Individual states and intergovernmental organisations increasingly use financial sanctions to punish or influence the behaviour of targeted entities. However, our latest research shows that even universally adopted sanctions can throw a spanner into the works of the global financial system for want of being enforced everywhere.
Since the invasion of Ukraine in 2022, much ink has been spilled over the sanctions on Russia. Such economic sanctions – including arms embargoes and travel and trade restrictions – have been regularly used since World War II and have become indispensable foreign policy tools. And since the late 1980s, there has been a shift toward imposing financial sanctions, which involve freezing assets and investments.
The idea behind financial sanctions is to target key entities – such as decision-makers and major industries – to discourage the sanctioned country from breaking international law or acting aggressively, while at the same time limiting negative consequences for civilians. As a result, these so-called smart sanctions only ban some transactions with the target country, and financial institutions must thus scrutinise business opportunities to ensure they undertake only those that remain legal. Failing to comply can result in sizable penalties. In 2015, for example, BNP Paribas was required to forfeit $8.83 billion and pay a $140 million fine after failing to comply with sanctions against Sudan, Cuba and Iran.
How sanctions impact lending
Sanctions will impose extra compliance costs on a bank, as it must fulfill reporting requirements and undertake due diligence checks to ensure its transactions are legal. The bank will also have to factor in the litigation costs and the reputational risk involved if its due diligence should fail. We wanted to understand how these costs and risks alter lending decisions. One possibility would be that the bank withdraws all business from the sanctioned country – but that would be an extreme position.
Instead, we assume that a bank’s decision to lend in sanctioned countries will depend on the trade-off between the expected profits and the costs of due diligence and possibly litigation. However, both the cost of compliance and the risks associated with non-compliance vary significantly across countries. In Germany, for example, labour costs are high, so hiring people to carry out due diligence is expensive. Strong data protection laws in Germany also increase the costs of carrying out checks. In some other countries, those costs may be lower, or the government may not have the resources to enforce compliance, making litigation less likely. Do those differences affect how banks respond to sanctions?
Location, location, location
Thanks to data provided by Germany’s central bank, the Deutsche Bundesbank, we were able to study the behaviour of German banks worldwide. The data show how much each bank in Germany was lending in foreign countries from 2002 to 2015. Importantly, German banks are also required to record how much their foreign affiliates (branches and subsidiaries outside Germany) are lending in each country.
Looking at this data, we see clear differences in how German banks in different countries responded to sanctions. Banks in Germany strongly reduced their positions in countries targeted by sanctions. But their foreign affiliates, on average, increased lending relative to their parent banks at home and, in some cases, also in absolute terms.
The importance of the Financial Action Task Force
There are variations in behaviour between affiliates in different countries, so we needed a way to categorise countries according to the sanctions-related costs they impose, which are related to the quality of the countries’ institutions and anti-crime policies.
Founded in 1989, the Financial Action Task Force (FATF), also known by its French name, Groupe d’action financière (GAFI), is an intergovernmental organisation that sets international standards to allow national authorities to go after illicit funds linked to money laundering, terrorism and other related threats to the integrity of the international financial system. Our analysis showed that German bank affiliates located outside the FATF increased their positions in sanctioned countries by an average of 95% relative to German banks inside the FATF. That figure rises to 151% in countries blacklisted as noncompliant with FATF rules.
The fact that banks in Germany and within the FATF strongly decreased their lending in sanctioned countries, whereas banks outside the FATF increased their positions, suggests that lending decisions indeed depend on a trade-off between seizing profitable investment opportunities and the costs of due diligence and possibly litigation.
Levelling the playing field
One key takeaway from this is that, regardless of whether it is the litigation risks or compliance costs that ultimately drive the decision to lend in sanctioned countries (or not), you don’t have a level playing field. Banks in locations with weaker standards for the integrity of the financial system seem to find lending in sanctioned countries more attractive.
Regulators work together to harmonise rules and financial standards across countries, with a view to ironing out any regulatory irregularities for international banking competition. However, our analysis of financial sanctions and cross-border lending shows that this doesn’t go far enough. To guarantee a level playing field, it is also vital to make sure all countries effectively comply with these sanctions.
Such conclusions are probably valid beyond the realm of sanctions and may very well extend to other contexts of international regulation and globally integrated markets. Indeed policymakers typically won’t limit themselves to harmonising rules and standards in money laundering, sanctions, and terrorism financing (FATF) across countries, but also seek to harmonise the financial regulations of banks – such as in the area of leverage, for example.
This important finding applies as much to standards that regulate the litigation and compliance risk of banks (i.e., the FATF standards) as those that regulate financial risk-taking and leverage. Our work ultimately suggests that policymakers must pay equal attention that all countries enforce such financial regulations to the same degree.