The Unintended Consequences of Financial Institutions De-risking
In June 2014, the U.S. Treasury Department inflicted BNP Paribas with a $8.9 billion fine for failing to comply with U.S. economic sanctions against Sudan, Iran, and Cuba. This put the spotlight on the risks that the complicated web of international sanction regimes poses to financial actors. Indeed, in the last decade, the variety of contexts in which governments employ sanctions has grown, as part of a larger shift in the international arena towards the growing use of economic means to achieve foreign policy objectives. As a consequence, financial institutions have increasingly adopted a de-risking strategy to minimise the severe consequences of inadvertently violating sanctions, and sometimes over-complying with sanctions, and a priori refuse to enter into business relationships or terminate existing ones with entire categories of customers due to their alleged excessive sanction-related risks.
The result is the complete severance of financial transactions to and from sanctioned countries, even when they are authorised by humanitarian exemptions or are excluded from the sanctions’ scope. A 2017 survey by the Charity and Security Network of 8,500 U.S. humanitarian actors found that two-thirds of them had increasing financial access difficulties, while a 2015 World Bank report highlighted that 75 per-cent of the large international banks had decreased the number of their correspondent bank relationships mainly in sanctioned countries. However, de-risking violates the principle of non-discrimination of access to basic financial services, which is the 20th European Pillar of Social Rights. Also, it causes negative economic consequences on the populations in sanctioned nations and an increase in opaque alternative financial mechanisms that boost the underground economy and foster corruption and criminal activities. Thus, de-risking strategies jeopardise the effectiveness of sanctions as well as lead to outcomes that hinder Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT) efforts.
Drivers of de-risking
The main driver of de-risking is that sanction-related risks exceed financial actors’ risk appetite. In particular, sanctions give rise to (1) compliance risks, which are the risks of incurring fines and reputational losses due to the failure to comply with sanction packages, and (2) regulatory risks, i.e., the risk that a future change in sanction laws will negatively affect financial institutions’ operations. Indeed, the lack of uniformity and clarity of multiple overlapping sanction regimes and the complex company hierarchies put in place by sanctioned individuals to circumvent asset freezes against them make it challenging for financial actors to comply with different countries’ sanction regulations and understand which entities fall within the scope of the different sanction packages. Moreover, the growth of sanction lists means that financial institutions also have to foresee future developments in sanctions, since, as a senior banker at a large Asian bank put it, “no one would like to sign a billion-dollar trade finance deal only to be told a week later that the entity has been added to the sanctions list”. This uncertainty couples with the US’ enactment of secondary sanctions and the fact that sanction violations are strict liability offences, which means that anyone violating sanctions even involuntarily commits a criminal offence thus triggering hefty fines -as in the case of BNP Paribas- or the loss of access to the US financial system and the USD. The result is that deciding which transactions from sanctioned countries are legitimate carries too big risks for financial institutions. The only measure to mitigate such risk would be to carry out enhanced due diligence to verify customers’ (individuals, firms, but also respondent banks) identity, as well as the nature and purpose of their activities. However, this would be considerably costly and time-consuming, and would hinder banks’ profitability. In such a situation, de-risking becomes the natural preferred choice for a rational economic actor.
Consequences of de-risking
De-risking by financial institutions has a dual negative impact:
1) Negative impact on correspondent banking relationships (CBRs). CBRs are financial relationships aimed at executing cross-border payments between two banks (respondent banks) that do not hold accounts with each other and thus use a third institution (the correspondent bank which usually is a US or European international bank) to act as an intermediary. However, correspondent banks need to be certain that they are not executing transactions involving sanctioned individuals or goods in order not to incur the liabilities and sanction-related risks analysed above. For this reason, they are increasingly breaking ties with respondent banks operating in sanctioned (and thus high-risk) countries. According to the Bank for International Settlements, from 2011 to 2019 the number of CBRs globally decreased by 22 per-cent, and more than 50 per-cent in sanctioned countries [Figure 1 below]. This exclusion of sanctioned countries from the financial payment system has a negative consequence on (1) cross-border trade and (2) remittance flows, since local banks and money transfer operators cannot process international payments and provide basic trade finance services like import or standby letters of credit. Lastly, the lower access to the USD leads to a fall in tourism flows and FDI into sanctioned countries.
Figure 1: Sanctioned Countries Are Increasingly Excluded From the finanical System
2) Negative impact on the ability of international humanitarian organisations to respond to crises in sanctioned countries. Often, US and European banks close NGOs’ accounts or refuse to execute financial transactions to fund humanitarian projects in sanctioned states, even when such transactions are expressly authorised by sanction regimes and NGOs are granted humanitarian exemption by governments. This is because these NGOs operate in areas deemed to be too high-risk, and banks are not familiar with humanitarian organisations’ business model, which makes it difficult to identify NGOs’ trustees, suppliers and beneficiaries. Banks do not provide any rationale or possibility of appealing their decisions. Even when transfers of humanitarian funds are eventually authorised, still they are delayed by an average of 4-6 months, which hinders the fast implementation of projects that is necessary to tackle humanitarian crises.
As a result, financial transactions to and from sanctioned countries are executed via alternative channels such as shadow banking or the physical transport of cash across borders. However, these are unregulated and not transparent substitutes, which makes it easier to circumvent AML/CFT regulations and carry out illicit transactions for criminal or corruption purposes.
Recommendations
The following measures can be taken to tackle de-risking by changing financial institutions’ cost-benefit analysis regarding over-compliance with sanctions:
1) Promoting the adoption of new digital technologies by the clients of financial institutions. This can facilitate banks’ due diligence, thus lowering their compliance costs and sanction-related risks. Private firms and NGOs operating in sanctioned countries can lower the probability of being de-risked by using a Legal Entity Identifier (LEI). This is a 20-character code developed by the International Organization for Standardization, that uniquely identifies legal entities and their true ownership structure. LEI records are publicly accessible, thereby making it easier for banks to verify their customers’ identities and ensure that they (or their owners) are not included in any sanction list. Similarly, respondent banks in sanctioned states can adopt Know-Your-Customer (KYC) Utilities, which are digital repositories containing information about banks’ customers. By allowing US and European correspondent banks to access their KYC utilities, local respondent banks can expedite due diligence procedures and increase their transparency, thus reducing sanction-related risks and the costs of CBRs.
2) Adopting measures by U.S. and European regulators to reduce the uncertainty surrounding sanction regimes and reassure banks that the due diligence they have in place is sufficient to prevent any involuntary violation of sanctions and their consequent fines. This can involve clarifying sanction requirements, issuing detailed guidance on how to manage high-risk scenarios arising from sanction regimes without withdrawing from sanctioned countries, as well as carrying out reviews of US and European financial institutions’ risk assessment/compliance procedures to test their adequacy. Already existing or ad-hoc multi-stakeholders dialogue forums could facilitate such exchanges between financial actors and authorities. At the same time, sanctioning countries could formalise the non-prosecution of sanction violations by financial institutions with strong sanction-compliance mechanisms, provided that this is done inadvertently and in good faith. This would guarantee that banks will not have to pay fines if the funds they transfer for humanitarian purposes to sanctioned countries accidentally end up in the hands of sanctioned individuals. Therefore, sanction-related risks for financial actors would be reduced.
3) Establishing channels through which banks’ de-risking decisions can be legally challenged and mandating financial institutions to notify financial regulators of the rationale to implement activities aimed at de-risking. In this regard, standard templates can be created requiring banks to specify which kind of sanction-related risks they face, the measures considered to mitigate them and the reasons why these measures are insufficient, thus making de-risking necessary. This would increase the scrutiny on banks’ de-risking decisions and reduce the a-priori de-risking of entire categories of customers based on their economic link with a high-risk country. Consequently, it would ensure that financial institutions employ individual risk assessment procedures that do not violate the principle of non-discrimination.
Conclusion
Even though economic sanctions are established by governments, they are concretely implemented by private actors like financial institutions. The current complex web of overlapping sanction regimes is such to tilt the decisions of rational private economic actors in favour of de-risking. This is what is happening in the case of Russia: although sanctions include exemptions that allow for payments of Russian energy, the sanction-related risks associated with potential breaches of sanction packages have sparked over-compliance from European financial institutions, with Société Générale, Deutsche Bank, BNP Paribas and HSBC even exiting the Russian market altogether. In this regard, the recommendations of this policy brief would allow to change financial institutions’ cost-benefit analysis, thus tackling de-risking and its negative consequences.