Prudential risks for banks with a Russian presence

Prudential risks for banks with a Russian presence

Mon 11 Apr 2022

The invasion of Ukraine by Russia on 24 February 2022 is considered the most significant geopolitical event since the Second World War. While there is no question of military intervention by the European Union (EU) at the moment, the EU has nevertheless decided on a major package of sanctions that will have a heavy impact on the Russian economic and financial system. These sanctions will also impact foreign banks and companies present in Russia and, by extension, the banking system.

Limited direct exposure to Russia

Many foreign banks operate in Russia directly via dedicated subsidiaries or offshore entities. However, in a recent statement, chair of the European Central Bank’s (ECB) Supervisory Board, Andrea Enria, confirmed that the direct exposure of European banks to Russia was not significant. Banks such as BNP Paribas and Crédit Agricole have since announced that they are suspending their activities in Russia.

The main risk is the bankruptcy of subsidiaries present on Russian soil or the threat of nationalisation by the Russian state. However, major banks would be able to absorb such a shock, given their solvency level, and would not call into question their share buyback and dividend payment plans, although the ECB has reinforced its expectations on distribution plans.

Indirect consequences present risks

Fuelled by the sanctions regime, the indirect consequences stem from the impact of the economic and financial context on customers and bank counterparties, such as exporting companies. Banks are thus exposed to interest rate, credit, liquidity, market, and operational risks, including reputation, non-compliance, ICT and cyber threats.

As a result of freezing the Central Bank of Russia’s foreign currency assets, the ruble collapsed, forcing the Central Bank of Russia to raise its key rates from 9.5% to 20%. This severe shock poses a significant interest rate risk to the economic value of Russian banks’ equity. In addition, net interest incomes could suffer from weaker credit demand as refinancing conditions tighten.

With regards to loans, banks are exposed to significant credit risk in the non-financial sector. On the one hand, the Russian state’s threat to nationalise all foreign-owned factories that have been voluntarily shut down[1] is a source of significant credit loss for foreign companies with a significant presence in Russia. On the other hand, to force Russian companies and individuals to repay their ruble debts to creditors in Western countries would constitute an event of default. The situation would be exacerbated by the probable default of the Russian State on coupon payments of its bonds issued in dollars, of which a considerable maturity is expected in April, with the corollary effect of crowding out private companies from international refinancing. The closure of EU airspace to Russian planes, the US embargo on Russian raw materials, the ban on the export of advanced technologies or naval equipment, and the ban on luxury product exports are likely to affect the airline, energy, technology and luxury goods sectors in particular. Finally, the ability of households and companies to repay their loans could come under intense pressure due to the significant price inflation of energy, cereal and metal raw materials.

The disconnection of the seven main Russian banks[2] from the international SWIFT messaging network not only exposes the Russian banking system to systemic risk but also global financial system contagion in the event of an interbank liquidity crisis. In addition, the freezing of Russian Central Bank assets aims to prevent the bank from liquidating its assets into foreign currencies to support the ruble and refinance its banking sector.

With regards to financial instruments, banks are exposed to market risks from trading portfolio losses in the event of a general decline in the markets or an increase in margin calls on derivatives for both their ruble and non-ruble assets.

Banks could also suffer significant exposure to reputational risk[3] related to their asset management activities. Some funds have already suffered significant losses due to the valuation of exposures linked to Russian assets considered illiquid. The situation comes from Central Bank of Russia’s sales restrictions on assets to non-residents or direct and indirect exposure to Russian entities or activities..

In addition, banks are significantly exposed to the risk of non-compliance when freezing foreign assets of oligarchs and other Russian personalities listed by the EU if they cannot identify the final beneficiaries of client structures and vehicles used or prevent new fund subscriptions. Banks are also expected to monitor financial transactions by Russians, even EU residents, including new credits, payments or large deposits. This ensures that transactions are not circumventing  Western sanctions, including customers depositing money on behalf of people subject to sanctions.

Finally, there are two major emerging risks. First, the risk of massive cyberattacks by Russia against European financial and non-financial companies. Less immediate is increased exposure to climate-related risks, due to the recourse to coal needed to reactivate certain gas-fired power plants due to possible Russian energy supply shortages, particularly in the event of a gradual or immediate withdrawal of Russian oil and gas.

Banking watchdogs on the alert

The EU subsidiary of the Russian-owned Sberbank became the first financial casualty of the conflict, having suffered a major run from depositors that left the bank unable to meet its commitments.[4] Although reassured by the low exposure of banks to Russia, the prudential authorities nevertheless remain vigilant about the indirect consequences of this conflict. For example, supervisors could reactivate measures to ease prudential requirements applicable to the banking sector, such as a relaxation of capital buffers or payment moratoria on loans, to support credit. However, with a high inflation and rising interest rate environment unfavourable to an increase in household and corporate debt, such measures are less relevant than at the time of the pandemic crisis.

On 11 March, the European Banking Authority (EBA) called on institutions to enforce EU sanctions against Russia and facilitate refugees’ access to bank accounts. The EBA also expects institutions to assess the adequacy and effectiveness of their internal control and governance frameworks and adapt their systems and processes if needed. Where necessary, banks should also verify the adequacy of their business continuity plan in light of the high risk of cyber-attacks and carefully assess the prudential consequences of their economic activities in light of the geopolitical situation.

As for the ECB, Andrea Enria has recently spoken more cautiously about plans for banks’ dividend distributions and share buybacks, particularly those most exposed to Russia and Ukraine. The same applies to their provisioning plans. Distribution plans must be consistent with robust capital trajectories under central and adverse scenarios and be submitted to the ECB before any public announcement.

[1] For example, Renault announcing that it is suspending its production in Russia, which means stopping the activity of its subsidiary Avtovaz.

[2] Excluding Gazprom bank and Sberbank

[3] Or more precisely the risk of “step-in”, i.e. of supporting a fund without being contractually bound to do so, or beyond contractual obligations.

[4] The parent company in Austria will be liquidated and the two subsidiaries depending on the banking union area operating in Croatia and Slovenia sold to local banks, following a decision by the SRB.