freeze! financial sanctions and bank responses...)litigation and compliance costs are higher for...

Freeze! Financial Sanctions and Bank Responses

Matthias Efing* Stefan Goldbach Volker Nitsch

HEC Paris* Deutsche Bundesbank TU Darmstadt

Discussion Papers and presentations represent the authors’ personal opinions anddo not necessarily reflect the views of the Deutsche Bundesbank or its staff.

Matthias Efing (HEC Paris) Financial Sanctions and Bank Responses 1 / 36

Financial sanctions in international diplomacy

Germany imposed financial sanctions on 20 countries between 2002-15204 sanctions have been imposed worldwide between 1914 and 2006(Hufbauer, Schott, Elliott, & Oegg, 2007)

What do financial sanctions do?

Targeted entities cannot access existing funds.

Targeted entities must not receive new credit or financial services.

Typically part of a larger package of sanctions(export restrictions, arms embargoes, ...).

Designed to minimize harm to civilians while at the same time:

“to bring about a change in policy or activityby the target country, entities, or individuals”

(EU, Common Foreign and Security Policy, 2017)

Financial sanctions and banks

Banks are required to end business with sanctioned entities.

European banks were fined over USD 16bnfor money laundering and sanction breaches between 2012 and 2018.

(Moody’s, 2018)

Financial sanctions and banks

...Deutsche 2015 USD 258m US sanction breachesCommerzbank 2015 USD 1.45bn US sanction breachesBNP Paribas 2015 USD 8.9bn US sanction breachesDeutsche 2017 USD 0.63bn Money laundering (moving Russian money through

accounts in London, Cyprus, Estonia, Latvia)ING Groep 2018 EUR 775m Money laundering & terrorism financing (Uzbekistan)Deutsche ongoing Money laundering by a former affiliate of Deutsche

on the Virgin IslandsDanske ongoing Money laundering by a branch in EstoniaDeutsche ongoing Involvement of Deutsche in Danske scandal...

Main contribution and findings

1 Focus on legal (non-financial) risk in banking.

2 Multinational banks reroute credit to sanctioned countries.

→ through affiliated banks in offshore locations

→ using internal capital markets, i.e., intra-group credit

3 Why is this possible?

→ ...because of weak supervision and law enforcementin offshore locations.

→ harmonizing just the rules and regulations is not sufficient!

→ also harmonize compliance with a given set of rules!

Research question and hypothesis

Determinants of banks’ business decisions in sanctioned countries?

Trade-off (Becker, 1968):

+ Preservation of profitable business in sanctioned countries

− ILLEGAL business: (expected) litigation and reputation costs

− LEGAL business: compliance costs

→ Supervisors introduce new regulations to implement sanctions:

more due diligencemore documentation

How to identify the trade-off?

Identifying assumption:

Sanction-related costs depend on the institutional environment of banks.

⇒ litigation and compliance costs are higher for banks facing

strict supervisioncompliance requirementseffective judicial system

→ i.e., stronger policies against financial crime

Prediction:

Banks in countries with high institutional quality (e.g., Germany) withdrawbusiness from sanctioned countries.

Other banks in countries with weak anti-crime policies (e.g., Panama) dorelatively more business in sanctioned countries.

Prediction:

strict supervision

compliance requirementseffective judicial system

Prediction:

strict supervisioncompliance requirements

effective judicial system→ i.e., stronger policies against financial crime

Prediction:

External Position Report for German Banks (Dt. Bundesbank):

Assets / liabilities vis-a-vis all foreign entities, 2003-2015 (monthly)

All German banks (incl. subsidiaries and branches) at home & abroad

Aggregated by type, maturity, (major) currency, and counterparty type

No identities of individual counterparties

→“short-term $-loans to non-financials in Qatar of bank ABC’s subsidiary in UK”

Service Center Financial Sanctions (Dt. Bundesbank):

All EU and UN sanctions

One observation is a triplet (bank, country of counterparty, month)...

Never sanctioned Sanctioned at least once

Obs. Mean S.D. Obs Mean S.D.

bank abroad 2,230,944 0.49 0.50 159,107 0.43 0.49bank outside EU 2,230,944 0.35 0.48 159,107 0.29 0.45b. in ctry of counter. 2,230,944 0.02 0.15 159,107 0.01 0.07

total assets 2,230,944 245,300 2,597,298 159,107 37,118 268,687loans 2,230,944 180,265 2,203,512 159,107 33,729 218,300counterparty = bank 2,230,944 101,970 1,353,109 159,107 14,480 148,379

(positions in e1,000 ; positions with counterparties in Germany excluded)

One observation is a triplet (bank, country of counterparty, month)...

Never sanctioned Sanctioned at least once

Obs. Mean S.D. Obs Mean S.D.

bank abroad 2,230,944 0.49 0.50 159,107 0.43 0.49bank outside EU 2,230,944 0.35 0.48 159,107 0.29 0.45b. in ctry of counter. 2,230,944 0.02 0.15 159,107 0.01 0.07

total assets 2,230,944 245,300 2,597,298 159,107 37,118 268,687loans 2,230,944 180,265 2,203,512 159,107 33,729 218,300counterparty = bank 2,230,944 101,970 1,353,109 159,107 14,480 148,379

(positions in e1,000 ; positions with counterparties in Germany excluded)

2002 20062004 2008 2010 2012 2014 2016

Bank groups with presence abroadBank groups with presence outside EUBank groups with presence outside FATF

Foreign Presence of German Banks

2002 2004 2006 2008 2010 2012 2014 2016

Foreign host countriesHost countries outside EUHost countries outside FATF

Foreign Countries Hosting German Banks

How do German banks implement sanctions?

How about...

German banks located inside Germany ,

their branches and subsidiaries abroad ?

How about...

Identifying a compositional shift in credit supply

No sanction

DEU CYP

bank locations

RUS SWE

counterparty locations

Sanction on RUS

DEU CYP

bank locations

RUS SWE

Identifying a compositional shift in credit supply

Log Assetsb,c,t = β1 Sanctionc,t Dum: c sanctioned in t

+ β2 Abroadb × Sanctionc,t Diff-in-Diff

+ κb,c bank-country F.E.

+ ηb,t bank-time F.E.

( + γc,t country-time F.E. )

+ εb,c,t

size of lending relationship (b, c)credit supply of bank b in month t

credit demand of country c in month t

(Khwaja and Mian, 2008)

Credit supply in DEU (abroad) decreases (doesn’t change).

Log Total Assetsb,c,t (1) (2) (3) (4)

Sanctionc,t -0.470*** -0.275* -0.470***(0.151) (0.164) (0.086)

Abroadb × Sanctionc,t 0.532*** 0.511***(0.110) (0.169)

Sum of coeff. 0.062p-value 0.753

bank-country (b, c) Yes Yes Yes Yesbank-time (b, t) Yes Yes Yes Yescountry-time (c, t) No No No Yes

Bank sample DEU All All AllObs. 1,217,711 2,377,900 2,377,900 2,377,900R2 0.858 0.840 0.840 0.844

Sanctionc,t -0.470*** -0.275* -0.470***(0.151) (0.164) (0.086)

Specification (3) graphically...

-.2-.1

-12 -8 -4 0 4 8 12 16

Time to sanction (months)

bank is in Germany bank is abroad

Log Assets Abroad of German Banks

Do we care about the inertia of German banks abroad?

2004 2008 2012 2016

In Never Sanctioned Countries

2004 2008 2012 2016

In Sanctioned Countries

External Positions of German Banks

banks inside DEU banks abroadbanks outside EU banks outside FATF

Prediction 1:

Banks do relatively more business in sanctioned countries if they are located injurisdictions that are less committed to fighting financial crime.

(low expected litigation costs and low compliance costs related to due diligence)

⇒ Theoretical literature on int’l regulatory arbitrage

Acharya (2003), Dell’Ariccia & Marquez (2006):

competitive advantages of banks in weaker jurisdictions.

Prediction 1:

Banks do relatively more business in sanctioned countries if they are located injurisdictions that are less committed to fighting financial crime.

(low expected litigation costs and low compliance costs related to due diligence)

⇒ Theoretical literature on int’l regulatory arbitrage

Acharya (2003), Dell’Ariccia & Marquez (2006):

competitive advantages of banks in weaker jurisdictions.

Financial Action Task Force (FATF)

Intergovernmental organization founded in 1989 on the initiative of the G7

Housed at the OECD headquarters in Paris

Developing policies to combat money laundering and terrorism financing

Non-FATF: Isle of Man, Malta, Panama, etc.

Financial Action Task Force (FATF)

Explicitly addressing sanctions:

“to freeze without delay the funds or other assets of, and to ensure that no fundsor other assets are made available, directly or indirectly, to or for the benefit of,any person or entity either (i) designated by, or under the authority of, the UnitedNations Security Council under Chapter VII of the Charter of the United Nations(...)”

Precise preventive measures regulating customer due diligence, record keeping,transparency of counterparty information, international cooperation, business inhigh-risk countries, etc. For example:

“financial institutions should be prohibited from keeping anonymous accounts oraccounts in obviously fictitious names.”

Credit supply outside FATF countries increases.

Model 1 Model 2

Log Total Assetsb,c,t (1) (2) (3)

Sanctionc,t -0.320**(0.159)

Not in FATF country b 0.826** Sum: 0.506** 0.718**× Sanctionc,t (0.363) p-value: 0.035 (0.311)

In country of counterparty b,c 1.436*** Sum: 1.116*** 1.621***× Sanctionc,t (0.259) p-value: 0.000 (0.507)

bank-country (b, c) Yes Yesbank-time (b, t) Yes Yescountry-time (c, t) No Yes

Obs. 2,377,900 2,377,900R2 0.840 0.844

Model 1 Model 2

Sanctionc,t -0.320**(0.159)

Obs. 2,377,900 2,377,900R2 0.840 0.844

Model 1 Model 2

Sanctionc,t -0.320**(0.159)

Obs. 2,377,900 2,377,900R2 0.840 0.844

Model 1 Model 2

Sanctionc,t -0.320**(0.159)

Obs. 2,377,900 2,377,900R2 0.840 0.844

Limitations

Measurement error:

Some countries outside the FATF are members of regionalorganizations with similar objectives as the FATF.

→ Focus on FATF-non cooperative countries:

Countries that the FATF has officially declared as non-cooperative.

German bank affiliates in Malta, Jersey, Mauritius, Guernsey, Russia,Cyprus, Iran, Pakistan, Philippines (as of February 2018)

Limitations

Measurement error:

Some countries outside the FATF are members of regionalorganizations with similar objectives as the FATF.

→ Focus on FATF-non cooperative countries:

Countries that the FATF has officially declared as non-cooperative.

German bank affiliates in Malta, Jersey, Mauritius, Guernsey, Russia,Cyprus, Iran, Pakistan, Philippines (as of February 2018)

Credit supply from high-risk jurisdictions

Model 1 Model 2

Sanctionc,t -0.287*(0.161)

Non-cooperative country b 1.104** Sum: 0.817* 1.111**× Sanctionc,t (0.461) p-value: 0.052 (0.440)

Obs. 2,377,900 2,377,900R2 0.833 0.836

Credit supply from high-risk jurisdictions

Model 1 Model 2

Sanctionc,t -0.287*(0.161)

Non-cooperative country b 1.104** Sum: 0.817* 1.111**× Sanctionc,t (0.461) p-value: 0.052 (0.440)

Obs. 2,377,900 2,377,900R2 0.833 0.836

Prediction 2:

Bank groups allocate business to their affiliated branches and subsidiaries abroadin a way that minimizes legal risk and compliance costs.

→ Internal capital markets in multinational bank groups?

Prediction 2:

Bank groups allocate business to their affiliated branches and subsidiaries abroadin a way that minimizes legal risk and compliance costs.

→ Internal capital markets in multinational bank groups?

Rerouting credit

Example: German bank laundering Russian money moving itto accounts on Cyprus.

No sanction:

DEU CYP

bank locations

RUS SWE

Sanction on RUS

DEU CYP

bank locations

RUS SWE

Rerouting credit

Dep. variable: Credit that parent b in Germany sends to its affiliates in location c.Regressor: Credit that affiliates of b in location c provide to sanctioned countries.Sample: 2010-2015

Log Growth Intra-Group Creditb,c,t

(1) (2) (3) (4)

Log Growth Affiliates’ Sanctioned Creditb,c,t 0.039** 0.040** 0.039** 0.034**(0.016) (0.016) (0.016) (0.017)

Log Growth Affiliates’ Total Creditb,c,t 0.399***(0.091)

Month F.E. (t) Yes No No NoBank-country F.E. (b, c) No Yes Yes YesBank-month F.E. (b, t) No Yes Yes YesCountry-month F.E. (c, t) No No Yes YesObs. 471,318 471,318 471,318 471,318

Rerouting credit

Log Growth Intra-Group Creditb,c,t (1) (2) (3)

Dum(Affiliates’ Sanctioned Credit Growthb,c,t > 0) 0.044* 0.014 0.167***(0.025) (0.030) (0.054)

Dum(Affilates’ Sanct. Cr. Gr.b,c,t > 0) × Outside FATF c 0.146**(0.061)

Log Growth Affiliates’ Total Creditb,c,t 0.400*** 0.400*** 0.166*(0.096) (0.096) (0.090)

Month F.E. (t) No No NoBank-country F.E. (b, c) Yes Yes YesBank-month F.E. (b, t) Yes Yes YesCountry-month F.E. (c, t) Yes Yes YesSample of affiliate countries all all non-FATFObs. 471,318 471,318 237,704

Col. 1: ∼5% more intra-group credit when affiliate increases credit in sanctioned countries.Col. 2-3: ∼16% more intra-group credit in the case of affiliates located outside the FATF.

Mechanisms to prevent arbitrage:

1 Increase supervisory intensity and law enforcement in non-FATF countries(‘EU only’ sanctions vs. UN-wide sanctions)

2 Align legal compliance requirements of bank parents and their affiliatesabroad (subsidiaries vs. branches)

Effects on credit supply for “EU only” sanctions.Model 1 Model 2

EU Sanctionc,t -0.219UN Sanctionc,t -0.408*

Not EU country b × EU Sanc.c,t 0.138 Sum: -0.081 0.188Not EU country b × UN Sanc.c,t -0.422* Sum: -0.830* -0.535*

Not FATF country b × EU Sanc.c,t 0.689*** Sum: 0.470*** 0.596***Not FATF country b × UN Sanc.c,t 1.177 Sum: 0.755 1.073

Obs. 2,377,900 2,377,900R2 0.840 0.844

(s.e. not reported)

Mechanisms to prevent arbitrage

Alternatively:

“Import” German compliance requirements to offshore locations?

⇒ Choose legal status of German bank establishments abroad s.t. theymust comply with German (EU) rules and regulations?

⇒ Compare branches to subsidiaries!

Unlike subsidiaries (subject to local law), German branches must complywith EU regulations regardless of their location!

⇒ Formally identical compliance requirements for branches and parents!

Alternatively:

Branches vs. subsidiaries

Subsidiaries Branches

Sanctionc,t -0.396*** -0.363**(0.098) (0.149)

Not in FATF country b 1.133** Sum: 0.737* 0.487* Sum: 0.124× Sanctionc,t (0.483) p-value: 0.067 (0.278) p-val: 0.656

In country of counterp.b,c 1.352*** Sum: 0.956*** 2.548*** Sum: 2.185***× Sanctionc,t (0.134) p-value: 0.000 (0.279) p-val: 0.000

bank-country (b, c) Yes Yesbank-time (b, t) Yes Yescountry-time (c, t) No YesObs. 1,780,575 1,815,036

Branches behave more like subsidiaries than like their parents!

⇒ Formally harmonizing rules and regulations (branches = parents) isnecessary but not sufficient.

⇒ Also harmonize supervision and enforcement of these rules!

(→ model by Acharya, 2003)

Branches behave more like subsidiaries than like their parents!

⇒ Formally harmonizing rules and regulations (branches = parents) isnecessary but not sufficient.

⇒ Also harmonize supervision and enforcement of these rules!

(→ model by Acharya, 2003)

Extensions and robustness

1 Loans versus other bank assets – qualitatively similar effects

2 Non-bank versus bank counterparties – effects concentrated inpositions with non-bank counterparties

3 Euro-denominated external positions – qualitatively similar effects

Conclusion

2 ...via internal capital markets.

3 ...managing legal (non-financial) risks.

4 ...arbitraging supervision and law enforcement!

→ Not enough to harmonize only regulations!

5 Only a part of total German credit is rerouted.

⇒ The average German bank (irrespective of its location) still reducespositions by -24% (compared to -38% by banks located in DEU).

Conclusion

Appendix

Parent bank

Affiliatedsubsidiary

NFIOtherbanks

Foreigncountry

Germany

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