Understanding the Russian Sanctions

By Roy C. Smith and Ingo Walter

The latest tightening of the US and EU sanctions on Russian business and finance will provide an interesting lesson in international political, economic and military affairs. Here are some key issues to think about:

These Financial Sanctions Can Be Very Potent

They deny Russian access to capital markets in the US and Europe, which is to say global capital markets. Asian markets are not included but they are not significant enough to matter much.  This is the most important sanction imposed on Russia so far, since Russian banks and businesses have been obtaining about half of their total funding requirements from these markets over the past three years, according to the FT. 

Between them, Russian non-financial state-controlled companies ($41 billion), state banks ($33 billion), private banks ($20 billion) and non-financial private companies ($67 billion) will have $161 billion of foreign debt maturing in the next 12 months. The sanctions prohibit these borrowers from rolling-over this debt.

Where’s the Re-funding Money Going to Come From?

The Russian borrowers will have to obtain funds from sources other than the capital markets to avoid default.  The logical main source of refinancing is the Russian central bank, which can draw upon the country’s $500 billion or so of foreign currency reserves.  Russia has the means to absorb the effects of the sanctions for a few years, at least, but the effects on economic performance will certainly be meaningful. It could have the effect of shutting down Russia’s internal credit generating capacity.

If Russia fails to refinance its maturing debt, the borrowers will have to default – and since many of the borrowers are state-controlled, this will turn into a “sovereign” default. Default makes all outstanding foreign debt become immediately due and payable.

This will trigger all sorts of additional denials of credit to Russian banks and businesses, which would deepen the isolation of the Russian economy, reduce the value of its currency, increase interest rates and inflation and curtail domestic growth, which is now forecasted at about 0% for 2104. 

Adding to the pressure is the recent ruling of the international Court of Arbitration in The Hague that the Russian state misappropriated assets of Yukos several years ago and must return $50 billion to shareholders of the company. Russia does not want to pay this claim, but it is an obligation of the government and surely will involve default litigation if not paid.

Default most likely would trigger a rush by foreign creditors to impound Russian assets abroad (think of Lukoil’s gas stations and Aeroflot aircraft “arrested” at JFK Airport), plus certain foreign currency receipts - including (possibly) those related to sales of oil and gas and other commodities.

Some may not believe a default would have that much of an impact. Russia says it can become more self-reliant. But just ask Argentina about its economic track record since 2001, when it undertook the world’s largest default, compared to how the country would have done otherwise. Now that Argentina in on tenterhooks again after 13 years in default, stay tuned. Russia tried a debt “moratorium” in 1998, and learned to regret it. The key to avoiding default is the ability and willingness to service foreign debt. Russia may be able but unwilling.

The Other Announced Sanctions are Meaningful - But Longer-Term

They also include prohibitions on the access to oil and gas industry technology that is crucial to Russia’s ability to develop its energy reserves in the future, and limit transactions in the armaments industry. The effects of these sanctions are much more structural and will only be felt over the years, but they are important nonetheless.

The Sanctions Are Enforceable.

As we saw in recent US litigation of major European banks engaged in sanctions-busting, violations of the rules related to the enforcement of sanctions can involve very meaningful penalties. These rules are now not just American rules, but have been adopted and will be enforced in Europe also.

Economic Sanctions Can Replace Military or Diplomatic Moves

The Russian sanctions are the first set of US and European economic  “blockades” that have been applied to a major country with serious military capability. They may have a chance because of the increased globalization of the Russian economy which brought with it growth and increased prosperity for its people. Sanctions can result in a serious drop in Russia’s domestic economic welfare and possibly cause pressure on the government to change its behavior in Ukraine in order to avert domestic discontent.

But don’t bet on it. Russia is far from democratic. Russians are nationalistic and Putin at least temporarily is at the top of his game. He thinks Russians are stoic and suffer well – invoking World War II and decades of stagnation under Communist rule. His oligarchs and cronies are certain to squeal under the sanctions, but he can pick them off one at a time. And he can point to the spotty record of sanctions imposed on countries like North Korea, Cuba Iraq, Sudan and Iran in changing offending policies.

But whatever he says, these sanctions are going to be painful and reduce growth and economic opportunity for all the Russians. It will be an interesting time. Fasten your seat belts.

The New Unwritten Mandate for the Fed

Roy C. Smith and Ingo Walter

In recent testimony before Congress, Janet Yellen noted that “protecting the US from systemic risk is an unwritten third mandate of the Federal Reserve,” the other two being keeping inflation under control and promoting full employment.

Received wisdom says that managing two conflicting goals requires at least two policy tools. The classic duo of monetary and fiscal policy to manage inflation and unemployment has encountered plenty of problems over the years, with atrophied fiscal policy (heavily weighed-down by entitlement and other non-discretionary spending, and equally heavily politicized) placing a heavy burden on the Fed – one that is unlikely to go away anytime soon.

Now comes another policy target: safety and soundness of the financial system, using the same toolkit (with some unconventional tweaks) that is already stretched.

The three mandates get in each other’s way, making things worse rather than better.  

Zero interest rate monetary policy and Quantitative Easing were intended to stimulate consumption and investment spending, boost the trade balance through a weaker dollar, and cut unemployment. But, in keeping both short and long term rates well below market levels that would otherwise properly reflect a debt risk premium and inflation, both policies involve significant distortions of markets.

Neither policy, however, seems to have been particularly effective: Economic activity expansion since 2008 has averaged less than 2%, well below the US historical average of 3.5%.  Though the unemployment rate has fallen from a peak of 10% to just over 6% in the past six years, in June of 2014 only 59% of the civilian labor force was engaged in full time employment, still less than the 63% employed seven years earlier.  Now comes Obamacare, encouraging companies to substitute part-time for full-time and duck under company employment minimums. Around 17% of the labor force today is unemployed, stuck in part-time work or has given up looking for jobs.

The overall recovery of the US economy from the financial crisis of 2008 is one of the slowest on record.  It is certainly miserable compared to recoveries from the five previous US recessions, although defenders can always argue that things would have been immeasurably worse without the Fed’s unconventional policies. Who knows? We can’t run the world twice.

The stock market’s sharp recovery is an offset to the gloomy picture, but even that only reflects a modest 4.2% annualized growth in the S&P 500 index from its 2007 peak level.

We believe, along with many others, that the ongoing slow recovery has a lot to do with the curtailment of credit from the banking system to the real estate, commercial and entrepreneurial sectors of the economy due to efforts to “control” systemic risk by the Federal Reserve and other financial regulators.

From 2008 to 2012, US bank loans shrank at a rate of 4% annually – due in large part to de-risking household, corporate and bank balance sheets in the first couple of years of the recovery. Since 2012, loans have increased by 3% annually, a significant relative change but still a very low rate of growth in lending. Recently the Fed reported that much of the new lending was in the riskiest credit categories – borrowers that banks have been driven to for profits in an ultra-low interest rate environment. Heavily affected are small and medium-size businesses that are both reliant on bank finance and generators of a large proportion of new jobs in the economy.

For their part, banks have been under severe pressure to adapt to new regulatory regimes that have crushed several of their pre-crisis profit centers and added many billions to the cost of complying with the new rules. These rules are numerous (the Dodd Frank Act spawned about 400 of them) and have been slow in coming (only about half are finalized even today), which adds to the uncertainty as to what banks will or will not be permitted to do in the future. 

The biggest banks – those involved with substantial investment banking activities, and still defending themselves from a torrent of litigation stemming from industry practices leading up to the financial crisis – have not earned their cost of equity capital since 2009.  This is an important sector of the financial industry that is struggling to remain viable.

So, is the cost of under-performance in the economy worth the protection Americans have received by reducing systemic risk in the financial system? Last time solid economic expansion in the mid-2000s gave way to a collapse estimated by the Congressional Budget Office to have cost some $10 trillion in lost GDP, plus vast damage to particularly vulnerable parts of the population like pension beneficiaries.

The government has not defined systemic risk in the US financial architecture, other than to set a trigger of $50 billion in assets for imposing special risk-reducing regulations on the largest banks – a pretty arbitrary number.

At NYU Stern, the Volatility Lab headed by Nobel Laureate Robert Engle defines systemic risk as the gross amount of capital a bank would have to raise to replace capital lost to mark-downs of assets after a stock market decline of 40% over a six-month period. This approach recognizes that systemic risk is mainly a function of market risk at a time when markets undergo sudden, panic-driven changes - as occurred in 2008.

Using this definition, US exposure to systemic risk has declined by approximately 30% from its peak in 2008.  The risk reduction comes mainly from a shrinking in the size of the larger banks and a lowering of the volatility of their stock prices. But it suggests as well that there is a trade-off between squeezing the banks to reduce systemic risk and allowing them to make a living as providers of risk finance to the global economy.

The most useful thing the Federal Reserve can do now is to reduce the unsustainable cost of this trade off. It would help if the Fed would challenge the conventional wisdom that the banks are perpetually powerful, insatiable, manipulative and almost solely responsible for the crisis and its resulting economic hardships. This greatly overstates the problems that banks represent. Indeed, the Fed could say the time has come to return the banks to a normal, competitive and economically viable state. This can be greatly aided by saying that Dodd Frank Act has given it (and the Financial System Oversight Committee, to which it reports) sufficient powers to regulate the US banking system without having to rely on the voluminous, costly and often unnecessary stream of new rules incorporated in the Dodd Frank Act.

These new regulations are also costly to regional and smaller banks. New research shows that local and regional banks fared substantially better – and with far less reliance on government bailouts – than the big banks. So a financial system dominated by the need to control six or eight financial goliaths – controls that affect all the rest of the banks as well - may not be in the national interest.

Indeed, the Fed has shown that its combination of stress testing and appraisal of governance and management efforts can force banks to meet qualitative and well as quantitative standards for “fitness and properness” in order to be able to return capital to shareholders through dividends and stock buyback programs. There are only a dozen or so financial institutions in the country that pose real systemic issues, so the Fed, with supervisory staff imbedded in these banks, ought to be able to monitor what goes on sufficiently to meet the key safety and soundness standards.

These standards are based on the idea of reducing leverage and increasing capital to keep banks safe, but they also need to recognize that banks have to be sound as well. That means being healthy, sustainable businesses that attract investors.

Furthermore, the Fed needs to acknowledge that banks require healthy capital markets in which to raise funding sell loans through securitizations other avenues.  It needs to weigh in on what to do with Fannie Mae and Freddie Mac, to revive and deepen the mortgage-backed securities market - an enormous component of the US capital market that has not recovered much since the crisis, leaving inadequate availability of mortgage credit to support recovery of the housing sector.

The Fed remains the only institution with the political independence, credibility and institutional knowledge to do this.  Its power to intervene in problematic banks and nonbanks are considerable.  It has to be the main advocate in government circles for a healthy financial system, one that does not depend on market-distorting subsidies or intervention, or on politically inspired but growth-killing regulatory constraints to manage the delicate task of keeping major banks in line while enjoying the market freedoms to meet their shareholders’ objectives.

Time for a Moratorium on Prosecution of Banks

Roy C. Smith

As large investment banks begin reporting yet another quarter of lackluster earnings, leading them into their sixth year of failing to earn the cost of their equity capital, it is time to recognize that the industry is in severe distress and contributing much less than it should be to economic recovery.

Since 2008, large US and European banks have been designated the principal villains responsible for the financial crisis. Accordingly they have been hit with regulatory changes that have crippled their business models, and subjected to litigation by US federal and state attorneys general for mortgage and securities fraud, foreclosure abuse, market rigging of Libor, foreign exchange rates and metals prices, tax evasion, and circumventing money-laundering rules and sanctions.

Witness Citigroup’s announcement on July 7 of a $7 billion settlement to end all US government investigations of the banks’ pre-crisis involvement in mortgage-backed securities. A $3.8 billion provision slashed second-quarter profits to $181 million from $4.2 billion in the same period last year.

Bank of America is in endgame negotiations with the US Justice Department to settle similar charges and several other banks are expected to do the same, yet all the major banks are still under investigation in connection with other allegations.

It is clear that bad things did happen during a financial bubble that burst with a huge effect on the real economy. Regulatory changes and some prosecutions were necessary to restore stability to the financial system and to enforce tax and money-laundering laws, but the judicial pursuit of banks, rather than responsible individuals, has been taken to lengths that defeat the government’s other aim of restoring economic growth.

Most of the large investment banks replaced their chief, and other, executives, most of whom lost heavily as bank shares tumbled. But evidence of criminal (or civil) misconduct at the highest level of management was invariably difficult to find, though it was certainly sought. They may have failed as managers, but managers are not legally liable for mistakes.

Lacking sufficient evidence to convict senior executives, who would fight back in court, prosecutors pursued the banks’ corporate entities instead, which they know would prefer to settle than fight. Generally corporations are not sued unless there is evidence that management has corrupted the organization or failed to prevent such corruption.

The settlements have amounted to approximately $120 billion at the last count. The shareholders of the banks have paid the cost by subtracting it from capital they are required to increase as part of the most comprehensive and restrictive financial regulatory reforms since the 1930s.

As a result, the banks have become cautious, risk-averse and dull while they wait for the next shoe to fall. Share prices have slumped and much of the banks’ high-priced talent has quit to join boutiques, hedge funds or private equity groups.

Pyrrhic victories

So the high-profile litigation “victories” continuously announced by the US Attorney General, Eric Holder, and several of his state equivalents are substantially pyrrhic. They have won some battles but risk losing the more important war against economic stagnation and deflation.

True, the political gains have been satisfying – much of the public is convinced that bank bashing is a good thing. The settlements have contributed to government debt reduction (especially in New York State) and have enhanced the credibility of US efforts to enforce laws preventing tax evasion, money laundering and sanctions avoidance.

Citigroup’s chief executive, Michael Corbat, expressed his hope that the settlement last week would help the bank “to move forward and to focus on the future, not the past”. The Justice Department should follow the same advice.

At a time when economic growth in the US and the EU is dangerously below what it needs to be, government regulation and litigation have driven many of the largest providers of risk finance to the sidelines.

We need the banks to help economic recovery, and we need economic recovery badly.

It is time for governments to declare the war against the big banks to be over and won. It is time to remove the overhanging uncertainty of future settlements, capital shortfalls and permitted global activities to let the banks recover and adjust to their new environment.

Especially we need the Obama administration to declare a moratorium on the prosecutions of banks (but not of individuals) because these have entered the realm of diminishing returns, and because, under Dodd-Frank, regulators have accumulated sufficient powers to be able to monitor and control individual bank riskiness and governance effectively.

To make such a moratorium politically possible, the regulators could require enhanced governance conditions that might include the need for bank non-executive directors to acknowledge personal responsibility for the management of systemic risk (which they are largely required to do anyway) and to report concerns to regulators. The Federal Reserve did something similar during the banking crisis of the 1980s. Bank directors at the time took the acknowledgements seriously as an extension of their fiduciary duties.

Governments should also extend a moratorium on any further regulations that restrict banking operations or impose additional compliance burdens until they have a better understanding of the costs and benefits of the hundreds of new regulations already mandated by Dodd-Frank, Basel III and the European Central Bank.

Even better would be a quiet promise to put forth a corrective amendment to Dodd-Frank to eliminate extraneous, redundant and unworkable regulations as these are identified.

Regulators in the US and Europe need also to consider the deglobalization effects of their recent actions, and try to reverse the trend. Globalization adds to competition, liquidity and innovation, which are needed for recovery. It also adds to the complexity of systemic risk management, but the net effect is positive.

Systemic risk in finance is a consequence of a healthy system that exceeds its limits. Governments have rules to control these limits, but also use litigation to punish institutions they believe allowed rule violation to occur.

They know the banks will settle, so these are easy victories they have grown accustomed to enjoying.

They come, however, at a cost to a “systemic economic risk,” that of prolonging a painful period of slow to no growth in the global economy over a period now approaching a decade.

That is too big a war to lose for pyrrhic victories. We need the moratorium now.

From eFinancial News, July 21, 2014