets for us. Would I be willing to do 200 more airplanes tomorrow in China or Taiwan? Hmmm I’m not so sure about that,” Plueger added. “It’s going to have long lasting impacts beyond when this is settled,” said Robert Korn, president and co-founder of Carlyle Aviation Partners at the same conference, citing “significant changes” to the availability of insurance. “It’s going to take quite a long time for financiers, for lessors, for institutions to truly feel comfortable returning to many of these places.”
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