The National People’s Congress’ recent draft decision to impose a national security law on Hong Kong to target secession, subversion of state power, terrorism activities and foreign interference caught most in the former British colony off guard. Amidst signalling that the ‘one country, two systems’ doctrine had been prematurely eroded 27 years too soon, it required financial institutions to take a stand in a show of support. Yet, the bigger surprise arguably materialised when HSBC, Britain’s (and Europe’s) largest bank publicly backed the move in what Lisa Nandy MP (Shadow Foreign Secretary, UK Labour Party) described as 'morally abhorrent'. With Standard Chartered following suit, HSBC subsequently warned Downing Street that it feared reprisals should the UK proceed to ban Huawei from participating in its 5G network.

While it is convenient to compartmentalise these disputes to the realm of geopolitics, such moves have broader implications for financial regulators. In this respect, this post argues that regulators must confront the consequences of a normative shift away from the preceding age of globalisation to one that recognises how increasingly exogenous political risks from the Sino-British decoupling threaten domestic financial stability.

To understand political risk, we must firstly distil the ‘pragmatic necessities’ of operating in China. In this respect, despite the media’s response in condemning HSBC’s pledge of support for its moral misalignment, it is nevertheless arguable that HSBC was coerced into doing so by calls from senior Communist Party officials, including the former Chief Executive of Hong Kong, to ‘boycott’ the bank. In balancing this threat against a reciprocal call from Hong Kong Pro-Democracy protesters to ‘initiate a bank run’, HSBC arguably took the side of the Chinese government in a gamble that the overwhelming coordination costs facing protesters would prevent them from credibly delivering on this threat. Accordingly, focusing on what some term the ‘moral repugnancy’ of such moves inherently misunderstands the need for pragmatism amongst foreign banks operating in China as an implicit condition of its license, and thereby fallaciously extrapolates the luxury of political discretion enjoyed by its Western affiliates.

While such political risks have predominantly been borne by bank creditors and shareholders thus far, lessons from Hong Kong demonstrate how political misalignment may cause the transmission of contagion. In this regard, China’s latest move arguably sets a precedent for nations to use an adversary’s banks as a tool in its foreign policy. Moreover, in downgrading HSBC China’s outlook in December 2019, Moody’s alluded to the increasing potential for political risks to ‘negatively impact the bank’ which required ‘higher levels of affiliate support’ from its UK-headquartered parent. Accordingly, while such support has been willingly provided thus far, it would be naïve to dismiss the potential for the transmission of financial risk to its Western-incorporated parent as irrelevant given the the prevalence of direct and indirect linkages.

Moreover, this is not to say that the move will not bear other private consequences. Only days after its declaration, Aviva Investors’ Chief Investment Officer publicly rebuked the pledge in a call for asset managers to reconsider investment strategies in politically misaligned institutions. To the extent that asset managers increasingly employ their discretion to deploy capital alongside their own political views, this has the direct potential to materially impact the volume of equity investment in banks such as HSBC and may consequently have direct implications on its cost of capital. 

However, it is important to recognise how this development can be distinguished from HSBC’s prior operation in China as the rate of political decoupling accelerates. In this respect, although HSBC has been able to endogenously mitigate political risks thus far by appeasing China’s political views, this latest rebuke in respect to Huawei signalled China’s willingness to penalise British banks for Downing Street’s failure to ‘fall in line’. In doing so, British banks can no longer pragmatically mitigate political risks as these become increasingly exogenous and dependent on Downing Street’s hawkish China policy.

The challenges this places before financial regulators are novel insofar as the recognition of political risks requires them to tailor regulation alongside foreign policy and intrinsically uncertain geopolitical developments. Moreover, predicting the likely countermeasures China may take against banks such as HSBC and tailoring responses to these risks ex ante may prove futile given the myriad of potential measures China has at its disposal. Accordingly, a surgical solution to address the manifestation of political risk remains too targeted given the number of possible states of the world and the inherent complexity in identifying causally relevant data to circumstantially prepare for each eventuality. Rather, it is arguable that an appropriate regulatory strategy must holistically address the channels for risk transmission and the ability for a UK-domiciled parent to withstand such shocks. Nevertheless, it is conceded that even these measures may be inadequate given the dynamism and unpredictability of various actors. In this regard, the Trump Administration’s latest threat to revoke China’s access to the SWIFT international payments messaging system would likely send significant shockwaves through the financial system that would exhaust the current loss-absorbing capacity of most Chinese-based foreign banks multiple-fold.

However, a crude extrapolation of the precautionary principle suggests that the solution is not to prepare for the worst. To the extent that such risks do not materialise, disproportionate regulatory strategies may prove wasteful in impeding a bank’s transformative functions and thereby undermine its welfare-enhancing functions. Rather, regulators must make sufficient appropriations for political risks through risk-weighted measures that factor in the probability of occurrence. While the challenges in quantiying political risks in the intrinsically uncertain world of geopolitics are formidable, the existing regulatory infrastructure under Basel III is pertinently suited for the incorporation of political risk. In this regard, political risk could be eiher accounted for as an additional component of operating risk or explicitly included under G-SIB classifications as a component of ‘cross jurisdictional activity’. Accordingly, by keeping dynamically appraised of such developments, regulators may better calibrate capital buffers to withstand shocks to the value of a bank’s assets exposed to deteriorating geopolitical conditions.

Nevertheless, many questions remain unanswered with respect to whether such tools are pertinent to mitigate political risk. What is clear is that financial regulators can no longer assume that political risks pose negligible threats that banks can endogenously mitigate. Rather, financial regulators must be proactive in recognising the incumbent challenges of a shifting geopolitical landscape and respond accordingly.

Pranaav Devnani is a candidate for the MSc in Law and Finance at the University of Oxford.