Wielding SWIFT against Russia is a big risk

Western leaders have agreed on an ambitious move to punish Russian President Vladimir Putin for invading Ukraine: Cut some of Russia's largest banks off from the international financial system by excluding them from SWIFT, the messaging service that facilitates the vast majority of money transfers globally.

If only the logic of their initiative matched its boldness. Although it will deal Russia a brutal blow, it will also wreak havoc elsewhere in a way that traditional sanctions do not. The allies should be mindful of setting a dangerous precedent with this historic intervention.

The Society for Worldwide Interbank Financial Telecommunication plays a crucial role in international trade and investment. The Belgium-based cooperative, overseen by a global group of central banks, provides a secure network and standardized language for sending and receiving payment instructions — allowing for much larger volumes and greater automation than the error-prone telexes that prevailed before its inception in the 1970s. The actual money moves separately, wending its way through a web of correspondent banks before reaching its destination.

Suppose a Detroit-based machine shop wants to pay an aluminum supplier in Russia. Its local bank sends a SWIFT message to a larger bank — let's say Citibank — with all the necessary information, including the alphanumeric address of the receiving institution. This sets into motion a series of transactions — moving funds, say, from the local bank's account at Citi to a European institution such as Deutsche Bank to the Russian bank and ultimately to the supplier.

Financial sanctions usually target the latter, money-moving part. Consider last week's US measures against Sberbank, Russia's largest: They require American banks to close any correspondent accounts, effectively cutting Sberbank and its clients off from the US dollar financial system. Law-abiding banks won't hold or move funds for the sanctioned institutions, no matter how many SWIFT messages they send.

Such traditional measures also have flexibility to limit collateral damage. The US sanctions, for example, include an exception for Russian energy exports, to avoid aggravating a surge in global oil and gas prices that has weighed particularly heavily on Europe. They also make allowances for existing business — so Sberbank's foreign creditors, for example, can get their loans repaid.

Exclusion from SWIFT is a much blunter weapon. It doesn't on its own prevent foreign banks from dealing with their Russian counterparts, but it does severely impair the Russian banks' ability to exchange any payment instructions whatsoever with thousands of SWIFT-connected institutions in more than 200 countries. To some extent, Russia has prepared for this by setting up its own messaging system and trying to link up with China. Russian banks can also attempt to transmit payment instructions by phone or fax. But such workarounds can't support anywhere near their current volumes of business.

The repercussions are potentially severe within Russia and abroad. Without the exceptions that traditional sanctions allow, the excluded banks will struggle to process payments for exports to Europe, impeding Russian trade — possibly including energy exports to Europe. Payments through the sanctioned banks to all Russian creditors, including holders of Russian stocks and bonds, will at the very least be disrupted, if not shut down completely.

Aside from the immediate collateral damage, excluding Russian banks from SWIFT risks longer-term consequences for international finance. As with any network (think Facebook), the value of SWIFT depends on the number of banks that use it. To that end, the cooperative seeks to encourage the broadest possible participation by maintaining neutrality. Only Iran, which was already isolated financially, has ever been cut off. The example of Russia could prompt others — such as China — to turn to alternatives, fragmenting the payments system and potentially even undermining the US dollar's dominance as the global reserve currency. One could even imagine a future in which rival nations turned similar financial weapons against the US

So far, at least, the decision to focus on specific institutions rather than the entire country will mitigate the immediate blowback, allowing some necessary flows through unaffected banks. Still, Europe will bear the brunt: Its banks are more exposed to Russia, and it's more dependent on imports of Russian natural gas. The US must provide what support it can — for example, by stepping up efforts to supply liquefied natural gas. It also needs to resist the urge to unilaterally wield access to the dollar system as a geopolitical bludgeon, so it can credibly argue that harsh measures like these will be used only in extreme scenarios.

Western leaders should be wary of going further and ejecting Russia from SWIFT completely. The effect would be utterly indiscriminate: Supplies of Russian oil, gas and other commodities could collapse, foreign creditors would suffer heavy losses, and even Russians who scorned Putin's actions and sought to emigrate would have to resort to laundering techniques to get their money out of the country. Putin might well interpret such a cutoff as an act of war and respond accordingly.

As the conflict continues, the international community should work together to coordinate more traditional sanctions aimed at an increasing number of Russian banks, which would impose similarly harsh punishment without such dire unintended consequences — and on measures (such as those already announced) aimed at limiting the Russian central bank's ability to support targeted institutions. Western nations' desire to do something big and bold is correct, but they — and the US especially — should be wary of taking actions that they'll regret.

Disclaimer: This article first appeared on Bloomberg, and is published by special syndication arrangement