Wednesday, December 27, 2017

“Wheat doesn’t grow in Dubai.” – How Cikinova sidesteps U.S. Sanctions on Iran

For those working in trade finance, there is a readable case currently pending with the U.S. Southern District Court of New York. Reza Zarrab and his business comrades are accused of having disobeyed U.S. Sanctions Regulations against Iran.

U.S. / Iran Sanctions Regulation

Before spelling out how Reza  how to sidestepped the U.S. sanctions, let’s first start by briefly describing what U.S. authorities aim at:

Since 1979, the U.S. considers that Iran constitutes a threat to its national security, foreign policy, and economy. Opening sanctions were endorsed in 1995. Then, in 2013, the U.S. Government laid out further details and inhibited

  • the exportation, re-exportation, sale, or supply,
  • directly or indirectly, from the United States, or a United States Person,
  • of goods, technology, or services
  • to the Government of Iran, whereby the U.S. Government set a list of entities constituting the Government of Iran,
  • including business affairs with a third country knowing that such goods, technology or services were destined to Iran or the Government of Iran,
  • without a license from the United States Department of the Treasury, Office of Foreign Assets Control (OFAC), bearing in mind that such exceptions could be general (i.e. authorizing some general types of transactions such as food and medical sales and exports for humanitarian purposes) or specific (i.e. authorizing specific businesses only).

Let’s clarify the most important thing right away: The case is actually not about a U.S. company exporting stuff to Iran, in contempt of applicable sanctions. It’s actually about Iranian companies selling stuff (namely oil and gas) to people (not even U.S. citizens) and getting US Dollars in return. This is enough for the U.S. to consider that U.S. financial services have been provided, so triggering a sanctions violation.

Zarrab’s Sanctions Violation – Step 1 – Paying through a web of companies

Let’s assume the National Iranian Oil Company (NIOC) wants to sell crude oil to an international buyer for USD. A simple USD transfer from the Buyer to NIOC cannot work. Indeed, the U.S. Bank processing the USD transfer would block the money transfer right away because NIOC is a sanctioned entity. The solution is palpable: Set up some companies in different countries acting on behalf of NIOC but not declaring NIOC as recipient.

This is what Reza Zarrab and his associates are supposed to have set up. They held companies in Turkey, the United Arab Emirates, Switzerland, Canada, China, and the U.K. and routed payments through these entities.

But here is the catch: How can you track payments if you don’t pay the right beneficiary and don’t refer to the underlying contract while making the payment? Zarrab’s response is a mix of

  • indicating references such as “transfer to MAPNA” [Mapna Group, the Iranian construction and power plant company] in the subject heading of the wire transfer;
  • sending separate Emails defining the purpose of the payments.

The more sophisticated banks’ wire transfer tracking software becomes, the less efficient the first solution gets. This is what happened in the Zarrab case: U.S. banks repeatedly froze payments because they tampered with U.S. Sanctions.

Zarrab’s Sanctions Violation – Step 2 – Stretching Exceptions

As written above, sanctions usually come with exceptions for food, medical exports, humanitarian aid and the like. The Zarrab clan used such exclusions extensively – unfortunately too extensively. Indeed, the defendants are accused of having produced falsified shipping documents. In addition, the U.S. pretends that they have colluded with bank officials who, regularly ask for shipping documents to process the payments. The Turkish Halk Bank is not named as such in court but, due to the name of the defendants involved as well as their functions, easily recognizable.

Here are some illustrations the U.S. Attorneys have produced in court:

On March 16, 2013, Reza Zarrab wrote to Halk Bank’s Mehmet Hakan Attila: “They’re gonna stop the gold in about a month and a half […] do food! Wherever you can provide a document from, do it.”

Another quotation from Zarrab is even more outspoken: “Wherever you can provide a document from, do it […] whichever way you provide it, provide it. Provide it to Cikinova [coded language meaning false documentation] and Cikinova will send it; it is not a problem.”

When fine-tuning customs documents and bills of lading, “inaccuracies” occurred:

I’m thinking it would be slightly difficult to carry [goods] weighing 140-150 thousand tons in things that carry five thousand tons. That’s not physically possible.”

They want to be able to determine that the product is food. […] The wheat’s country of origin is Dubai… I mean, it’s impossible for wheat to be originated from Dubai. […] The man says wheat doesn’t grow in Dubai.”

Zarrab’s Sanctions Violation – Step 3– Getting caught

How do you get caught? You get caught because you are selling your services to Iran and because you exchange with your clients and partners. Supplemental to the above, here are some examples the U.S. prosecutors have presented:

You also get caught because you have to bribe politicians and bank managers. Indeed, the former Turkish Minister of the Economy and the former general manager of Halk Bank are accused as well and supposed to have accepted millions of USD as bribes.

One final word: The above are allegations. You may guess that the defendants dispute the case. Let’s wait and see what will be the final court decision.


  • Indictment dated December 15, 2015
  • Indictment dated March 21, 2016
  • Superseding Indictment dated November 7, 2016
  • Sealed Complaint dated March 17, 2017
  • Superseding Indictment dated September 6, 2017

Sunday, December 3, 2017

Manias, Panics, and Crashes – Financial Crises forever!

Do you remember Occupy Wall Street? The people “fighting back against the corrosive power of major banks and multinational corporations over the democratic process and the role of Wall Street in creating an economic collapse that has caused the greatest recession in generations”?

They would probably be disillusioned upon reading “Manias, Panics, and Crashes”, the reference book on financial crises written by Charles P. Kindleberger and Robert Z. Aliber. Why? Because once you read this book, you will understand that the next crisis is already underway – it’s just a question of time…

The course of a financial crisis

Walking us through the history of many financial crises, the authors outline a typical financial crisis:

Phase 1 – Going up

Asset price increase

The cycle starts with cheap credit – lots of credit.

At the beginning, companies raise funds through hedge financing: Their operating income is more than sufficient to pay both interest and scheduled reduction in indebtedness. At one point in time, speculative financing kicks in: A company’s operating income is sufficient to pay interest but not the indebtedness itself. For the latter, the company must raise new money. The final stage involves so called Ponzi financing, meaning that the anticipated operating income is not enough to pay interest and/or principal. The company must either raise new financing or sell assets to pay back.

On the retail side, households see that others are profiting from speculative purchases and invest as well. Trading volumes increase.

The above trends then spread around – from one country to another, from one sector to another, from one asset class to another, etc. This process is often self-enhancing. Let’s take the example of money flows between countries:

  • The receiving country attracts foreign capital because its economy is booming.
  • The incoming capital leads to higher asset, especially stock, prices. Higher stock prices mean that raising capital for investment becomes less expensive. This further accelerates the economic boom.
  • The economic boom and higher asset prices lead to an increase in household wealth and this, in turn, favors household spending. This then further enhances the economic boom.

The result of the above is higher asset prices. The curve goes up.

At the end of phase 1, an increasing number of investors seek short-term capital gains from increases in prices of real estate and stocks rather than from the investment income based on the productive use of these assets. In other words, people want to earn money not through holding on to the asset but through re-selling it as soon as possible with a profit. This is the moment when the famous bubble builds up. The authors write about a “loss of touch with rationality”.

Can central bankers do something about it?

The short answer is: No. They can perhaps shorten the supply of money as such. However, financial history tells us that there are many close substitutes of money that people can revert to: credit in all possible forms, real estate, commodities such as gold, crypto currencies, etc. Every time the monetary authorities try to control the amount of money, people will circumvent that covert by producing more near-money substitutes.

How to detect a bubble

If we cannot avoid the next financial crisis, can we, at least, detect the bubble before it bursts? For stock markets, the authors give some hints: In the long run,

  • the level of stock prices should reflect the growth rate of GDP;
  • the profit share of GDP (= corporate profits / GDP) should be about 8 %;
  • the price / earnings ratio for stocks (= stock prices / corporate earnings) should be about 18x;
  • excesses in the debt / capital ratio of a large number of firms and individuals lead to financial distress.

Phase 2 – Stay high

During phase 2, we remain in the bubble but it stops growing. At the end, buyers become less and the sellers more eager.

Oftentimes, when prices stay high but don’t sprout any more, fraud and swindle spread around: As a matter of fact, when credit becomes scanty, people start using fraud to compensate. This is especially true in case of evergreen finance: This hints to the practice of loans being paid back not through earnings but through cash from new loans.

Phase 3 – Going down

In phase 3, both firms and individuals realize that it’s time to become more liquid, i.e. to reduce holdings of real estate and stocks, and increase holdings of money. Prices start declining and credit is nowhere.

At this point in time, a specific event (failure / bankruptcy of a specific bank or firm, namely one which has previously been thought successful; revelation of a swindle; sharp fall in the price of a specific security or commodity such as oil; an unanticipated devaluation of a currency; a war or other far-reaching political changes; etc.) precipitates the crisis. The bubble bursts. It has to be like this; bubbles always implode because, by definition, they involve a non-sustainable pattern of price changes or cash flows.

The panic is often magnified through international contagion. Indeed, only very few markets are completely separated. This is all the more true in today’s globalized 21st century. Financial crises either affect a number of countries at the same time or, alternatively, spread from the centers where they originate to other countries. The means of transportation can take various forms – commodities, bank deposits, bills of exchange, specie, and last, but not least, pure psychology.

Phase 4 – Going up again

At one point in time, public authorities will feel obliged to intervene to avoid further price decline. Without doubt, such intervention can create moral hazard:

  • Investors first benefit privately on the upside and then avoid losses on the downside through public intervention.
  • Today’s intervention might fuel the next future crisis.

Still, in practice, authorities always arbitrate to stop the panic. Kindleberger and Aliber write – “Today wins over tomorrow.”

Panoply of interventions

How can public authorities react? The book puts together possible measures which have been applied throughout financial history:

  • Formal deposit insurance
  • Informal state guarantee to cover losses if banks fail
  • Lender of last resort
  • Close banks or markets temporarily to take political, military, and other measures
  • Suspend the publication of bank / financial statements: “What you don’t know won’t hurt you.”
  • Set daily limits on the maximum change in commodity and other asset prices
  • Set a time out in financial markets whenever the imbalance between buy and sell orders becomes exceptionally large
  • Issuing clearinghouse certificates (= near-money substitutes which constitute the liability of a group of large banks or other financial institutions) for use by a bank which is under a bank run
  • Other forms of bank collaboration (loan funds, funds for guarantees of liabilities, arranged mergers of weak banks and firms, etc.)
  • Issuance of marketable securities to a firm in financial difficulty against appropriate collateral
  • Tighten financial regulation such as daily mark to market, reserves and write-offs of problematic loans, capital requirements as a percentage of assets or other liabilities

National and international lender of last resort

Who can intervene to stop a financial crisis? There are plenty national lenders of last resort in financial history. By contrast, international lenders of last resort are rather sporadic.

On a national level, the lender of last resort is either the treasury or central bank. The former can be less effective. By definition, a Government’s treasury cannot print money. This, indeed, makes it less flexible to meet any potential demand on the part of sellers. Is simply cannot buy once it has spent all funds and is unable to raise additional liquidity.

Financial crises oftentimes spread across countries, hence the need for an international lender of last resort. But such lender encounters several shortfalls:

  • There isn’t one unique world currency that could be used to face the financial crisis.
  • On an international level, there is no (or, at least, only a very limited) legal framework which could govern the international lender of last resort.

The International Monetary Fund is today the main example for an international lender of last resort, even though his intervention is also pretty much dependent on its member states.

A somewhat similar form of international lender of last resort is the international SWAP network among national central banks.

The book undeniably teaches you to take a step back and accept any financial crisis as what it really is: An unavoidable and recurring pattern of any financial system. In my view, it is a good preparation for the next crisis. On the downside, I found it sometimes a bit repetitive. But this is perhaps due to the fact that financial history itself is iterative.


Charles P. Kindleberger / Robert Z. Aliber – Maniacs, Panics, and Crashes

Tuesday, November 28, 2017

Bank Commitments in the structured trade finance space – Why we (don’t) need them and what this means for regulators

Whenever we discuss transactions with clients, at one point in time, we encounter the topic of bank commitments. What are we precisely talking about? Who needs a bank commitment and why? What does it imply for the instructing corporate and the bank? In this post, I look at all these questions and conclude that there is no one unique form of commitment. The practice is indeed more complex and nuanced than theoretical legal definitions can ever be.

What is a bank commitment?

Let us first have a look into a general dictionary:

The Cambridge Dictionary defines a commitment as “a willingness to give your time and energy to something that you believe in, or a promise of firm decision to do something”. Merriam Webster writes about an “agreement or pledge to do something in the future”.

If we move a bit closer to the business world, terms such as “willingness” and “promise” are a bit less useful, even though they keep some importance. I will return to this point later. In contractual negotiations, showing a commitment is still part of the pre-contractual phase. However, being committed to your business partner is more than just figuring out whether you have common interests. You are actually entering a phase where your behavior must respect certain good business practices. In other words, when you show commitment, your negotiating partner has the right to expect a negotiation practice that corresponds to common international standards.

Moving into the finance space, the term commitment becomes even stronger: Most companies (some more others less – depending on their financial stance and direct access to financial markets) need banking support for their business. Indeed, any contract in the business world requires some form of financial product and if a corporate cannot rely on its financial partner (be it a bank, a bond investor, an insurance company, and the like), it will usually not be able to close the transaction. This is, by the way, the precise reason why all financial institutions run ad campaigns worshiping their culture for long-term and trustworthy relationships with clients.

Negotiating big contracts for huge projects, for example in the oil & gas business, is a particularly good example for the above described aspect of commitments. Let’s look at the example of an EPC (Engineering, Procurement, & Construction) Contract: Naturally, the EPC Contractor will be chosen, first and foremost, for his competence to carry out the project, i.e. his engineering, procurement, and construction works. But sometimes, this is not enough: Buyers of turnkey projects want to ensure that their partner has also the financial capacity to carry out the project until the end. Beyond financing the project itself, this is where trade finance instruments come into play. And this is also the point where the commitment of the EPC Contractor’s financial partner is raised to a higher level. Depending on the stakeholders involved, it might not only be the bank’s client who relies on a financial institution but the client’s client as well.

This is where the story becomes relevant for financial regulators as well: To put it bluntly, if a financial institution promises too much but several stakeholders still rely on it, it’s not only the bank’s client who will have a problem but all the stakeholders involved. And if we take this still a step further where it’s not only one financial institution but all financial institutions who promise too much, we enter into a space where the problem becomes systemic for the whole financial system.

This is why regulators today have a precise idea of what constitutes a bank commitment. However, surprisingly, the European Union’s Basel III regulation (more precisely called Capital Requirements Regulation (CRR) initially issued on June 26, 2013) does not include a definition of what is a commitment, although it is still 580 pages long. Yet, indirectly, we can understand that regulators distinguish between firm and non-binding undertakings of a bank: As a matter of fact, credit lines that are unconditionally cancellable at any time without prior notice and those which cancel automatically upon deterioration of the client’s creditworthiness do not require any minimum capital.

Why do bank commitments matter in trade finance?

The importance of bank commitments is basically a function of four parameters:

  • the credit stance of the Exporter (The better the exporter’s credit rating is, the higher is the competition among banks, and the lower is the need for a commitment.);
  • the size of the transaction (The bigger the transaction is, the more important it becomes for the parties secure its financing, and the more likely it is that the parties will ask for a bank commitment.);
  • the tenor of the transaction (The longer the tenor is, the more one must put emphasis on the bankability of the project and the likelier it becomes that a bank commitment will be necessary.);
  • the competition among banks and insurance companies for a given transaction (The more financiers are available, the less important it becomes to formally secure their commitment for a transaction.).

The importance of committed trade finance instruments – A 360° Perspective

From the exporter’s perspective, there is a trade-off to be made between a hard commitment and a soft commitment. The hard commitment is easy to qualify: The bank writes to his client: “I will accompany you on this export deal, whatever may happen in the future.” The soft commitment (We sometimes also talk about pure commercial commitments) is more subtle: The financial institution engages commercially with his client while, at the same time, reserving the right to retract if its appreciation of the client or the project changes.

The importer’s perspective is different: As a matter of fact, the importer will only indirectly be interested in any banking commitment. His interest is only indirect in a sense that, without financial support, the exporter will not be able to carry out the export transaction as such. Oftentimes, it is the size and quality of his business relationship with the seller and the countries involved which can trigger the need for a hard commitment.

The bank’s perspective is usually dominated by a risk / return trade-off. The question of a bank commitment is no different: The more I commit the more it becomes risky the more I should earn. Let me be more precise:
  • If a bank issues a hard commitment, it increases the risk profile of the transaction and its regulator will ask for mobilizing regulatory capital. This costs money and then triggers the need for a commitment fee.
  • If, however, the commitment is only of a commercial nature and leaves room for the bank to walk away, it incurs less risk on the transaction which, in turn, does not require additional capital.

We have already touched upon the regulator’s perspective: Bearing in mind the possibly systemic importance of commitments issued by the financial industry as a whole, the regulator might want to transform firm commitments into risk weighted assets which then require the backing through regulatory capital.

(Un)committed bank guarantee lines in practice

At first glance, one would expect the practice being pretty simple: The corporate should want a commitment only if it is absolutely necessary because it costs him finance charges. The financier should always want a commitment because this generates revenue.

The practice is more nuanced though:

  • The bank might actually not want to commit, for example because the option to walk away simplifies risk approvals or because a commitment would unnecessarily block available country risk limits.
  • The client might actually want a commitment even though his contractual counter party does not require any: In a large transaction, the corporate might want to secure the banking consortium involved in order to avoid a higher workload due to changes in the constitution of the financing pool.
  • There is no one single concept of a banking commitment. It’s a contractual instrument and, therefore, will always depend on what you specifically agree on with your bank. Indeed, a bank might commit subject to this and that, meaning that a commitment is sometimes worth paying for and sometimes not.
  • To complicate things further, a commitment evolves over time as well: For example, a commitment today is worth nothing if an embargo tomorrow runs against it.


The topic of bank commitments is difficult to grasp because it is very much dependent on the business practice in the sector at hand and because every stakeholder looks at it from its own and unique perspective. Whether it’s worth issuing (and paying) for them, will probably remain a case-by-case question.

Tuesday, October 17, 2017

Exporting military equipment from Europe – The EU Council Common Position

Assume you are a European producer of smoke grenades that you want to export to an Asian country. Can you do that? Yes, you can – but only if your home country has issued an export license.

Why do you need an export license?

You need an export license for two reasons: First, the EU has set out specific reasons for regulating the export, transit, and brokering of military technology and equipment. Second, smoke grenades are on the EU Common Military List and, thus, their export requires a specific license.

Why is a specific EU framework necessary?

The European Council mentions four reasons why he restricts the trade in military equipment:

  • Exporting military technology and equipment implies a special responsibility.
  • This makes it necessary to fix high common minimum standards for such exports and increase transparency in the field.
  • With regard to military technology and equipment, Europe wants to cooperate and converge.
  • Harmonizing Europe’s external relations requires consistent export activities, especially when it comes to defense material.

The EU Common Military List

EU member states need to assess export license applications for all items on the EU Common Military List.

When will you get your export license?

Focus on the importer

When appreciating whether or not to grant an export license, EU countries mainly focus on the importer:

  • Are human rights in the country of final destination respected? If there is internal repression or human rights violation, there should be no export license.
  • Is the internal situation in the country of final destination stable enough to allow for the export? If there is a possibility to provoke or prolong armed conflicts or aggravate existing tensions or conflicts in the country of final destination, there should be no export license.
  • Are regional peace, security, and stability preserved? If the importer country is concerned by an armed conflict with its neighbors, there should be no export of defense material.
  • Does the buyer country respect the international community and international law?
  • Is there a risk that the military technology or equipment will be diverted within the buyer country or re-exported under undesirable conditions?
  • Is the importer technically and economically able to handle the bought military equipment?

Focus on the exporter

Let’s turn to the exporter now: He cannot export if this would violate international obligations and commitments of Member States. Examples include embargoes, the Nuclear Non-Proliferation Treaty, and the Wassenaar Arrangement.

Is there anything that the exporter could raise to defend his willingness to export defense material? Indeed, only his own national security interests and self-defense as well as his responsibility towards friendly and allied countries should receive appropriate consideration.


  • EU Council Common Position 2008/944 dated December 8, 2008
  • EU Common Military List dated February 9, 2015

Tuesday, October 3, 2017

UN Arms Trade Treaty – How to restrict arms trade on 16 pages

Is it possible to regulate the arms trade in the world on 16 pages? Indeed, the length of the UN Arms Trade Treaty (ATT) is astonishingly short. Why is that? Because the ATT only contains a few general principals; a global regulation on such a topic will probably always remain wishful thinking.

On April 2, 2013, the United Nations have adopted the Arms Trade Treaty (ATT) and proposed the agreement to its member states for ratification. As of today, 130 states have signed and 92 states ratified the ATT. To enter into force, the ATT required at least 50 states to ratify it. Therefore, the ATT is, today, binding on the 92 states which have ratified it.

As always, let’s stick to the basics:

  • Which arms are concerned? (A)
  • What kind of trade? (T)
  • What is the treaty about? (T)

Which arms are concerned? (A)

The ATT targets conventional arms and lists them as follows: battle tanks, armoured combat vehicles, large-calibre artillery systems, combat aircraft, attack helicopters, warships, missiles and missile launchers, small arms and light weapons. Now we know what weapons the ATT applies to. As a general rule, the weapons shall be defined broadly. Said differently, in case of doubt, national laws shall rather be interpreted broadly than restrictively.

However, once you talk about “conventional weapons”, the obvious next question is – What about unconventional weapons? Unfortunately, the ATT has no response. It does not even say what unconventional weapons are. One thing is for sure, the right conclusion is not that any weapon other than unconventional weapons could be traded without any restriction. It’s rather the contrary.

What kind of trade? (T)

The ATT gives a self-explanatory definition: Trade includes export, import, transit, trans-shipment, and brokering.

What is the treaty about? (T)

What have the parties to the ATT agree on? Besides some general principles applicable to any arms’ trade, the ATT addresses trade related topics alongside the typical steps of an export transaction. A specific focus is put on export assessments and authorizations.

General Principles on arms trade

Trade Regulation along the entire export transaction timeline

Export Assessments & Authorizations

The cornerstone of the ATT is to set minimum standards for granting export authorizations. Some arguments argue for restriction:

  • Offence of international conventions or protocols relating to terrorism to which the exporting country is a party
  • Possible use for violations of international humanitarian law or human rights including gender-based violence or serious acts of violence against women and children
  • Threat of transnational organized crime

Other parameters are favorable to allowance:

  • Possible mitigation of the factors above (confidence-building measures or jointly developed and agreed programs by exporting and importing states)

Finally, some parameters can be both restrictive and liberal:

  • Maintain peace and security
  • Objective and non-discriminatory appreciation

The ATT is a sort of least common denominator: It’s a strict minimum on which UN member states could agree with reasonable success of the ATT being ratified by a maximum number of countries. The treaty is, therefore, pretty limited. This is not much but better than nothing. Obviously, nothing prevents states from adopting additional and more effective measures to pursue the purpose of the ATT.


United Nations – Arms Trade Treaty dated April 2, 2013

Tuesday, August 15, 2017

The U.S. “Countering America’s Adversaries Through Sanctions Act” – What does it mean for Russia?

On August 2, 2017, the U.S. President Donald Trump has signed new sanctions on Iran, Russia, and North Korea. For constitutional and other reasons, he was not happy:

I favor tough measures to punish and deter bad behavior by the rogue regimes in Tehran and Pyongyang. I also support making clear that America will not tolerate interference in our democratic process, and that we will side with our allies and friends against Russian subversion and destabilization.”

But, in the U.S. President’s view, “the Congress included a number of clearly unconstitutional provisions”, relating to the distribution of competences amongst U.S. constitutional institutions. Donald Trump says, the bill “encroaches on the executive branch’s authority to negotiate” and, probably most importantly, “I built a truly great company worth many billions of dollars. That is a big part of the reason I was elected. As President, I can make far better deals with foreign countries than Congress”.

Let’s put the political controversy aside for a minute and look at what is actually new about U.S. sanctions on Russia.

Why the U.S. burdens Russia with new sanctions

The U.S. Congress answers in its press release:

Vladimir Putin has actively undermined U.S. national security for years. Putin has a long record of aggressive acts that threaten global stability. […] Left unchecked, Russia is sure to continue its aggression. […] Putin and his cronies must face serious consequences for these dangerous and threatening acts.”

The bill is more specific, imploring that “Russia undermines the democratic processes and institutions in Ukraine and “Russian President Vladimir Putin ordered an influence campaign in 2016 aimed at the United States presidential election”.

Who undergoes which additional sanctions?

1. Modification of existing sanctions

As a reminder, the U.S. administration, until now, already established four separate categories of sanctioned persons, according to their degree of threat for the U.S.. The new bill tightens the sanctions for each of those groups:

Prior Interdictions
New Interdictions
Category 1
No new equity and no new debt maturing after 30 days or more
No new equity and no new debt maturing after 14 days or more
Category 2
No new debt maturing after 90 days or more
No new debt maturing after 60 days or more
Category 3
No new debt maturing after 30 days or more
No modification of prior interdictions
Category 4
No provision of goods or services for the oil exploration and production business if the project is a deepwater, Artic offshore, or shale project situated in the Russian Federation
No provision of goods or services for the oil exploration and production business if the project is a deepwater, Arctic offshore, or shale project and held at least at 33 % by the sanctioned person

The most far-reaching modification seems to be in category 4. Indeed, Russian upstream oil projects may, potentially, be sanctioned word-wide.

2. Sanctions with respect to cybersecurity and human rights abuses

The U.S. President shall identify persons

  • who engage, on behalf of the Russian Government, in activities undermining the cybersecurity of any person or democratic institution;
  • who are responsible for committing human rights violations in any territory occupied or otherwise controlled by Russia.

He may than block assets of and exclude such person from the U.S. territory.

3. Sanctions on the Russian intelligence & defense sector, Russian pipelines, and privatizations of state-owned assets in Russia

The bill allows for new U.S. sanctions to be taken against

  • persons engaging in transactions with the intelligence or defense sectors of the Russian Governments;
  • a person who participates in the construction or maintenance of Russian energy export pipelines through providing goods, services, technology, information, and support to Russia in the amount of 1 MUSD for each individual support or 5 MUSD for cumulative transactions over 12 months;
  • people who invest at least 10 MUSD in a privatization in Russia which unduly benefits officials of the Russian federation or their associates or family members.

There is a long list describing of what such sanctions can consist of:

  • No U.S. EXIM Bank assistance;
  • Refusal of export licenses;
  • Prohibit a U.S. financial institution to grant loans totaling at least 10 MUSD over any 12 months period;
  • Influence on international financial institutions (meaning multilaterals such as the IMF, IFC, EBRD, MIGA, and ADB) to avoid their financing;
  • No permission for the sanctioned person to act as primary dealer of U.S. Government debt instruments and prohibition to serve as a repository of U.S. Government funds;
  • Exclusion from U.S. Government procurement contracts;
  • Prohibition for the sanctioned party to participate in FOREX transactions which are subject to U.S. jurisdiction;
  • Suspension of banking transfers and payment flows which are subject to U.S. jurisdiction;
  • Ban on property transfers which are subject to U.S. jurisdiction;
  • Ban on investment in equity or debt of the sanctioned person;
  • Exclusion of executives and corporate officers of the sanctioned person.

In some cases, the U.S. President can waive sanctions if this is in the national security interest of the USA.

4. Sanctions targeting Russian financial, material, or technological support to the Government of Syria

In case this support relates to chemical, biological, nuclear, or conventional weapons, ballistic or cruise missile capabilities, or significant defense articles, the U.S. President can order the blocking of property or exclude individuals from the U.S. territory.

However, he also has capacity to waive such sanctions if this is in the national security interest of the USA.

All of the above still needs to be implemented in the weeks and months to come. Signing the bill by the U.S. President is certainly not the end of the story...


Bill H.R. 3364 (Countering America’s Adversaries Through Sanctions Act”) dated August 2, 2017

Monday, July 17, 2017

Mervyn King’s “The End of Alchemy” – The Beginning of new Banking Regulation?

In 2016, Mervyn King has written a great book about money, banking, and the future of the global economy. In my view, the book is at least 20 years ahead of its time. What Mervyn King proposes to make the financial system crisis resistant is both simple and completely intuitive. But it’s probably too easy to be adopted today. The complexity of financial regulation is too much of a crowded place for consultants, auditors, middle managers, and regulators to be left desert…

The financial crisis is the result of a saving / spending disequilibrium.

If the economy had grown after the crisis at the same rate as the number of books written about it, then we would have been back at full employment some while ago.” If King writes this in his introduction, the obvious question is: Why do you add another one?

The reason is that King is convinced that the 2008/09 financial crisis is not about the failure of some overambitious bankers but the failure of the financial system as a whole:

The 2008/09 financial crisis actually starts in 1989, when the Berlin wall fell and the free market doctrine was going global: King explains how China, India, and the countries of the former Soviet Union started producing and exporting cheaper consumer goods for the developed world. Over time, this lead to an imbalance between the developed and the developing world:

  • The developing world was exporting and saving but not consuming.
  • The developed world was borrowing and spending but not saving.

However, the developed world borrowed less than what the developing world wanted to invest, thus leading to ever lower interest rates which accelerated the vicious circle. At one point in time, the borrowers could no more reimburse and the house of cards collapsed.

What is financial alchemy?

At the heart of King’s book is his concept of financial alchemy – the idea that money equals physical goods such as gold and other precious metals. The alchemy consists of the belief that banks take everyone’s deposits short term (because we can claim the same amount of money back at any point in time) and invest it long-term without any risk for the depositor. Indeed, this is only true if you trust the system (investors, bankers, central bankers, etc. - basically everyone who participates in the financial system) and your trust holds true. In practice, Mervyn King writes, financial alchemy simply doesn’t work.

But why? The reason is that risk diversification doesn’t work. The idea that our short-term deposits are safe although the bank invests them long-term is based on the idea that the bank can diversify the risk of its investments. Mervyn King says that diversification cannot contain risk: There are, indeed, economic crisis events when everybody moves in the same direction, thus making risk diversification meaningless.

Uncertainty – radical uncertainty – is the spice of life.”

But what are these economic crisis events all about? King tries to come closer to a meaningful explanation using the concept of radical uncertainty.

Probability forecasting is everywhere in finance: Mathematicians take data sets from the past and derive probabilities for future scenarios. King writes that this is ok for managing risk. Risk is exactly that – the nature of a future outcome that can be defined precisely and, based on past experience, can be assigned some probability of the outcome occurring.

However, probability forecasting cannot handle uncertainty. The latter describes situations where you don’t know the outcome and, therefore, neither the probabilities of them occurring.

How to avoid financial alchemy?

Given the problem of maturity and risk transformation, how can we make bank deposits safe? The author gives four possible solutions:

  • Suspend the withdrawal of deposits in times of economic crises: This seems impossible. Beyond the panic that would spread around the population, how would people pay for their transactions?
  • Government guarantee for bank deposits: This is where we are today, at least implicitly. But this is not ideal because it virtually subsidizes the banks and creates problems of moral hazard.
  • Revoke the possibility for banks to create limited liability companies: This would mean we go back a few centuries and abandon capitalism. But who would then want to run a bank?
  • The central banks replaces lost deposits with official loans to banks: This is what Mervyn King suggests. In such system, he calls central banks the pawnbroker for all seasons (PFAS).

LOLR vs. PFAS – Does it make a difference?

Today, in times of financial crisis, central banks are “lenders of last resort” (LOLR). They lend to failed banks if nobody else does any more – not to save any individual bank but to save the financial system as a whole.

Apart from taxpayers’ sentiment of injustice (“We pay for bankers who got high bonuses in the past for lousy work!”) LOLR involves two problems:

  • Providing emergency liquidity to a bank increases people’s incentive for a bank run.
  • Banks may be reluctant to accept central bank liquidity because of the implied stigma.
  • As LOLR, a central bank should provide liquidity; it should not, however, solve an underlying solvency problem. If it did the latter, it would actually help individual financial institutions and not the whole system and that is not what taxpayer money should be used for. But can anyone draw a sharp front-line between liquidity and solvency?

Acting as a pawnbroker for all seasons (PFAS), the central bank’s role in a financial crisis changes:

  • A PFAS is different from a LOLR in that the PFAS plans in advance for lending a specific amount of liquidity to any bank in crisis against a specific nature and amount of collateral that the bank provides.
  • The central bank doesn’t protect the financial system by protecting a specific bank. It protects the deposits directly, not because they are held with such or such bank but because they are backed by either cash or a guaranteed contingent claim on its reserves. This, obviously, requires that banks are obliged to hold a specific amount of cash or collateral to back deposits at any time.

Mervyn King suggests implementing the PFAS system over a period of 10 to 20 years and describes the following concrete functioning:

  • Each bank decides how much and which collateral it wants to provide to the central bank in case of a liquidity crisis.
  • The central bank examines such assets upfront and decides on the applicable haircuts (i.e. How much will this asset be worth during a crisis?)
  • The sum of these assets determines the maximum amount that a bank can lend.
  • The financial regulator determines the bank’s total effective liquid liabilities, i.e. the bank’s total demand deposits and short-term unsecured debt (up to, say, one year).
  • The total effective liquid assets should exceed the total effective liquid liabilities. This rule constitutes a form of mandatory insurance against a banking crisis.

Minimum Capital Requirements, Risk Weighted Assets, Leverage Ratio, Liquidity Ratio – Do we still need all this?

In Mervyn King’s world of banking and finance, the answer is no. The central banking committing upfront to lend at all times against predefined assets makes all these things unnecessary. A pity for all the regulators, consultants, and compliance staff but what a fantastic win over bureaucracy!

But would it really be easier to determine asset haircuts for PFAS than to determine risk weighted assets? The author says that “the possibility to calibrate risk weights is an illusion [because of the presence of radical uncertainty].” I would say more or less the same about the asset haircuts. If you cannot figure out the riskiness of an asset because you don’t know anything about the future events that will trigger a crisis, how can you possibly know what an asset will be worth in such crisis? But still, the beauty of King’s system is that the central bank engages upfront to lend instead of hypocritically denying the necessity for a LOLR if such and such financial ratio is met.

Mervyn King’s book is excellent. If you are interested in the banking and finance world, you should definitely read it!


Mervyn King – The End of Alchemy – 2016