The United States and the European Union moved quickly to impose economic sanctions against Russia and selected state-owned businesses following Russia's Feb. 24 invasion of Ukraine. One of the strongest measures imposed to date was to remove select Russian banks from SWIFT (Society for Worldwide Interbank Financial Telecommunication), a secure financial messaging service used to execute international transactions among banks.
What is SWIFT and how does it work?
SWIFT is a world-leading, member-owned, cooperative organization that provides secure financial messaging services for the execution of financial transactions and payments across borders. Within the SWIFT network, the 11,000 member banks communicate with each other through a standard language—the SWIFT message. These SWIFT messages are used to initiate and execute transactions with unique bank identifiers called SWIFT codes. SWIFT handles about 10 billion messages a year. The vast majority of any individual or corporate international transactions settled among banks relies on the SWIFT messaging system.
Cutting off Russia from the SWIFT system could have an immediate dramatic financial impact. Every Russian citizen paying an Uber fare or buying a movie ticket with a credit card likely has their transactions go through SWIFT. Similarly, any bank transaction corresponding to payments for energy exports accruing to Russian companies, for technology imports, or to meet financial obligations owed abroad go through the SWIFT system. It is a critical component of the international financial plumbing system, and any country cut off from it would see its international financial and trade ties instantly frozen and these transactions disrupted.
What did the U.S. and Europe do?
Neither the United States nor the European Union controls SWIFT directly, but each can exert influence on its governing body, and has done so in the past in either cooperating or competing with each other. On Feb. 26, the United States, the European Commission, and the United Kingdom announced a commitment to ensure that selected Russian banks are removed from the SWIFT messaging system or have their access restricted to permitted transactions. While the details are not available at this time, it is likely the ban will be similar to one imposed by the United States earlier last week, which restricted U.S. financial institutions to transact with Russia's two largest state-owned banks (Sberbank and VTB Bank) and other financial institutions.
How painful would it be for Russia if its banks were shut out of SWIFT? Could Russia continue to conduct business?
Banning a bank from SWIFT freezes, at least temporarily, its ability to transact with the rest of the world. It prevents the excluded bank from executing and settling its and its customers' obligations with foreigners, receiving payment for exports, or providing short-term credit for imports. This can paralyze the sectors of the economy engaged in international trade and finance. Russian citizens would also find traveling abroad much more cumbersome.
Russia's domestic payment system could also be disrupted to the extent that any transactions issued by the major credit card companies (VISA, Mastercard, Amex, etc.) all operate through SWIFT. However, Russia has already developed its own transaction system known as the System for Transfer of Financial Messages (SPFS), currently used only for domestic transactions. SPFS was created after the United States attempted to impose a similar ban from SWIFT following Russia's annexation of Crimea in 2014. Even a selective ban on Russian banks would have a major immediate economic impact on the Russian economy and its businesses.
Indeed, reactions to the SWIFT announcement, combined with the actual freezing of the Russian Central Bank foreign assets on Feb. 28, were immediate and attest to the severity of the penalties imposed. The ruble tumbled about 30%, the central bank doubled interest rates to 20% and imposed controls on payments abroad. The public reacted with a generalized run on bank deposits amid fears that citizens may not be able to use credit cards for day-to-day purchases and tried to buy dollars on the parallel market to protect their savings from losing value in domestic currency. Russia last witnessed such degree of financial disruption in 1998 when it defaulted on its foreign debt and plunged its domestic financial system into a deep crisis.
Are there any risks for the larger global economy?
Yes. Banning Russian banks from SWIFT poses significant risk for the world economy. First and foremost, it risks disrupting the energy supply to Europe, and commodity exports to global markets, triggering further increases in energy and food prices. Prices of oil, gas, and many other commodities are already elevated due to supply shortages, adverse weather shocks, and supply chain disruptions. This materially complicates the job of the Federal Reserve and European Central Bank in lowering inflation, which is already running at historically very high levels. Default on Russian obligations abroad could have repercussions on the foreign creditors and bring about a liquidity shock to the U.S. or European interbank market. Large American and European corporations rushing to liquidate their stakes in Russian operations, as already announced by oil giants BP and Shell, would incur further losses on their holdings that may ultimately have to be written off. Indeed, dollar shortages in the global interbank market started to surface on Feb. 28, as American and other foreign counterparts to targeted Russian financial institutions rushed to cover their exposures.
Given that the success and the efficiency of a payment network depends on the universal adoption and use of its services, the greater risk of using the figurative "nuclear weapon" in the arsenal of financial sanctions is permanent damage to international financial integration.
Has this type of sanction been used before, and was it effective?
North Korea and Iran have long been cut off from SWIFT. Although this particular sanction has contributed to the crippling of these economies, like any other economic sanction, it has not brought about regime change or conflict resolution. Venezuela was also targeted by a similar action in 2019, without leading to material change in the situation on the ground.
The strong impact of a ban from SWIFT is bound to be temporary. When lighter SWIFT sanctions were applied to Russia in 2014, the country was quick to develop its own messaging network to support the domestic payment system. Russia also changed the composition of its foreign reserves away from the U.S. dollar and strengthened ties with the Chinese Cross-Border Interbank Payment System (CIPS), which can settle international claims in yuan.
China, in turn, developed its own parallel international messaging system over the past few years as a precautionary measure against the increased likelihood of U.S.-imposed financial sanctions. Even the European Union, at the time of the breakdown of the Iran nuclear deal, had started to develop its own financial messaging system to avoid getting trapped in the web of U.S.-imposed sanctions on Iran.
So countries adapt and find ways around sanctions. Sanctions are likely most effective as threat in diplomatic negotiations. Nonetheless, the short-term economic impact on the targeted country and the willingness to bear economic costs to show support for the aggressed nation certainly steepen the price tag of the invasion and provide desperately needed to support to the victims of the aggression.