Monday, 02 September 2024
By Achille Deodato, CEO of Indigita SA
Sanctions target individuals, corporations, or organizations. Those listed on sanction registries cannot transact in the currencies or with banks governed by the sanctioning country. Their assets listed on stock markets or circulating within the financial system also get frozen. As a consequence, sanctions have consequences that impact all players of the financial system: banks and investors. The latter have to take into consideration five critical aspects regarding sanctions.
Considering the strategic exposure
Sanctions issued by a country impact not only its domestic institutions but also foreign banks exposed to the sanctioning country’s currency.
The reason is that a bank can only independently transact in its domestic currency. For any foreign currency transactions, from simple payments to financial investments, a bank must rely on a correspondent bank. These correspondent banks, domiciled in the countries providing the foreign currencies, are subject to local regulations.
Consequently, a bank in country X must adhere to the sanctions that its correspondent bank in country Y is obligated to follow.
For example, if an individual sanctioned by the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC) were to hold an account with a French bank, the latter would be unable to perform any transaction in US Dollar for him, as its correspondent US Bank, having to comply with US sanctions, would refuse execution. Similarly, an entity sanctioned by OFAC would effectively be barred from participating in any U.S. stock market and have all its USD-denominated bonds and shares frozen, regardless of where its banks or the company itself conducts transactions.
The consequence for financial institutions is that they have to diligently manage their cross-border sanction risks. This implies identifying all the countries to which they are exposed from a currency, stock market or strategic perspective, then ensuring they comply with the sanctions issued by the authorities of all their countries.
Similarly, investors should adopt a comparable approach when investing in stock markets. This strategy would help them avoid stocks or bonds of potentially sanctioned companies, thereby preventing potential write-offs until further notice.
Ensuring proper monitoring and access at all levels
Governments can impose sanctions swiftly. Consequently, sanctions can be volatile and change rapidly in response to geopolitical developments. Financial institutions must conduct risk assessments and strategically update their lists of sanctioned entities and individuals daily. This is necessary as Regular updates are crucial to prevent transaction errors, asset misvaluation, reputational damage, and operational complications.
In practice, banks subscribe to one or more specialized data monitoring services that provide daily updates on sanctions lists These lists are automatically checked by bank IT systems during the pre-trade phase, ensuring that no financial instrument linked to a sanctioned entity is processed. Additionally, financial institutions conduct overnight batch checks to identify any newly sanctioned individuals or entities among their clients.
Despite these standard practices, some loopholes remain. This primarily affects bank front offices, external asset managers, and end investors. These three categories often are not fully aware of or do not have a cross-border sanctions strategy. Moreover, they often lack direct access to relevant sanctions lists. As a consequence, clients may send a purchase order to their bank, ignoring the fact that the stock they want to purchase is linked to a sanctioned entity. The bank’s relationship manager or the external asset manager may accept and try to execute the order until they realize that the IT systems are, hopefully, blocking it. The operational risks and inefficiencies are clear.
A bank may end up in extreme situations as the following: let’s assume a client domiciled in China is willing to purchase shares of a company that is sanctioned by OFAC. The client transmits the order to the relationship manager, who does not have the capability to immediately perform a sanctions check as per the lists that the bank has decided to respect, which include those issued by OFAC. As a consequence, the order may be initially accepted. Only when the Relationship manager will try to perform the transaction, the system will block it. However, it may be too late, because the stock market is closing and/or the client has become unreachable. If by any chance the following day is a public holiday in Switzerland, the client will be informed of the unexecuted transaction only a few days later. Assuming that the stock price may have surged, what would the legal responsibility of the bank be? The client could potentially sue the bank, stating that from a legal perspective, the bank is not obliged to comply with US law. From a mere legal stand point, this would be correct.
To prevent such situations, banks and asset managers should equip their relationship managers with tools that allow real-time sanctions checks.
Deploying clear measures
Given the fallibility of IT systems and human error, banks must establish clear internal procedures and measures. Banks need to ensure timely, consistent, and adequate data and information flow to both personnel and systems. Additionally, they must implement mitigation measures in the event of a breach.
Transactions with a sanctioned entity or individual may occur due to technical glitches or human errors. In such cases, the bank faces three types of threats:
First, the bank may be indirectly exposed to actions by domestic or foreign sanctioning authorities. For instance, if OFAC identifies a foreign bank as a transactional conduit for sanctioned companies or individuals, it could place the bank on a grey list or even impose sanctions directly. As a consequence, all business in USD of the foreign bank would be frozen.
Second, the bank's domestic regulatory authority may question the adequacy of its control systems and governance, potentially leading to audits, enforcement actions, or even revocation of its banking license. In many jurisdictions, governance bodies like the Board of Directors and top management face personal unlimited liability, which could personally affect these individuals.
Third, reputational damage can devastate relationships not only with regulators but also within the institutional market and among clients. A bank known for breaching sanctions may face severe difficulties in securing correspondent banking relationships, thus impairing its ability to conduct transactions in foreign currencies.
Although perfection is unattainable, robust internal escalation procedures can significantly mitigate the impact of an unintentional sanctions breach.
Assessing collateral damages
Sanctions primarily serve as instruments of political power. The financial system acts as the principal vehicle for enforcing these sanctions. Although sanctions can be imposed overnight, political changes leading to these actions can often be anticipated to some extent. Consequently, banks and investors should monitor geopolitical trends closely and adjust their commercial and investment strategies accordingly. Analyses should extend beyond future business strategies to include the potential impact of future sanctions on existing clientele and investments.
Should a bank or investor hold securities that become sanctioned following a political change, these assets will likely be written off, losing their value. The consequences can be severe, especially if these securities serve as collateral for further investments or mortgages. In response, the bank might issue a margin call, requesting additional collateral from the client. Without sufficient alternative assets, the client could face default.
This example underscores the importance of monitoring political trends, conducting risk assessments, and recognizing the potential consequences of upcoming sanctions for both banks and clients.
Maintaining a neutral stance
The financial system is required to adhere to regulations. Given the volatile nature of political sanctions, banks and asset managers should strive to maintain neutrality to avoid repercussions when sanctions are lifted. Taking a political stance could backfire once sanctions are lifted.
Following Russia's invasion of Ukraine, many Western banks have closed the accounts of Russian clients or those domiciled in Russia, irrespective of their ties to the Russian regime. Consequently, many individuals have been excluded from the Western banking system solely based on their nationality.
This exclusion likely results from an assessment of 'collateral damages' as previously described. While these measures may be justified by the significant operational risks associated with these clients, Western financial institutions must consider that, once sanctions are lifted, re-accessing the Russian market and its nationals may prove challenging.
In conclusion, the dynamic and intricate nature of sanctions highlights a critical need for vigilance and adaptability within the financial industry. From the direct implications on transaction capabilities and market accessibility to the broader repercussions on client relationships and institutional reputation, the stakes are undeniably high. Financial professionals and investors must continuously fine tune their strategies to manage sanctions risk effectively. This entails not only maintaining up-to-date knowledge of geopolitical shifts and sanction specifics but also developing robust internal protocols to swiftly adjust to changes and avoid costly mistakes.
As the landscape of international finance grows increasingly complex, the ability to navigate through the turbulent waters of sanctions will distinguish the most resilient and forward-thinking institutions. By implementing the takeaways outlined, banks and asset managers can safeguard their operations and client interests, ultimately supporting global financial stability.
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