Sanctions Compliance: Western banks can play a key role in controlling the supply of dual-use goods to Russia

Sanctions control over the supply of dual-use goods to Russia should become preventive, and financial organisations should play the main role in its implementation, primarily this should be financial organisations of the Western coalition, i.e. it should be enforced ‘at the source’. Supplies of dual-use goods to Russia have not stopped and in price terms have reached the same level that was observed before the war. This means that they have decreased in physical terms but remain still very significant. However, reactive sanctions enforcement is proving unproductive. Last year, more than 1 million transactions were made to organise shipments worth $12.5 billion. Sanctions bodies — the American OFAC, European FinCEN, and British OFSI — do not have the resources to monitor such a volume of operations. At the same time, much, if not most, of this production is linked to Western manufacturers and firms, meaning their accounts are involved, at least at the beginning of the payment chain. Therefore, financial institutions of the coalition countries should play a key role in intensifying sanctions pressure, according to experts from the Bruegel think tank. Sanctions that are imposed post factum against individual organisers of parallel imports are only symbolic — usually targeting shell companies that are easily replaced. Western banks have the resources and expertise for this. However, the compliance system needs to be fine-tuned. At present it is focused on identifying suspicious transaction participants; banks are not always aware of the details of the transactions they service. There are also problems with identifying companies whose transactions need to be scrutinised particularly carefully. There are still no clear requirements in this regard. But, establishing clear rules of the game is not enough — incentives for their enforcement must be created. Banks need to see that violations are strictly punished.

The ongoing battle over the effectiveness of sanctions may eventually lead to significant changes in many of the rules of international trade. Analysts insist that traditional reactive sanctions enforcement is not working. Control mechanisms should become preventive, and the main role in their implementation should lie not so much with producers or suppliers, but with financial organisations. This is what the authors of a report by the Bruegel think tank, focused on the problem of controlling the supply of dual-use products and prepared with the participation of Benjamin Hilgenstock, a member of the Yermak-McFaul International Expert Group on Sanctions.

Since the beginning of the war, Russia has banned the export of 50 dual-use goods. According to the Kyiv School of Economics, as cited in the Bruegel report, Russia acquired such goods worth $12.5 billion in 2023. This volume was the same in terms of value as in 2021. Overall, the volume appears to have declined as the costs of parallel imports were higher (→ Re:Russia: Sanctions Party). According to expert estimates, Russia was overpaying more than 80% for the same microchips in 2023 than the legal market. Nevertheless, supply volumes remain significant. There are no clear signs that defence companies are experiencing a shortage of certain components or equipment. In 2021, Russia purchased $1.08 billion worth of goods from this category per month; immediately after the sanctions were imposed (March-July 2022), the value dropped to $600 million, i.e. by more than 40%. However, it then started to grow and now averages $1.06 billion per month. 

Russian imports of military-purpose goods, 2021-2023, million USD

The prohibited goods are divided into four groups, based on their importance for the military-industrial complex. The first group includes, in particular, the most advanced microchips, which Russian businesses are unable to produce. Their supply is estimated at $2.3 billion, or 18% of the total volume of imports of dual-use goods. Almost all imported components that Ukrainian experts extract from Russian military equipment, ammunition and other weapons were produced by companies incorporated in the countries of the sanctions coalition. More than 70% are of American origin. For example, Intel alone supplied components worth $474 million. The main supply routes pass through China and Hong Kong. However, the overall export of goods from the sanctioning coalition countries to Georgia, Armenia, Kazakhstan, and Kyrgyzstan has also more than doubled since the invasion of Ukraine.

Since we are primarily talking about goods produced by companies from the sanctions coalition countries, Western banks are involved in supply chains in one way or another — at the very least their correspondent accounts are used, the Bruegel experts point out. Analysing processed transactions post-factum is futile: last year, to organise supplies worth $12.5 billion, more than 1 million transactions were made, according to the Kyiv School of Economics. American and European authorities overseeing sanctions compliance do not have the resources to examine each one. At the same time, financial organisations have both the resources and the necessary experience to block suspicious transactions as they occur. Procedures that were once implemented to combat money laundering and the financing of international terrorism (know your customer, KYC) can be used effectively to block transactions involving sub-sanctioned goods. 

At the same time, existing compliance mechanisms need to be fine-tuned to detect complex transaction chains, convoluted ownership structures, the use of shell firms and opaque jurisdictions. Above all, financial organisations need to have more information. Under existing KYC procedures, they focus on identifying suspicious transaction participants. They are not always aware of the details of the transactions they service. For instance, if counterparties use letters of credit, the goods or services being paid for can be omitted from the details according to SWIFT rules. Organisers of parallel imports actively exploit this, the Bruegel experts assert.

There are also problems with the identification of companies whose transactions need to be scrutinised particularly carefully. This topic was recently discussed in the British Parliament. Representatives of UK Finance, the Association of British Insurers (ABI) and the Institute of Chartered Accountants in England and Wales (ICAEW) said that their members do not fully understand whether they can service transactions involving companies that are not on the sanctions lists, but are in some way related to listed entities. The UK Treasury's Office of Financial Sanctions Implementation (OFSI) has not explained to them what constitutes ‘control in a company’ - only ‘ownership’ has been clarified. 

The sanctioning bodies (US OFAC, European FinCEN and UK OFSI) need to establish not only clear rules of the game, but also to create incentives for their fulfilment. First and foremost, according to Bruegel experts, banks need to see that violations are strictly punished — in the absence of fines, they will continue to fulfil the requirements only formally. The first step in this direction was giving OFAC the authority to impose restrictions for direct or indirect facilitation of Russian military production. As we have previously written, the threat of secondary sanctions has forced not only Western banks, but also Turkish and even Chinese banks to reconsider their relations with clients connected to Russia (→ Re:Russia: The Spillover Effect). This appears to be one of the reasons for the reduction in Chinese exports to Russia in the first quarter. However, a recent Reuters investigation suggests that smaller banks are gradually taking the place of large banks unwilling to take risks. The only way to slow down this process is to start implementing the threats outlined and strengthening control ‘at the source’, as suggested in the Bruegel report. These efforts are likely to eventually lead to partial success and, at least in the short term, will continue to drive up the cost of parallel imports for Russia.