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

Getting Serious About Sanctions-Busting Banks

Roy C. Smith and Ingo Walter

(Wall Street Journal,  June 27, 2014)

BNP Paribas is expected any day to admit to criminal violations of U.S. sanctions against Iran and Sudan. This is likely to mean that the giant French bank will pay a fine of between $8 billion and $10 billion to the U.S. government, dismiss several executives, and temporarily cease its dollar-clearing business. The case has dramatically elevated the liability of global banks to the regulatory enforcement of U.S. law.

Trade and financial sanctions have long had a place in international affairs—from the high-profile sanctions applied to South Africa under apartheid to their increasing use as a substitute for military intervention in countries including Iraq, Libya, Iran, Cuba, Sudan and most recently Russia, where they are pending. They’ve attempted to discourage countries from building nuclear weapons, abuse human rights or invade their neighbors. Such sanctions, however, have been controversial because they have appeared to lack the cohesion and determination of allies to make them work effectively.

The U.S. prosecution of a major international bank for evading sanctions has changed the game. BNP allegedly stripped out identifying information from wire transfers to disguise sanctioned countries as origins or destinations of international payments. By raising the cost of violating the rules to significant levels, the Justice Department has insured that U.S. sanctions will be complied with and effective.

Foreign banks and their home governments may or may not agree with the policies underlying the U.S. sanctions. But like it or not, in the dollar world U.S. law is the law. Banks around the world must comply or face consequences that have been escalating steadily since 2005. Banks including HSBC, ABN Amro, Standard Chartered, Lloyds, Barclays, Credit Suisse and now BNP have ponied up more than $20 billion to settle money laundering and tax evasion charges. The stocks of these banks also lost significant amounts of market value as a result of the settlements. BNP shares lost about 4% of their value after it was reported to be in settlement discussions.

More important than the size of the fines, however, is that the most recent lawsuits against Credit Suisse and BNP were brought under criminal, not civil, law. Technically the guilty plea by Credit Suisse was from a non-U.S. subsidiary that does not hold a U.S. banking license. But the two cases are warning shots. If a license-holding financial-services entity is convicted of a criminal offense, it may lose the right to do business in the U.S. The Justice Department reportedly sought the assurance of state regulators that admissions of guilt would not require the banks to surrender their licenses. But future cases might be handled differently.

Global banks today settle most of their trade and financial transactions in U.S. dollars. This is a large and profitable business for these banks, and one that it is necessary for them to service client transactions. They must have access to the U.S. clearing and settlement apparatus to conduct it.

Sanctions that restrict access to the dollar market can be very burdensome for targeted countries, particularly those with mineral resources that need to be sold abroad. Sanctions on countries like North Korea may have been ineffective, but those applied to Iran have been significant. Russia may be next, and because Russia depends on dollar-priced oil exports, it is vulnerable.

Russian President Vladimir Putin recently said he hopes to switch Russia’s enormous dollar trade in oil to Chinese yuan, in order to reduce the impact of financial sanctions. That may be difficult, since the yuan is neither convertible nor widely used as a currency for international trade.

Mr. Putin may assume he can find banks willing to help subvert sanctions via the yuan and drive wedges between the U.S. and more sympathetic European governments. But such banks would put at risk their U.S. business and their ability to undertake clearing other currencies for U.S. dollars. Beijing may also want to think twice before putting Chinese banks’ access to the dollar market at risk to help Mr. Putin.

Many bankers and lawyers believe that the Justice Department has applied its considerable powers unfairly against BNP Paribas. The lawsuits are against the shareholders of the banks, not individuals deemed to be responsible for the alleged misconduct. Fair or not, the case demonstrates how much power the government has when it wants to enforce its rules.

Several major U.S. banks, including Bank of America and Citigroup, are trying to avoid paying massive fines related to their sales of mortgage-backed securities, and, conceivably, might go to trial rather than settle. These cases are subject to civil law and their licenses to do business are not at stake.

Sanction and tax evasion cases are a different matter. U.S. banks have not been among the offenders, but some foreign banks apparently assumed they could get around U.S. sanctions with impunity. They haven’t. The Justice Department has made it clear it will use the criminal law to enforce the rules even when the banks’ government officials have attempted to intervene.

BNP Paribas shows that the U.S. can and will impose financial sanctions unilaterally in the dollar market without the broad agreement that is typically required for other international policy issues. By pursuing this case, the U.S. government has dramatically boosted the credibility of financial sanctions that banks around the world now need to take very seriously.

 

Busting the Sanctions Busters

Ingo Walter

It looks now like BNP Paribas will plead guilyy to a criminal violation of US payments sanctions and an accompanying $9 billion fine and temporary suspension from dollar clearing business - coming only a few months after the guilty plea by Credit Suisse to a criminal charge of aiding and abetting tax evasion - elevates the real-world exposure of financial institutions to US regulatory enforcement.

Like it or not, in the dollar world, US law is the law. Banks must comply or face severe consequences. Since 2005 they have been fined heavily to settle civil violations of US tax or money laundering laws. Some bankers and investors may consider this a cost of doing business, It becomes another matter entirely when the legal venue transitions from civil to criminal.

Trade and financial sanctions have long had a place in international affairs – from the high-profile sanctions applied to South Africa under Apartheid to their increasing use as a substitute for military intervention in countries like Iraq, Libya, Iran, Cuba, Sudan, and most recently Russia, where they are still pending. The objective is to encourage targeted countries not to build nuclear weapons or engage in human rights abuses or invade their neighbors. Sanctions are both serious and controversial. Serious because the alternative may be boots on the ground and people dying. Controversial because lack of international cohesion may undermine the effectiveness of sanctions and because it has not always been easy to tell whether they actually work.

One thing is certain: Evading sanctions can be a very profitable business. Money is made in imperfect markets, and sanctions can be an excellent source of market imperfections. The global arms trade, “conflict minerals,” smuggling, aiding and abetting tax evasion, and money laundering have long been growth businesses and there are well-developed, adaptable transaction conduits around the world to facilitate them. As long as there are sanctions there will be sanctions-busting.

So it is with “wire-stripping,” a practice in international financial transactions to falsify the origin or destination of international payments, often routed through multiple intermediaries – a form of money laundering without which evading trade and financial sanctions would be much more difficult and costly. The falsification has to be executed by one or more intermediary banks willing to engage in transactions that are illegal in one or more countries. Presumably the idea of banks collaborating in sanctions-busting must have been to turn the routine business of global transactions banking into a much more profitable activity by intentionally skirting the law. Was this the work of a few rogue employees or deliberate bank strategy?

In 2005, ABN Amro’s Dubai branch was tagged for fraudulently bypassing US controls of financial transactions with Iran and Libya. In agreement with the Dutch Central Bank, ABN Amro was subject to a cease and desist order, permitted the bank to enter a no-contest plea, and was fined €65 million plus €1 million clawed-back from the previous year’s bonuses earned by the bank’s Management Board. Acquisition of parts of ABN Amro by the Royal Bank of Scotland led to a further $500 million fine imposed on RBS in 2010, and continuing probes by the Federal Reserve and Department of Justice. The wheels of justice sometimes turn slowly, but they do turn.

In 2012, Standard Chartered was alleged to have engaged in $250 billion of wire-stripping through its New York branch, almost all of which management initially attributed to “clerical errors.” StanChart briefly fought the charges, but in the end settled for a no-contest plea, $667 million in fines and a humiliating in-person apology in Washington by senior management. Its shares dropped 15% on announcement of the money laundering charge.

As well, HSBC was fined $1.9 billion and ING $619 million in civil money laundering settlements, joined by Lloyds, Credit Suisse, Barclays and others. Did bankers decide not to take US law seriously, or were they oblivious to risk exposure that accompanies circumventing the rules? Not entirely. An e-mail from Standard Chartered’s US CEO to headquarters in London noted that the US wire-stripping inquiry had the “…potential to cause very serious or even catastrophic reputational damage to the Group and expose senior managers to criminal liability.”

BNP Paribas may be no better or worse than some of its competitors in its alleged wire-stripping activity, but the enormous cost of the settlement indicates that the goalposts have now shifted in several ways.

First, US authorities have greatly improved their ability, both unilaterally and in cooperation with other countries, to monitor international dollar transactions and detect violations.  They have the ability to subpoena bank records and email traffic in building cases against firms that break the law and possibly show “intent.”

Second, US authorities, both state and federal, have abundant political support for no-tolerance enforcement policies, and are willing to threaten withdrawal of operating licenses to do business. Lingering public resentment over the financial crisis and its consequences continues to provide plenty of political cover.

Third, the US Justice Department has elected to bring criminal charges against banks deemed to be less that fully cooperative in order to force them into compliance and acceptable behavior going forward. This is a powerful weapon, because any bank on the wrong end of a US criminal indictment will normally be forced to shut down. For the time being, this weapon remains in its holster, with key regulators agreeing not to pull the trigger and revoke US operating licenses of both Credit Suisse and BNP Paribas in their criminal guilty pleas.

Along the way BNP Paribas did itself no favors. It allegedly obstructed the US investigation. It put forward an “advice of counsel” defense that some of the wire-stripping was done outside the US and therefore was technically not illegal when the funds passed through US payment system. It argued that the fine was excessive compared with previous money laundering cases and would force the bank to raise capital, suspend dividends and defer expansion plans. And it engaged the big guns - including the President of France, the Foreign Minister and the Governor of the Banque de France - in its “Chicken Little” defense based on the systemic importance of BNP Paribas in Europe. Overhanging everything was the threat of damage to US-European and Franco-American relations, a theme taken up by the US Chamber of Commerce in support of lighter punishment. The Obama Administration stuck by its guns.

Credit Suisse may have been able to swallow its criminal tax evasion “guilty” plea and accompanying $2.6 billion fine with relative impunity -- at least according to CEO Brady Dougan, who suggested that CS’s criminal conviction would have “no material effect” on the bank’s business and that no management or board changes were contemplated. Investors seemed to agree, with CS stock up by 2% in an otherwise flat market. That is not the case with BNP Paribas, which lost heavily in market value and will sacrifice about 30 senior management positions in connection with the settlement. Nor will it be for future violators. 

Global banks today continue to rely on the dollar market, the world’s largest for trade and financial transactions. Sanctions that restrict access to this market can be very burdensome for targeted countries, particularly those with mineral resources that need to be sold abroad. Whereas sanctions imposed on countries like North Korea may have been relatively ineffective, those applied to Iran are thought to be quite significant. Russia is next, and because of its dependence on dollar-priced hydrocarbon exports is highly susceptible.

For its part, Russia has announced that it hopes to switch its dollar trade in oil to Chinese Yuan in order to reduce the impact of any US sanctions. That may be a naïve, since the Yuan is neither convertible nor widely used as a currency for international trade. Russia may assume it can find banks willing to help subvert sanctions via the Yuan and drive wedges between the US and more sympathetic European governments. How China will react when its own banking regulations are subverted is anybody’s guess.

The BNP Paribas case shows that the US can still impose and enforce sanctions unilaterally in the dollar market without the kind of broad international agreement required for trade treaties and banking regulations. And it has the ability and the willingness to detect and punish those who violate its laws, including denial of access to its financial market - something that no major international bank can endure. This may change in the future. But for now it is the reality.

Argentina Upsets the Restructuring Model, Again

 Roy C. Smith

The Supreme Court’s refusal on June 16^th to hear an appeal of lower court rulings upholding Argentina bond investors’ claims for payment has thrown a monkey wrench into sovereign debt restructuring, which for thirty years has been an important part of the international financial system.

The ruling, which entitles the hedge funds that bought defaulted Argentine debt to be paid full value, is actually a fairly narrow one. It applies only to Argentine debt issued under US law that was not exchanged in restructuring offers made by Argentina in 2005 and 2010. The lower courts held that under the “equal-treatment promise” inherent in US law, unexchanged “old” debt holders must be paid on their claims as long as “new” debt holders are being paid.

The hedge funds, which bought the bonds for pennies on the dollar at various times since 2001 have been very aggressive in pursuing their claims against Argentina. They have pursued activist strategies through litigation designed to force Argentina to buy back their bonds at a price approximating full value. Argentina’s president Christina Fernandez has repeatedly referred to them as “vultures,” and has insisted she will not pay “extortion” of as $15 billion in principal and accrued interest owed on the defaulted bonds. Since the Supreme Court’s decision, she will be forced to make payments on the held-back bonds if Argentina is to continue to pay on the rest of its debt.

Sovereign Immunity is Thrown Out

The ruling upset Argentina’s (and much of the rest of the world’s) expectation that the long-held notion of “sovereign immunity” would be upheld.

The highlights the difference between two classes of sovereign debt – those issued under local government laws with unquestioned sovereign immunity, and those issued under laws of established international financial jurisdictions such as the US and the UK, in which sovereign immunity had been presumed but not really tested.

Government debt issued under local laws is as sovereign as it can be – sovereign states are above the law. There is no bankruptcy law that applies to sovereigns, so creditors are stuck (as they have been since the Middle Ages) when they default and must accept whatever the sovereign offers in its effort to “restructure” the debt.

However, sovereign debt issued under US law, the Supreme Court has made clear, is hardly sovereign at all.  Creditors are entitled to the equal-treatment provision and may seek to discover and impound overseas assets of the defaulting government.

The Market Evolves

Prior to the 1980s, there was no market for bonds of Emerging Market countries because so many had defaulted in the 1930s and it took more than a decade to work out investors’ claims.

In the 1980s, many Emerging Market countries borrowed “petrodollars” from banks. This was money deposited in the banks by oil exporting countries after the four-fold price increase imposed in 1973. The price rise led to a world economic slowdown, and a shortage of foreign exchange that these countries needed to import oil. The banks, needing to lend out the petrodollars, offered Emerging Market governments dollar loans subject to US law. The countries, however, did not manage their finances well, and a decade later many of them defaulted.

During the 1980s, thanks to a plan designed by the US Treasury Department, banks could exchange their defaulted loans for new bonds issued by the countries that were collateralized by long-term zero-coupon US Treasury bonds. Because interest did not have to be paid until maturity, the bonds could be acquired at a very steep discount. The new collateralized bonds (called Brady Bonds after US Treasury secretary Nicholas Brady) were issued in exchange for the old loans, at a “haircut” (discount) of about 30% of the face value of the defaulted bonds. $70 of new bonds would be offered to replace $100 of old loans. The banks had already written the loans down to about that level.

As a relatively small group of international banks (not a bunch of hedge funds) were the loan holders, there were few holdouts that did not accept the terms of the exchange, though there were some. The countries were able to reduce the old debt on their books by 30%, to end their defaults and renew their access to markets. The new bonds traded actively and several went to premiums. Henceforth, market prices would reflect the economic conditions of the country, reflecting a probability of default.

After this, the market for Emerging Market sovereign debt expanded rapidly, and provided access to financing sources for dozens of countries they were quick to utilize.

After Brady Bonds

There were a number of defaults or near-defaults along the way that resulted in restructuring operations, in which the governments involved would offer new bonds to replace old ones. There was always a haircut in the process of between 30% and 40% depending on the market price of the old bonds at the time.

The exchange offers were always conditional on a minimum percentage of the old bonds being tendered for exchange. As most investors estimated the market value of the new bonds to be somewhat greater than the market value of the old, most were happy to participate in the exchange.

The net result was that exchange offers could reset a sovereign’s credit position, from bad to better, over a relatively short time period that would enable countries to regain access the markets quickly. The terms of the exchange would depend on negotiations between creditors and the governments, often with IMF oversight and endorsement. These would require some improvement in the economic and financial management practices of the countries. It wasn’t the same as a bankruptcy proceeding, but it had a similar effect. 

But some hedge funds thought they could do better by buying old bonds, often at discounts from their market prices, and not exchange them – in the hopes that they could negotiate quietly with the government to buy back the old bonds at a profit. This process might involve a few years of waiting, with no return on the bonds in the meantime, and some additional cost in litigation expense, but it they made enough nuisance they could expect to be bought out sooner or later. Many were.

Argentina Upsets the Norms

Argentina, however, upset things when in defaulted in 2001 on $90 billion of foreign debt, requiring the world’s largest restructuring. Argentina did not follow standard procedures of negotiating with creditors with IMF assistance. In 2004, it took a much more aggressive position, offering a 70% discount. It refused to accept a “traditional” discount of 30%; it wanted to maximize debt reduction in the exchange, which meant a much larger discount. The creditor committee, backed by the IMF, was furious but the market price of the outstanding old debt was about 30 percent of face value, justifying Argentina’s notion of a 70% haircut.

Seeing no better alternative, investors gave in; 75% of the bonds were tendered and the deal went through. There were a few hedge fund holdouts that figured that they could pressure the government into buying them out at a profit.

In 2010, Argentina offered the holdouts a slightly better deal, but the funds rejected this offer too. Instead, they increased their legal harassments, commencing the suit that was declined for review by the Supreme Court and suing to impound Argentine assets abroad.

Then Greece

Also in 2010, the sovereign bond market’s attention had turned to Greece, a member of the EU and therefore not generally considered an Emerging Market country. It was, nonetheless, in great financial difficulty following the global financial crisis that began in 2008, and in 2012 it needed to restructure its $200 billion outstanding foreign debt then trading at 30 cents on the dollar. The debt was not in default, but was getting close.

The Eurozone countries had already provided some assistance to Greece, but more was needed. Some thought they would ultimately bail out the debt, but others thought German reluctance to do so would prevent it.  In time there was a compromise – Greece would restructure its debt and do a number of other things to improve its financial position, and the Germans would go along. The exchange offer involved new bonds supplemented by a note of the European Financial Stability Fund and that package was determined to have a net present value of 70% of face value (but the cash vale was more like 55%.

But the Greeks realized that even with the EFSF note, the exchange might not meet the 75% minimum exchange that was required, so the parliament enacted a law that added a retroactive “collective action clause” (CAC) to outstanding debt issued under Greek law. As an EU and Eurozone member country, Greece had been able to issue most of its debt under Greek law. A collective action clause provides that if a supermajority of the bonds held are voted in favor of some action affecting all the bonds, the majority may bind the minority to accept the action. Naturally investors do not like CACs, so most Emerging Market sovereign bonds don’t have them.

Doing this retroactively, of course, is contrary to the law just about everywhere, but in Greece, sovereign immunity would prevent contesting it. As a result, the exchange offer went through. Tellingly, the Greek government later bought out at 100% of par value a small portion of Greek debt issued under UK law rather than face a lawsuit in the UK similar to the ones that the hedge funds were pursuing against Argentina in the US.

Argentina in a Bind

The Supreme Court’s action puts Argentina in a bind. In order to continue paying principal and interest due on its previously restructured bonds, it must make similar payments on the old bonds, which Argentina claims would amount to $15 billion. It floated a scheme to force a conversion of restructured bonds (issued under US law) to new bonds issued under Argentine law, but doing so would not escape the US lower court rulings. Defying these would expose Argentina to having government assets held in the US and elsewhere being impounded.

For the Future

The significance of the Supreme Court’s action is that future Emerging Market sovereign debt restructurings have been made more difficult and expensive, and investors are now more aware of the difference between US and local law and will be reluctant to give up the added protection of US law which substantially limits sovereign immunity

It also should result in sovereigns insisting on including CACs in their loan agreements to be sure they can eliminate holdouts in any future restructuring. For now, anyway, while interest rates are low they should be able to do so as the market for high yield Emerging Market sovereign debt is hot. When markets are hot, investors agree to almost anything.

Are Major Banks Really Too Big to Jail?

Ingo Walter

It used to be that financial institutions indicted on a criminal charge went out of business long before they had their day in court in a proper jury trial, which is their right. Instead, clients and employees would flee and regulators would be forced to withdraw their operating licenses. Unlike individuals convicted on a criminal charge, this is as close as things ever came to jailing an institution. Not anymore.

By sowing fear and intimidation among its regulators and law enforcement officials - based entirely on its own vulnerability to punishment - the Credit Suisse pleaded guilty to a criminal offense and emerged as a convicted felon clean as a whistle, with no apparent effect on its business, its management or its shareholders.

Having confessed to one count of criminal fraud, CEO Brady Dougan told a press conference on May 20^th he didn’t think there would be any effects on the bank – no “material impact on our operations or capabilities.” There was the small matter of $2.6 billion in fines and penalties, but he said that could be earned back by the end of the year and wouldn’t affect the bank’s regulatory capital. No serious changes in strategy. No senior management changes. No discernible boardroom reaction. No client defections. No investor flight. Just business as usual. Credit Suisse stock in Zurich was up 2% on the day in an otherwise flat market.

Except for some media commentators, nobody seemed to care very much. The corporate-speak wordsmiths trotted out the importance of “putting the matter behind us.” Life goes on.

We like to think market discipline works. Corporate boards are supposed to be serious guardians of long-term shareholder value and oversee to the best of their ability and judgment the “market-economy trinity” that drives it – revenue growth, cost control and risk management. When things like market share losses or operating inefficiencies or excessive risk exposures pose a threat, directors presumably agitate for corrective action and in extreme cases change the management. Most shareholders in turn rely on institutional investors to watch out for their interests and vote their proxies. So owners ultimately depend on both asset managers and boards to do their jobs properly – the so-called “double agency” problem.

Especially in the case of large “systemic” financial institutions, regulators have an additional voice in corporate governance. They are supposed to represent the public interest and protect the taxpayer, the ultimate guarantor of financial system integrity. If the taxpayer must bear the risk, the taxpayer must have a voice. So the CS case can be considered a remarkable quadruple governance failure - the management, the board, institutional investors and the regulators. But if nobody really does care it may not be a failure at all, just a new chapter in the rules of the game.

At the other end of the spectrum, people worried about integrity of the financial system may consider the CS case a serious challenge to the institutional underpinnings of the liberal market system. Credit Suisse stood accused, certainly not alone, of aiding and abetting tax evasion (not tax avoidance) by tax residents of the United States, a country that taxes income earned globally and considers willful tax misreporting a criminal offense. Unlike its rival UBS, which settled civil charges of aiding and abetting tax evasion with the IRS back in 2010 - in a proceeding that included a $780 million fine and release of client information approved by the Swiss government. CS was late to the party. It had already been charged by the time a 2013 agreement was reached to extract “voluntary” disclosures and settlements with other Swiss banks that are now being individually negotiated.

As well, CS stood accused of obstruction and failure to cooperate with US authorities in their investigations (never a good idea), while two of its employees had already pleaded guilty to criminal charges and six more cases were pending.  

Obstruction, conspiracy, evasion ... these are not good words, especially after politically charged remarks by US Attorney General Eric Holder that criminally prosecuting systemically important financial institutions may impossible due to the unacceptable economic risk of their own demise – and voilá, the now famous term “too big to jail” was coined. Right after the CS guilty plea, Holder somehow concluded: “This case shows that no financial institution, no matter its size and global reach, is above the law.” Really?

The Credit Suisse case breaks new ground on the slippery slope of accountability failures in the financial sector since the effective end of criminal prosecutions (subject to appropriately high standards of culpability) in cases like Daiwa Bank, Drexel Burnham and Arthur Andersen, firms which apparently were not considered “systemic” or immune from criminal prosecution at the time. All disappeared.

Each of these firms’ collapse involved significant damage to their stakeholders. But it’s a good guess that the thousands of talented, loyal and honest employees who lost their jobs soon found new ones, and for many it was the best thing that ever happened to them. Competitors quickly circled to take advantage of a golden opportunity to recruit. The market for talent actually works. Financial functions are immortal. Financial firms are not. 

Like Voodoo, the concept of “too big to jail” is probably nothing more than a myth. But like Voodoo, though, it is a powerful one. Over the years has deflected regulatory enforcement into produced a waterfall of civil suits against prominent financial businesses. Most of the time they ended in negotiated “no contest” pleas, combining hefty fines and “deferred prosecution” agreements. Allegations of overzealous prosecutors extorting settlements from targeted banks were balanced by lots of repeat offenders - to the point that expected litigation costs now seem to be routinely provisioned in bank financial statements and operating budgets, just like any other costs, and have become part of the business model. Financial analysts and investors don’t appear to see anything unusual about litigation costs, and get nervous only when they turn out to be eye-watering.

Looking for the good news? Even with all the fault-lines in internal and external governance, there is a last line of defense - the threat to a firm’s reputational capital. But banks and other financial firms that require trust and confidence to operate presumably have valuable reputations at stake. First-rate clients prefer to deal with first-rate banks, so serious losses in reputational capital ought to be reflected in the share price. This in turn ought to catch the attention of management, boards, investors, and ultimately regulators.

Studies of the stock price impact of reputational losses have in fact shown that there are serious and immediate share-price effects triggered by an array of negative reputational events. In one study these averaged 7% of market capitalization. Still, reputations can be reestablished over time, and there’s no way of estimating the longer-term consequences. In an industry where the long term is often after lunch, stakeholders may not care very much about reputations - even in criminal cases - as long as they remain “fit and proper” to do business, which means that  exemptions from regulatory decertification have to be negotiated in advance.

The Credit Suisse case is a feat of superb lawyering and regulatory acrobatics, vaulting substance and plain old common sense. It probably spells the end of “mortality” of systemic financial firms. It puts the last nail in the coffin of holding entire firms accountable by inflicting meaningful pain in hopes of changing behavior in an industry where violations are often “industry practice” rather than firm-specific aberrations.

So what’s the other good news? Cumulating outrange among a long-suffering and already testy public almost six years after the financial crisis with little apparent improvement in the conduct of financial firms raises the likelihood that in the next round of transgressions the focus will be on individuals rather than firms themselves – including officers and directors. Real people must have made decisions that led to prosecutable criminal behavior. Even in the organizational labyrinth of global financial conglomerates, meetings were held and people took positions, and in the end they can be traced. Those who are tagged for committing or conspiring in criminal violations will have to face due process, and most likely will be hung out to dry by their employers. In criminal cases, the recent Credit Suisse outcome suggests this may be the only way to go.