International Finance #2: Sanctions on Russia
US is severing the Russian access to US dollar financial system.
This is a short post, that will build on my earlier posts, to explain how the US sanctions on the Russian financial institution are expected to work. If you are not familiar with how bank settlements work, I highly recommend you read the below two posts.
Issuing and managing Central Bank Digital Currencies (CBDCs) (substack.com)
Roshan Digital Accounts: The dollars never left the US (substack.com)
If the images appear too small to read, click on them to enlarge.
In light of Russia’s attack on Ukraine, US Treasury has imposed sanctions on the Russian banking system.
Treasury is taking unprecedented action against Russia’s two largest financial institutions, Public Joint Stock Company Sberbank of Russia (Sberbank)and VTB Bank Public Joint Stock Company (VTB Bank), drastically altering their fundamental ability to operate. On a daily basis, Russian financial institutions conduct about $46 billion worth of foreign exchange transactions globally, 80 percent of which are in U.S. dollars. The vast majority of those transactions will now be disrupted. By cutting off Russia’s two largest banks — which combined make up more than half of the total banking system in Russia by asset value — from processing payments through the U.S. financial system. The Russian financial institutions subject to today’s action can no longer benefit from the remarkable reach, efficiency, and security of the U.S. financial system.
Correspondent and Payable-Through Account Sanctions on Sberbank
Today Treasury is imposing correspondent and payable-through account sanctions on Sberbank. Sberbank is uniquely important to the Russian economy, holding about a third of all bank assets in Russia. Sberbank is the largest financial institution in Russia and is majority-owned by the GoR. It holds the largest market share of savings deposits in the country, is the main creditor of the Russian economy, and is deemed by the GoR to be a systemically important financial institution. Within 30 days, OFAC is requiring all U.S. financial institutions to close any Sberbank correspondent or payable-through accounts and to reject any future transactions involving Sberbank or its foreign financial institution subsidiaries. Payments that Sberbank attempts to process in U.S. dollars for its clients — with examples ranging from to technology to transportation — will be disrupted and rejected once the payment hits a U.S. financial institution.
Full Blocking Sanctions on VTB
OFAC has imposed full blocking sanctions on VTB Bank, Russia’s second-largest financial institution, which holds nearly 20 percent of banking assets in Russia. VTB Bank is majority-owned by the GoR, which deems it to be a systemically important financial institution. This will sever a critical artery of Russia’s financial system. By imposing these sanctions, assets held in U.S. financial institutions will be instantly frozen and inaccessible to the Kremlin. This is one of the largest financial institutions Treasury has ever blocked and sends an unmistakable signal that the United States is following through on its promise of delivering severe economic costs.
I gave the following example in my Roshan Digital Accounts: The dollars never left the US
When Asma in New York sends money from her Citibank NY (Citi NY) account to Allied Bank Limited (ABL) Foreign Currency Account (FCA) in Pakistan, dollars are not being airlifted to Pakistan in suitcases from New York to Pakistan to settle the transfer. The dollars never leave the US shores.
ABL will have a correspondent relationship with JP Morgan Bank New York (JPM NY) where it maintains a deposit/reserve/settlement account. The deposit is transferred from Asma's account at Citibank NY to ABL's account at JPM NY. ABL in Pakistan will report an increase in its dollar deposits in New York and record an accounting entry crediting Asma’s foreign currency account with an equal amount.
While Asma’s account at ABL Pakistan will show a US dollar balance of $10,000, the actual dollars are in the US in the JPM account rather in the form of reserves at the Federal Reserve.
For foreign currency transactions, all local banks maintain correspondent relationships with banks in foreign countries. The correspondent bank maintains an account with the central bank of the country. In the aforementioned example, JPM NY is acting as a correspondent bank of ABL Pakistan and maintains an account with the Federal Reserve which is the central bank of US.
Building on the aforementioned, I provided the following example of how export proceeds are settled.
When export proceeds are received, the exporter is provided the funds in his local currency account by converting them to rupees at the prevailing exchange rate. The foreign exchange remains in the NY account of commercial banks whereas rupees are credited into exporters' accounts in Pakistan. The foreign exchange balance comprises the commercial bank's foreign exchange reserve.
Assume Gul Ahmed Textiles exports to Walmart. This is how the payment will flow. In this example, Deutsche Bank (DB) is acting as a correspondent bank for MCB.
These examples show that dollars remain in the US and don’t come into MCB’s possession physically. Rather, the dollars remain with MCB’s correspondent bank in the US which was Deutsche Bank in the above example.
(If the above examples appear too complicated for you, I recommend reading the two posts mentioned at the beginning of this post, where I start from the first principles)
After the fall of Kabul, it was reported that Taliban visited the vault of the Central Bank of Afghanistan (DAB) to access the foreign exchange reserves of the country, which at the time were around $9 billion. The central bank governor who had fled Kabul tweeted the following
I am writing this because I have been told Taliban are asking DAB staff about location of assets
If this is true - it is clear they urgently need to add an economist on their team
First, total DAB reserves were approximately $9.0 billion as of last week.
But this does not mean that DAB held $9.0 billion physically in our vault.
As per international standards, most assets are held in safe, liquid assets such as Treasuries and goldThe major investment categories include the following assets (all figures in billions)
(1) Federal Reserve = $7.0
- U.S. bills/bonds: $3.1
- WB RAMP assets: $2.4
- Gold: $1.2
- Cash accounts: $0.3
(2) International accounts = 1.3
(3) BIS = $0.7
The above examples show that whenever a dollar is involved in a transaction, even when you are dealing in dollars between MCB and ABL in Pakistan, MCB and ABL need to access the US financial system through a correspondent bank in the US to settle the dollar transactions. If MCB or ABL do not have access to a correspondent bank in the US, they cannot settle dollar transactions or deal in dollar transactions. All their dollar balances are held in the US with their correspondent banks.
Countries hold a large share of their international reserves in US dollars or in US treasuries. Such balances are also physically held in US. This gives the US government excessive control over dollar balances. When the US wants to freeze foreign currency reserves, all it needs to do is to issue instructions to the banks based in the US to freeze the accounts of the relevant entity or the country or stop dealing with that entity. The banks comply immediately as they want to keep access to the most liquid and most resilient financial system i.e. US dollar financial system.
Revisiting the key sections of the US Treasury sanction announcement:
On a daily basis, Russian financial institutions conduct about $46 billion worth of foreign exchange transactions globally, 80 percent of which are in U.S. dollars. The vast majority of those transactions will now be disrupted. By cutting off Russia’s two largest banks — which combined make up more than half of the total banking system in Russia by asset value — from processing payments through the U.S. financial system.
Sberbank is the largest financial institution in Russia and is majority-owned by the GoR. It holds the largest market share of savings deposits in the country, is the main creditor of the Russian economy, and is deemed by the GoR to be a systemically important financial institution. Within 30 days, OFAC is requiring all U.S. financial institutions to close any Sberbank correspondent or payable-through accounts and to reject any future transactions involving Sberbank or its foreign financial institution subsidiaries
full blocking sanctions on VTB Bank, Russia’s second-largest financial institution, which holds nearly 20 percent of banking assets in Russia. VTB Bank is majority-owned by the GoR, which deems it to be a systemically important financial institution. This will sever a critical artery of Russia’s financial system. By imposing these sanctions, assets held in U.S. financial institutions will be instantly frozen and inaccessible to the Kremlin.
Thus, the two largest banks will not be able to deal in dollars. 80% of foreign exchange transactions of Russia take place in US dollars. By these sanctions, the US is crippling the ability of Russian banks to transact internationally in dollars.
The alternative available to Russia is to deal in other currencies such as Euro, GBP, Yen or Yuan, etc. for international transactions. There are two prerequisites for such transactions to take place. First, the counterparty dealing with Russia should be amenable to carrying out the transaction in the alternate currency. Two, the governments overseeing the financial system of those currencies should not impose sanctions on Russia similar to the US. The European Union imposing similar sanctions on Russia can intensify the pain to the Russian financial system and its economy.
There can be other arrangements, such as dealing in the currency of Russia or its counterparty or other clearing mechanisms, but then such arrangements need to be worked out individually with each country. Moreover, depending on how severe the US government wants to push, financial institutions in other countries may be wary of dealing with Russian institutions, fearing that the US may penalize them by also severing their access to the US financial system.
As the crisis continues, the pain felt by the Russian financial system due to the sanctions will spread to the farther regions of the Russian economy.
On an unrelated note, the cavalier attitude of the Pakistani banking system is a sight to behold.
This is coming on the heels of a record fine imposed on HBL under Sultan Allana in 2017. Beyond belief that Sultan continues to be the Chairman of HBL.
Which was followed by a warning to UBL. UBL subsequently decided to close the NY branch as it wasn’t making any money.
National Bank of Pakistan is the last man standing when it comes to a large Pakistani bank having a presence in the US. Whereas other countries lose access to the US financial system on account of wars, it will be the easygoing manner of Pakistani banks that will do it for them. I am exaggerating here for emphasis. You don’t need to have a presence in the US to have access to the dollar financial system. UBL, HBL, and other Pakistani banks continue to have access to the US dollar system through correspondent banks.