Structural model maps geopolitical shocks across bank balance sheets
A Banca d'Italia paper adapts the Merton structural framework to quantify how geopolitical uncertainty transmits across bank balance sheets. The study shows shocks propagate through existing credit and liquidity channels rather than isolated risk silos.
Adapting Merton to banking dynamics
The paper introduces an adapted contingent claims model incorporating asset heterogeneity, liability run-off dynamics, and endogenous funding costs tied to asset quality.
Total payouts remain proportional to assets, decomposing into redemptions, interest, and residual dividends.
In simulated stress from baseline to severe geopolitical tension, distance to default for a stylized less significant institution falls from 2.51 to 1.73, pushing the physical default probability from 0.60 percent to 4.14 percent.
For significant institutions, higher wholesale exposure and securities volatility reduce distance to default from 2.97 to 1.89, driving default probability to 2.93 percent.
Indirect contagion across smaller lenders
Italian supervisory data from the 2025 SREP cycle covering approximately 100 less significant institutions highlights that smaller lenders face higher average capital demand than larger banks for the third consecutive year.
Credit and interest rate risk add-ons represent over 90 percent of aggregate Pillar 2 requirements.
While significant institutions absorb shocks via wholesale markets, smaller banks suffer indirectly through domestic borrower strain and third-party operational dependencies.
No need for a new risk silo
The paper rightly rejects dedicated capital buffers by proving geopolitical stress transmits via established risks.
However, structural calibrations cannot fully compensate for blind spots in domestic supply-chain dependencies.
Supervisors need rigorous reverse stress testing rather than relying on generic Pillar 2 add-ons.