War in Europe: the financial front
Russia is reeling from massive financial sanctions, while Ukraine’s financial system is battered but remains functional, and the EU and global financial systems have rather easily absorbed the initial shock.
Financial sanctions against Russia since its invasion of Ukraine began on 24 February have included three main planks. First, sanctions against named Russian individuals have expanded dramatically. Second, a series of sanctions has been imposed on individual Russian banks. These include – but are far from limited to – the much-hyped ability of the European Union to require disconnection of individual Russian banks from SWIFT, the international interbank messaging system which is based in Belgium and thus under EU jurisdiction. Third, the Bank of Russia, the country’s central bank, has been blocked from using its international reserves in a number of jurisdictions. Critically, these include the United States, the EU, United Kingdom, Canada, Japan, Australia and Switzerland – in other words, all the world’s core reserve-currency jurisdictions bar China (China’s share of the world’s aggregate central bank foreign reserves remains in the low single digits, even though its share of the Bank of Russia’s reserves is significantly higher).
This third action, targeting the Bank of Russia, unambiguously counts as systemic and affects the entire Russian financial system and economy, starting with the ongoing slide in the value of the ruble. The first action is about individuals. The second occupies a middle ground: if only a relatively small share of Russian banks are affected, it is non-systemic, but if most are, it becomes systemic. From that standpoint, the EU’s ‘de-SWIFTing’ actions are still non-systemic, since only seven institutions representing about a quarter of the Russian banking system are on the latest list. More could follow, however. In addition to these governmental decisions, some key financial firms are on their own initiative restricting their Russian services, such as VISA and MasterCard, adding to the general disruption.
The impact on Russia’s currency and economy of the systemic sanctions targeted at the Bank of Russia is devastating, in part because they were so unexpected, and despite the continued ability of Russia to achieve a current-account surplus as long as it keeps exporting hydrocarbons. In the past, the United States has sanctioned other central banks (for example, Venezuela and Iran in 2019). What has never happened before, however, is coordinated action by all Group of Seven (G7) jurisdictions against a central bank, let alone one as large and internationally active as the Bank of Russia.
In fact, none of the 63 central banks that are members of the Bank for International Settlements (BIS) in Basel has ever been the target of financial sanctions. The Bank of Russia is not only a member of the BIS club but also of its more exclusive subsets, eg the Financial Stability Board or the Basel Committee on Banking Supervision. It was hard to anticipate that it could be blackballed so promptly. Astonishingly for observers of the ostensibly soft-spoken, consensus-driven central banking community, the BIS announced on 28 February that it would itself follow sanctions “as applicable”, which was widely understood as alignment with the G7 stance. This has no precedent since the establishment of the BIS in 1931, not even during the Second World War.
In recent years, the Bank of Russia diversified its international reserves away from dollars and sterling, but largely into euros (as well as renminbi and gold). In other words, it appears that the scenario that unfolded on 26 February did not feature on the risk map that underpinned the build-up of financial “Fortress Russia” since the invasion of Crimea in 2014. In hindsight, this was a clear miscalculation by the Bank of Russia’s otherwise highly competent governor and her team.
Ukraine, by contrast, is being devastated physically by the Russian military aggression, but is still very much standing financially. On 1 March, the Ukrainian government issued $270 million in war bonds; since 24 February, the country’s central bank has benefited from a swap line of the National Bank of Poland, granting it a degree of access to international liquidity. More assistance could come in the future from the International Monetary Fund, and possibly also in the form of a swap line from the European Central Bank, though the latter is far from sure at the time of writing. In the war zones, of course, financial services are disrupted, as is everything else.
In the European Union, the initial shock has already been largely absorbed by the safety cushions created since the previous great financial crisis: thank goodness for Basel III. The presence of Russian banks in the EU is being promptly terminated in an orderly manner. The largest such entity, Sberbank Europe AG in Austria, was liquidated in the immediate aftermath of the invasion after its Russian parent decided not to give it liquidity support. The second-largest, VTB Bank (Europe) SE in Germany, is likely to go the same way. On the other side of the divide, several EU banks, most prominently including Raiffeisen, Société Générale and UniCredit, have substantial operations in Russia and other financial exposures to its economy. Their stock prices have suffered, but have not collapsed, and it appears currently that their capital bases are sufficient to absorb the shock. Unexpected damage could surely pop up in other corners of the system. But that risk does not currently appear large enough to threaten financial stability at a systemic level.
What happens next is, of course, anyone’s guess, and will keep depending on military developments. Further financial sanctions are possible. For example, the EU could de-SWIFT more Russian banks, possibly including Sberbank which is already subject to harsh US sanctions in the form of a correspondent accounts cut-off that prohibits it from clearing payments through the United States. The EU could also sanction Russian banks more strongly, for example by banning all transactions with them and freezing their assets (full ‘blocking’ sanctions), as the US already does, for example with VTB. Perhaps most important, pro-Ukraine jurisdictions could move towards banning energy purchases from Russia, which are currently allowed under financial sanctions regimes.
On a more long-term, structural basis, only time will tell if the recent action against Russia has contributed to strengthening the international financial system, by punishing destructive behaviour, or will fragment it into increasingly decoupled competing blocks. It bears noting, once again, that the recent financial sanctions have been far from unilateral, but on the contrary have been adopted, certainly with local variations, by an extremely wide group of financial jurisdictions that goes beyond ‘the West’. Russia’s transgression of international norms is so radical that it remains to be seen to what extent the international response to it, radical as it has been, will set a precedent.
Kirschenbaum, J. and N. Véron (2022) ‘War in Europe: the financial front’, Bruegel Blog, 7 March
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