Financial instability in Europe:Does geopolitical risk from proximate countries and trading partners matter?

Using a spatial econometric approach, we measure 28 European countries' foreign geopolitical risks (GPR) from their proximate countries, export destinations, and import origins from January 1985 to January 2024 at a monthly frequency. Based on difference GMM estimation on dynamic panel data model, we find that the foreign GPRs increase Europe's financial instability through potential channels of surging energy inflation and capital flight to the U.S. Compared with high-income countries with a bank-based financial system, low-income countries with a market-based financial system are more fragile to the foreign GPRs. These findings can help European financial authorities improve prudential regulation policies.