Krishan Sharma warns that traditional risk models are failing to capture fast-moving geopolitical shocks. Banks must adopt dynamic stress testing, integrated modeling, and qualitative overlays to better manage rising uncertainty and systemic risk.
Geopolitical risk has moved from the
margins to the center of financial modeling, exposing fundamental weaknesses in
how banks assess and manage risk, according to Krishan Sharma, SVP Model Risk,
Regulatory Stress Testing and Capital Forecasting at Citi.
Sharma argues that the biggest
limitation of traditional models lies in their reliance on historical data and
stable relationships that no longer hold in a rapidly shifting global
environment.
“The fundamental issue is that our
traditional models rely on the assumption of stationarity,” he said, noting
that these models are calibrated on the premise that future conditions will
resemble the past.
That assumption breaks down under
geopolitical stress. Events such as sanctions, trade disruptions, or military
conflict do not behave like standard market shocks. Instead, they fundamentally
alter economic relationships and correlations.
“A geopolitical shock changes the
distribution entirely,” Sharma said, adding that models built on historical
patterns struggle to capture the speed and scale of such disruptions.
One of the most immediate
consequences is a breakdown in diversification. During periods of stress,
correlations across asset classes tend to converge, reducing the effectiveness
of traditional hedging strategies.
Sharma noted that “when a
geopolitical shock hits, the correlation matrix often goes to one,” leaving
portfolios far more exposed than expected.
To address these challenges, Sharma
believes banks must rethink how they approach stress testing. Rather than
focusing solely on the severity of shocks, firms should pay greater attention
to how quickly and persistently those shocks unfold.
“We need to move beyond standard
regulatory exercises which assume a linear degradation of variables,” he said,
emphasizing the need to capture the velocity and persistence of change.
This shift requires more dynamic
scenario design. Sharma highlighted the importance of modeling regime changes,
where relationships between variables shift abruptly.
In a stagflation scenario, for
example, the traditional inverse relationship between equities and bonds may
break down, undermining portfolio diversification.
He also pointed to the growing
importance of reverse stress testing. Instead of asking how portfolios respond
to predefined shocks, banks should work backward from potential failure points.
“We need to ask what geopolitical
event would break our liquidity position,” Sharma said, arguing that this
approach better reflects the unpredictability of current risks.
Another key challenge is capturing
the interconnected nature of geopolitical risks. Tariffs, sanctions, and supply
chain disruptions rarely occur in isolation, yet many models still treat them
as separate factors.
