On a pound for pound basis, European banks are far more exposed to Russian debt than their U.S. counterparts. And Russia is looking increasingly likely to default on that debt. 

It is getting harder and harder for European banks to continue operating in Russia as the pressure rises on them to pack their bags. Or at least close the office doors until the dust settles from Russia’s invasion of Ukraine, assuming it ever does. Last Thursday (March 10), Deutsche Bank’s chief financial officer said it was impractical for the bank to shutter its Russian unit; a day later, presumably following some serious arm twisting from European and US authorities, the bank changed its tune.

“Like some international peers and in line with our legal regulatory obligations, we are in the process of winding down our remaining business in Russia while we help our non-Russian multinational clients in reducing their operations,” wrote Dylan Riddle, a U.S.-based spokesperson for the German bank, in an email, adding “there won’t be any new business in Russia.”

First Movers

Goldman Sachs and JPMorgan Chase were the first major Western banks to announce they are leaving Russia following the country’s invasion of Ukraine. But the two lenders had already significantly pared back their operations in the country following Crimea’s referendum to join Russia in 2014. And whether or not the two Wall Street giants actually deliver on their threat remains to be seen. After all, both lenders have been gobbling up the distressed debt of Russian stocks and bonds after unprecedented economic sanctions crushed their market value.

The only major U.S. bank that has kept a large presence in Russia is Citigroup, which has around 3,000 employees in the country and close to $10 billion in total exposure. Citi said on Wednesday it was assessing its options.

On a pound for pound basis, European banks are far more exposed than their U.S. counterparts. As I noted in a previous article, cutting off Russian banks from the Belgium-based SWIFT payments system, the backbone of the cross-border payments and the global banking network, could backfire on European banks in a serious way. An unnamed banker cited by Reuters likened it to an “atomic bomb” for the industry since it could end up preventing the repayment of debts to European banks with significant exposure to Russia.

In the end, just seven out of 300 Russian financial institutions were cut off from SWIFT, but they included VTB, which has large operations in Europe. Even more importantly, the U.S., EU and Japan have barred the Russian central bank from accessing a large chunk of the vast foreign currency reserves Moscow had been amassing in their domestic banks. Russia’s central bank is still allowed to access its reserves for energy payments, which keeps a lifeline open for the central bank as well as for energy-dependent European countries. It is also still able to access the 13% of its foreign currency reserves held in Chinese yuan.

Looming Sovereign Debt Default

Nonetheless, this coordinated act by the US, EU and Japan to cut Russia off from its reserves has two huge potential ramifications: first, as NC has already covered in great depth (including in this piece by Michael Hudson), it risks doing serious damage to the U.S.’ dollar empire by essentially weaponizing the prevailing global currency system; second, it has made it much more likely that Russia will end up defaulting on its foreign debt, just as it did in its debt crisis of 1998/99 (albeit only on the foreign debt accrued during the Soviet-era). The International Monetary Fund Managing Director Kristalina Georgieva said on Sunday that a Russian sovereign debt default is no longer an “improbable event.”

Moscow has already threatened to pay international bondholders in roubles, which are sharply depreciating on an hourly basis, rather than dollars. On Monday Moscow said it had sent an order to a correspondent bank to pay interest of $117.2m on external loans, which is due on Wednesday. Given many of its bond contracts do not allow for this, that in and of itself could be interpreted by ratings agencies as a default event. Last week Fitch cut Russia’s sovereign debt even deeper into junk territory, warning that a default was imminent.

As the FT reports, Russia’s Finance Minister Anton Siluanov said on Sunday it was “absolutely fair” for Russia to make all of its sovereign debt payments in doubles until the West lifted its embargo of some $300 billion of the country’s reserves.

“We need to pay for critical imports. Food, medicine, a whole array of other vital goods,” Siluanov told a state television interviewer. “But the debts we need to pay to the countries that have been unfriendly to the Russian Federation and have limited our use of foreign currency reserves — we will pay off our debt to these countries in the rouble equivalent,” he said.

Siluanov said that almost half of Russia’s $643bn foreign reserves had been hit by the sanctions, but did not disclose the denominations and jurisdictions where Russia holds other currencies.

Investors have been bracing for a default, with both bonds trading at around 20 cents on the dollar. Moscow will have a 30-day grace period to make the coupon payments.

International investors hold around $170bn in Russian assets, according to Financial Times calculations, with foreign currency bonds accounting for $20bn. More than two dozen asset management companies have had to freeze funds with significant Russia exposure, while others have had to sharply write down their value.

Corporate bonds issued by Russian companies in USD, EUR, GBP, etc. are also facing default as the companies struggle to make interest payments to bondholders in foreign currency. The Russian government may even prevent them from doing so, forcing them to make the payments in rubles. Again, that could be construed as a default.

Ripples Through the System

The effects are rippling through the global financial system. The world’s largest asset management firm, BlackRock, has already posted $17 billion in losses on its funds exposed to Russian assets. JP Morgan Chase and Pimco have also posted large losses on funds they manage. As my friend and former colleague at WOLF STREET, Wolf Richter, noted on Monday, much of the money that will be lost is other people’s money (OPM):

Those funds with exposure to Russian assets have been heavily marketed to retail investors not in Russia, but in the US and Europe. “Emerging Europe” funds and Russia funds were supposed to be part of the strategy to increase returns and diversify assets. This is mostly the money of American and European retail investors.

US pension funds too have loaded up with Russian assets, and that’s the money of beneficiaries (OPM).

Now pension funds are trying to unload those assets but trading in those assets has halted and markets are frozen. This includes real estate assets that are now totally illiquid.

As for international banks themselves, they are owed around $120 billion by Russian entities, according to the Bank for International Settlements, which suspended Russia’s membership on Thursday. European banks have more than $84 billion if total claims, with France, Italy and Austria by far the most exposed. Italian and French banks each had outstanding claims of some $25 billion on Russia in the third quarter of 2021. Austrian lenders had $17.5 billion. That compares with $14.7 billion for US lenders.

The Most Exposed of All

No bank is as exposed as Austria’s Raiffeisen Bank International (RBI), which enjoys a presence in Russia dating back to the last Tsar. Today, Russia accounts for around €11.6 billion euros of its loans, or 11% of the group total, and provides around a third of its operating profits. After losing nearly half its share value since Russia invaded Ukraine prompting a vertiginous escalation of sanctions against Russia, the bank has suspended its 2021 dividend. But so far it has categorically ruled out leaving Russia, which together with Belarus and Ukraine account for roughly half its group profits.

During the past decade of rising geopolitical tensions between the West and Russia the bank has reduced its risk-weighted assets in Russia while also making structural changes to limit the risk of the parent. As Investors’ Chronicle notes, “the bank’s subsidiary structure offers some protection from contagion as cross border loans are comparatively small. So, while Raiffeisen bank has a theoretical exposure to Russia of €22.85bn, most of this is held within the local subsidiary and poses no real risk to the parent.”

But limiting the damage could still difficult. The expulsion of a handful of Russia’s largest banks from the SWIFT has left RBI’s Russian business units isolated. Companies heavily exposed to Russia are also facing serious political and social pressure to reduce their presence — a move that RBI is unwilling to consider.

On the bright side, as an article in Bloomberg points out, the bank has strong capital reserves and is attracting new deposits from Russians reluctant to keep all their money with local lenders. Crises also provide opportunities. Europe still needs to keep its cash lines with Russia open to ensure gas and oil deliveries continue. If RBI plays its cards right, it could strengthen its role as a financial intermediary between western-European states and Russia.

Also heavily exposed is Italy’s second largest lender and sole globally systemically important bank (G-SIB), Unicredit, whose losses on Russian exposure would exceed €7bn. If realized in full, that would be enough to knock two percentage points from its core tier one capital ratio – currently 15 per cent.

Blowback Begins

The blowback has already begun to be felt in some EU Member States, including Austria and Germany, where banks are now expected to have to pay higher payments to Deposit Guarantee Schemes to cover the resolution of Sberbank Europe AG in Austria and its subsidiaries in Croatia and Slovenia. This follows an announcement by the Single Resolution Board (SRB) on February 28 that Sberbank Europe AG in Austria and its subsidiaries in Croatia and Slovenia were failing or likely to fail due to a rapid and significant deterioration of the banks’ liquidity situation. The three banks were promptly placed under moratorium.

Before that Sberbank had total assets of $13.8 billion. Some of its deposits will now have to be covered by the Deposit Guarantee Schemes in Austria and Germany, where insolvency proceedings have already been initiated.

Now concerns are rising about the European subsidiary of Russian lender VTB, which has total assets of over $7 billion and is likely to suffer a similar fate to Sberbank’s European subsidiaries. According to a Bloomberg article published last week, authorities in Germany are exploring alternative solutions to minimize the impact on domestic lenders:

German authorities are stepping up scrutiny of VTB Bank PJSC’s European operations as they seek to avoid triggering the deposit insurance scheme that could represent a multi-billion-dollar upfront hit to other banks in the nation.

The Russian lender, with European operations headquartered in Frankfurt, is being monitored by the German central bank, the financial markets regulator and deposit insurance bodies, people with knowledge of the matter said. Authorities are trying to find a solution that avoids an automatic triggering of payouts to clients, while still bracing for a potential wind-down, said the people, who asked to remain anonymous as the matter is private.

Regulators want to win more time for VTB in Europe to avoid upfront costs for Germany’s other banks, said the people.

If VTB’s European subsidiary does go under, it will be the second collapse of a foreign bank on German soil in the past 12 months. In March 2021, Greensill Bank, the German banking arm of British supply chain giant Greensill, collapsed after it emerged that the company and its banking subsidiary had been engaged in all manner of financial chicanery. Greensill Bank had a reported €3.5 billion in deposits at the time, part of which had to be covered by the guarantee fund’s reserves, generating additional expenses for lenders including Deutsche Bank AG.

Attention is now turning to whether or not Europe’s already beleaguered banks will be able to cope with the potential fallout of a Russian sovereign debt default — and if not, what that could mean for the global economy at large. No doubt the ECB will unleash even more monetary stimulus, having already almost doubled its balance sheet over the past two years, but it may not be enough to prevent the ripples from turning into waves.