Back in January, a guy on Reddit laid out a cunning plan to bring down his local bank. His plan was “to withdraw cash like 100$ from them and deposit it with a different bank then transfer it back to them and withdraw the same 100$ until they run out of physical cash… This in turn should cause a bank run… I would love for this bank to go out of business or lose public trust.”

Fortunately, others knew better and cautioned him in the comments not to embark on such a fruitless endeavour. They explained that he could withdraw as much cash as he liked from the bank’s ATM, but by wiring it back in, he wasn’t inflicting the kind of liquidity damage his plan maintained. His wires would simply flow into the bank’s electronic reserves, which the bank is eligible to swap for cash at the Federal Reserve. As a means of causing the bank to “lose public trust”, Reddit guy’s plan was ill-conceived. 

None of this is to say it’s impossible to break public trust in a bank from the outside. On a much bigger scale, and via different means, that is what’s being attempted in Russia right now. Up until recently, Russian banks had a market cap an order of magnitude bigger than the 2 billion dollars Reddit guy was squaring up. But, very quickly, that has evaporated. 

We talked about financial sanctions last week from a theoretical standpoint. This week, I want to discuss how they percolate through a financial system. Events are unfolding so rapidly that I start by recapping what the financial sanctions actually are – as much for my own benefit as yours. If you’ve been doom-scrolling as much as I have over the course of the past week, feel free to skip the first section and jump straight to the bit about banks. Or if you’ve looking for something not related to Ukraine to read, paid subscribers can skip to More Net Interest at the end for detailed analysis on Klarna, Goldman Sachs and car financing.

As for Reddit guy, these are scenes he can only dream about:

Financial Warfare

Before events unfolded this past week, a cyber attack was the chief extraneous risk occupying financial regulators’ minds. Ironically, given that Russia industrialised cyber attacks, its own central bankers raised concerns about the threat in their latest Financial Stability Report: “Cyberthreats are becoming more common as financial technologies advance. Cyberattacks can have serious consequences for financial stability if they affect systemically important financial institutions or critical areas of market infrastructure. In such case, erosion of trust can lead to liquidity problems, and banks may face an outflow of deposits.”

Their concern was misplaced. Rather than cyber, the West has used the apparatus of global financial interconnectedness to destabilise Russian banks. The tools emerged in the aftermath of 9/11 when US policy makers escalated their fight against terrorists, rogue regimes and other illicit financial players. Juan Zarate, who was part of a team in the US Treasury Department, was instrumental in crafting them. “Finding the soft financial underbelly of our country’s enemies became our mission,” he writes in his book, Treasury’s War. 

The most important insight Zarate and his team had was in the need to recruit banks to act as enforcers. “In Treasury, we realised that private-sector actors – most importantly, the banks – could drive the isolation of rogue entities more effectively than governments – based principally on their own interests and desires to avoid unnecessary business and reputational risk.” After the financial crisis, their leverage depleted, banks were mobilised more extensively. Nevertheless, even then, this new kind of war was more like a “creeping financial insurgency.” 

Events this week show Zarate’s tools can also be used to “shock and awe”.

In the first wave of financial sanctions, Russian banks were shut out of the correspondent banking system for US dollar transactions. The US Treasury gave notice that certain Russian banks would have 30 days to close their accounts at US correspondent banks. Given that most global trade is conducted in US dollars, blocking Russian banks’ access is a serious sanction. Even though the US accounts for only 10% of world trade and 15% of global GDP, the US dollar accounts for 50% of global trade invoices and countries making up 70% of global GDP use the US dollar as an anchor currency. 

Since that first wave, sanctions have been ramped up.

The global messaging network SWIFT announced that it will disconnect seven Russian banks at the end of next week in accordance with a European Union Council directive. As discussed last week, excluding banks from messaging others via SWIFT is a less debilitating sanction than excluding them from making US dollar payments, but kicking them out serves two purposes. First, from a history of obscurity, SWIFT rapidly developed totemic significance – excluding Russia from a ‘club’ of 200 countries has broad public appeal and sends out a very visible signal. Second, excluding them impacts the affected banks’ ability to transact globally, not just with banks in those countries leading sanctions. Just as the US has power to influence who uses the US dollar around the world, the European Union has power to influence who uses SWIFT, since the organisation is subject to Belgian law. The combination of the two is especially potent. 

The caveat is that it is just seven banks being disconnected, out of the 291 Russian members of SWIFT, and two of the largest banks, Sberbank and Gazprombank, are not included. The reason is that these banks process a lot of the energy payments that are flowing to Russia and so far none of the sanctions apply to energy. Indeed, this week the US Treasury reiterated its energy carve-out: “Treasury remains committed to permitting energy-related payments – ranging from production to consumption for a wide array of energy sources – involving specified sanctioned Russian banks.” As we highlighted last week, the US Treasury even published a helpful guide explaining how banks could process payments for Russian energy imports without contravening sanctions. 

Nevertheless, even with this carve-out, it seems that foreign importers are shunning Russian energy supplies, despite the discount at which they are being offered. Some financial institutions are taking a super cautious approach, refusing to finance any Russia-related transactions. Companies, too, have shown reluctance to purchase Russian oil as they exercise “self sanctioning”. It’s not unusual for government policy objectives to be magnified as they hit the real economy. Central bankers take advantage of this through the forward guidance they provide around interest rates, seeking to influence market behaviour by direction.

But this degree of self sanctioning seems somewhat of a surprise. It could be that banks’ caution is exacerbated by the fines meted out in the past for breaches of sanction regulations (BNP Paribas was fined $8.9 billion in 2015, the largest penalty ever imposed in the US in a criminal case); or it could be that Russia has become such a pariah that companies want to go further than government guidance dictates. In both cases, banks and energy importers may simply be getting ahead of an anticipated eventual ban on Russian fuel imports.

Perhaps the most devastating sanction to be imposed was on the Central Bank of Russia (CBR). Since its Crimea invasion in 2014, Russia had sought to shore up its finances by accumulating an arsenal of foreign exchange reserves. These reserves – $643 billion in total, as at mid-February – were there to protect against shocks from the outside. The clearest potential shock was to the currency. An uncontrollable devaluation of the ruble would cause Russia’s import bill – denominated in foreign currency – to surge, wreaking havoc on consumers who buy foreign goods. Russia’s $643 billion of reserves gave it room to cover its import bill for years; by selling foreign currency in the market to buy rubles – as it did during the first two days of its war on Ukraine – it had capacity to prop up the value of its currency. 

But then central banks around the world froze the Central Bank of Russia’s assets. Russia’s perceived strength – its hoard of financial assets abroad – became its Achilles heel. In a coordinated move, the US, European Union, UK and Canada prohibited transactions related to the management of reserves and assets of the Central Bank of Russia. The move was a surprise because it was largely unprecedented. Although the Central Bank had begun diversifying away from US dollars, it maintained a lot of Euro exposure, and so these sanctions will bite. They essentially freeze around two thirds of the Central Bank’s reserves, with most of the rest comprising gold which it’s not obvious who will buy. 

The impact on the ruble exchange rate was immediate. The ruble collapsed in value from 83 to the US dollar to 122 after the sanction was unveiled. To cushion the fall, the Central Bank was forced to draft exporters into acting as currency stabilisation agents in its place, requiring them to sell 80% of their foreign exchange receipts for rubles. Although self-sanctioning may have slowed the flow of energy exports from Russia, volumes remain high and, with energy prices elevated, hefty foreign exchange payments still flow into Russia. The European Union is currently paying Russia nearly €700 million a day for natural gas, so the mandatory FX sales can add up quickly, supporting the ruble from falling further.

Some people have raised concerns about the long term implications of deploying this sanction. They argue that by using “shock and awe”, it ceases to be a deterrent, prompting governments to diversify away from dollars. The problem is that there are few other capital markets as deep to invest reserves. More importantly on this occasion, it was less the centrality of the US dollar that made the sanction so potent and more the coordination of large parts of the rest of the world. 

Meanwhile, more and more sanctions have piled up on Russia over the course of the past week. The European Union banned the transfer of euro banknotes to Russia (notwithstanding there are fewer air routes to fly them in). The London Stock Exchange announced the suspension of Russian shares listed on its market. Index provider MSCI announced it will remove Russian equities from its market indices next week on the basis that Russian assets have become un-investable. The overall level of uncertainty makes banking in Russia very difficult and they are beginning to feel it. 

Russian Targets

As they closed their books on 2021, Russia’s banks were sitting strong. Just before Christmas, the country’s largest bank, Sberbank, hosted an investor day. Its management team boasted of “record profits” and “improved resilience against macro shocks”; they even outlined a fresh new digital oriented strategy. For the month of January (yes, Russian banks disclose monthly earnings data) Sberbank reported a net profit of RUB100.2 billion, equivalent to a return on equity of 22.1% – a pretty good return for a bank. When it announced that result, Sberbank’s stock price in London was $13.60.¹

Three weeks later, the stock is at zero. By itself, that doesn’t reflect the whole picture. A stock price reflects a balance between buyers and sellers, and in Sberbank’s case there are no buyers – the London Stock Exchanges banned trading in its shares and the Moscow Exchange is shut. 

But the impact of sanctions is also evident on the banks’ operations. 

The last time a bank was shut out of the US correspondent banking system, it was bust within a week. In February 2018, the third largest bank in Latvia, ABLV, was accused by the US Treasury of money laundering and was prohibited from opening or maintaining correspondent bank accounts in the US, effectively removing its ability to transact in US dollars. Given its business model revolved around moving dirty money around the world, denying it access to the world’s reserve currency was a major blow. A bank run immediately followed, leading to a liquidity squeeze. The European Central Bank had to step in to wind the bank up. 

The episode gave the European Central Bank a preview of what was in store. This week, as soon as Russian sanctions were announced, Sberbank’s European subsidiary suffered a run. Even though Sberbank was given 30 days to sever its correspondent banking ties, the signalling was sufficient for customers in Austria and elsewhere to log in and pull out their local currency deposits. By Monday, the bank admitted that it had “experienced a significant outflow of customer deposits within a very short period of time.” At the end of 2020, there were €10 billion of deposits in there; a large proportion wanted out at the same time and the bank didn’t have liquidity to fund them. European authorities intervened and diced the bank up – Croatian and Slovenian parts were transferred to stronger local banks; Austrian, Czech and Hungarian parts were put into wind-down. While €913 million of deposits in Austria are covered by deposit insurance, some larger depositors will be left out of pocket. 

In Russia itself, the impact is playing out more slowly. Historically, lots of Russian bank deposits were dollar-denominated as corporations booked trade in US dollars and retail consumers just preferred the stability of the US dollar. But that has reduced over the past several years. At the end of last year, around a third of corporate deposits were held in foreign currency, down from just under a half at the end of 2015; in the consumer segment, foreign exchange deposits make up around 20% of the total, down from 30% six years earlier. Nevertheless, the numbers are still high. In total, Russians held just over $270 billion of foreign currency in banks – mostly US dollars – as at the end of January. The problem, according to the CEO of Tinkoff, is that there are not enough physical dollars in the system. “Right now,” he says, “we have no restrictions, but obviously the Central Bank is thinking about whether restrictions should be imposed across the system for cash withdrawals.”²

On the ruble side, Russian officials have already put in place stringent controls. One of their first actions was to hike interest rates up to 20% from 9.5%. But – as the pictures of lines forming outside ATMs testify – the demand for cash is high.

The impact on the banks is material. Higher rates will squeeze their margins. They will also squeeze borrowers who may be forced to default as debt servicing costs mount. A bill has been submitted to the State Duma reprising a Covid initiative that gives borrowers a credit holiday, but it won’t shield them from higher mortgage payments.

It will take time, but Russian banks will struggle to cope. Banks can go bust quickly via a liquidity squeeze (like ABLV and Sberbank Europe) or they can go bust slowly by running out of capital, as credit losses mount and earnings decline. Some Russian banks are state-owned, and so the state will take the strain. But as a means of inflicting economic pain, targeting the banking system is a good place to aim. The world learned that accidentally during the global financial crisis, and many European countries learned it again several years later.

Several of you have asked how my friend, whom I stayed with in Kyiv a few years ago, is getting on. He is safe (for now) with his family on the western edge of Ukraine, away from the main cities. He wrote to me: “In one second your head became full of pictures of what refugees are faced to. It was like a movie, as if what happens in happening not with you… From the person who had income, country, home I became a refugee.” His parents are in a more precarious position, in the besieged city of Mariupol in the south east of the country, without electricity, water or mobile access. Outside Ukraine, we are newsletter writers, investors, tech entrepreneurs, bankers; inside Ukraine there are only soldiers and refugees.