Sanctions and the Next Financial Crisis

Following the 9/11 attacks on New York and Washington DC, the financial sector was placed squarely on the frontline of global counterterrorism efforts. As well as mounting operations to target the groups themselves, the US and its allies woke up to the importance of combatting the finances of these groups that had previously abused the international financial system to fund and execute their operations. In the case of the 9/11 attacks, according to the 9/11 Commission report, approximately $300,000 had flowed unobserved through the formal financial system.

An immediate casualty of this effort was the not-for-profit community, which was branded ‘particularly vulnerable’ to abuse for financing terrorism by the Financial Action Task Force (FATF), the global financial crime watchdog that had ‘combatting the financing of terrorism’ added to its mandate following 9/11.

A direct impact of this warning was a heightened sensitivity among banks towards providing financial services to non-profit organisations (NPOs) for fear of falling foul of this particular vulnerability. This sensitivity to risk has resulted in heavy burdens being placed on NPOs to prove who their beneficiaries are and what compliance controls they have in place, and in many cases they have found that they are no longer welcomed as clients and have had their bank accounts closed (known in the jargon as ‘debanking’).

Over the past 15 years, a number of activists have worked tirelessly to reverse – or at least nuance – this blanket impression that all NPOs should be treated with increased suspicion. But NPOs have not been alone in suffering the debanking fate. ‘Politically exposed persons’ who might use their influence to line their own pockets, and entire countries’ banking systems deemed by the international financial community to be high-risk, have found themselves likewise afflicted and severed from domestic or international financial access.

Authorities have belatedly woken up to the implications of the debanking phenomenon, and some of the genie has been put back in the bottle. For example, the FATF has listened to the concerns of NPOs and significantly adjusted its guidance; banking communities have sought to support clients in addressing their raised risk concerns; and the impact of debanking on developing economies has received high-profile attention.

Although the debanking issue persists, policymakers, civil society and the financial sector have made significant efforts to limit the impact of the two main events that led to debanking, namely 9/11 and the supervisory fallout from the global financial crisis in 2008.

Yet the banking system now faces an even big challenge – a geopolitical schism that is forcing banks to choose sides and react accordingly.

Russia’s full-scale invasion of Ukraine triggered wide-ranging and extensive financial sanctions that sought to freeze Russian banks that support the Russian economy and its military out of the international financial system, thus restricting the Kremlin’s ability to fund its illegal war in Ukraine. Few would lament the ‘debanking’ of Russian banks from the international financial system, but the consequences of these sanctions have much more wide-reaching implications.

To appreciate why this is the case, it is important to understand how international finance works. The simple version is that domestic banks in most countries do not have direct financial connections with banks beyond their borders. For this, they need the services of ‘correspondent banks’, which provide the global plumbing that facilitates the flow of payments around the world. The correspondent banks are almost exclusively located in the US and Europe, jurisdictions that are firmly on the side of Ukraine in its brave fight against Russia.

The result is that these correspondent banks will inevitably closely scrutinise the politics of the countries in which their banking clients are located. The logic is simple: if a country’s leadership appears to favour the Kremlin – or even express indifference to Ukraine’s plight – it is not unreasonable for a correspondent bank to assume that the transactions flowing through that country’s banking system, to which it is exposed, are similarly indifferent and perhaps include clients that are subject to or connected with sanctioned individuals and entities. As night follows day, debanking of a local bank is a logical decision for the correspondent bank to make in this scenario in order to avoid the risk of facilitating sanctioned activity.

Adding to this risk for ‘Global North’ banks, decisions in Washington have made banks increasingly responsible for the actions of their clients. Where a bank is found to have processed transactions that are connected with Russia’s military-industrial base, it can expect to feel the full force of the US authorities. History has taught banks that this is a fate to avoid at all costs.

Whereas earlier versions of debanking saw NPOs and individuals facing the loss of banking services, the dramatic polarisation of geopolitics in the past two years has increased the chances that entire countries could find themselves cut adrift.

Even a decade ago, the implications of such decisions – dire though they would have been for the country in question – would have had little consequence for the West, as its dominance of the financial system was total. This is no longer the case as new financial systems have developed, technologies such as Central Bank Digital Currencies have matured, and financial partnerships of convenience or imperative have been established between Russia and malign states such as Iran and North Korea.

In the early months of Russia’s full-scale invasion of Ukraine, Kyiv’s allies imposed dramatic sanctions on a range of financial and trade activities and were slow to react to the unintended consequences these actions had for Global Majority countries, which faced energy and food security threats caused by the shock to the global financial and trade system stemming from Russia’s war. This provided an opening for the Kremlin to persuade many countries across the globe that their woes were caused by the West.

As this new threat emerges, Ukraine’s allies should avoid repeating the same mistake and elevate communication with both their own banks and ministries of finance in Global Majority countries now, to ensure that sanctions decisions made to isolate the funding and resourcing of Russia’s war machine do not unintentionally isolate countries that can ill afford to lose access to the global financial system.

The views expressed in this Commentary are the author’s, and do not represent those of RUSI or any other institution.

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