The Russian-dominated International Investment Bank (IIB), which was hit by US sanctions last week, announced on April 17 that it was unable to meet its obligations but would nevertheless still try to “honour its commitments towards its partners in full”.

“IIB states that currently, because of the imposed US sanctions, it has been deprived of the possibility to fulfil obligations to its counterparties,” it said in a brief statement. “Nevertheless, the bank has accumulated enough financial resources and assets to honour commitments towards its partners in full. IIB has already begun to contact corresponding authorities with a view to obtain appropriate licences and other necessary decisions to be able to fulfil these undertakings.”

The Budapest-based international development bank has in effect finally officially admitted that it is facing a liquidity crisis after being frozen out of international financial markets. At the same time it insists that it is not insolvent. Its statement implies that it will try to renegotiate terms with its bondholders to make its payments.

A spokeswoman told bne IntelliNews that liquidity was less the issue than how to make the actual  payments under sanctions. "There is enough liquidity in this bank to fully meet all obligations for a rather long perspective. It’s the execution of payments which is now a huge problem," she said.

The announcement marks the end of both Russia’s attempt to build a counterpart to the European Bank for Reconstruction and Development, and Hungarian Prime Minister Viktor Orban’s dream of turning Budapest into an international financial centre. It also symbolises the collapse of Orban's pro-Kremlin policy, which has so damaged the country’s reputation in the West.

Last week Orban said the future operation of the bank had "become impossible" after US sanctions were imposed on April 12.

Hungary, the largest shareholder after Russia, therefore had had to reluctantly leave the IIB, Orban said on April 14 in an interview to state radio. Hungary was the last EU member, following the withdrawal of Bulgaria, Czechia, Slovakia and Romania after the Russian invasion of Ukraine.

Leaked internal documents show that even before the imposition of sanctions the bank had been teetering on the brink of collapse after it was completely cut off from Western financial systems. The market expectation is now that IIB will soon cease operations due to insolvency.

Imre Boros, a Hungarian board member of IIB, said in a television interview the US sanctions against the bank would render its operation impossible. IIB's accounts will be blocked, it will not be able to transfer money, he said. It will be virtually destroyed by the punitive measures, "like a terrorist bombing", he added.

The Hungarian connection

IIB was originally established in 1970 as the Comecon bank, serving the then Soviet bloc’s economic area and Third World countries. The then Moscow-based bank went dormant during the collapse of the Soviet Union and was revived only in the early 2010s to support the expansion of Russia’s financial interests.

Hungary renewed its membership in IIB in October 2014, after a decade-long absence, following Orban’s second supermajority victory. This came nine months after the prime minister’s trip to Moscow, where he sealed the largest deal in Hungary’s history, assigning construction of the €12.5bn expansion of the Paks nuclear power plant without a tender to Russian state-owned Rosatom as the main constructor. Budapest and Moscow amended the terms of the contract last week.

Political analysts see 2014 as the turning point and the beginning of the end of liberal democracy in Hungary and the pivot to a Russian-style illiberal regime, which Orban openly acknowledged in a speech in the summer of 2014.

According to a leading Hungarian geopolitical analyst, Csaba Kancz, it was Orban’s former chief foreign adviser and former diplomat, Janos Balla, who proposed to the prime minister to raise the question of having the bank’s HQ relocated to Budapest in talks with the Russian president back when Hungary rejoined the bank.

The Hungarian government argued that moving the IIB’s seat to Hungary would strengthen the country’s role as an international financial centre. It also fitted well into the government's “Opening to the East” policy, which aimed to bolster economic ties with Russia, China and other emerging markets outside the EU.

"There are five supra-national development banks headquartered in the EU, but none of them are in Central Europe”, Orban said after meeting with IIB chairman Nikolay Kosov in Budapest in 2019.

Russia, as the biggest shareholder in the bank, also endorsed the idea to make IIB appear as less of a Kremlin operation.

IIB management sought to tap the advantages of moving to an EU capital and being the only multilateral development bank based in Central Europe. It began focussing much more of its lending in the Europe Union and sought to spread its client network to Western European multilaterals as well as to companies based in its member states. It was particularly strong in trade finance and lending to local SMEs.

It successfully issued several bonds in local currencies and euros in its member states to fund its activities, achieving low yields. In 2020 the IIB  became the first multilateral bank to launch two forint-denominated bond issues on the Budapest Stock Exchange. It participated in the issuance of the first Hungarian sovereign green bond in June, and then became one of the largest investors in the first green corporate bond issued by CPI Hungary Investments in August.

Credit rating agencies were also positive about the move. In a November 2018 note, Fitch said that the bank’s decision to relocate to a EU capital could lead to a positive rating action due to the improvement of the bank's business environment. Fitch then upgraded its rating to ‘A-‘ in September 2020 after the move.  

In 2018 December IIB member states unanimously voted for the proposal to relocate to Budapest. IIB officially started its activity in Budapest on April 2019.

In February 2021, IIB inaugurated its new Budapest HQ in the landmark Lanchid Palota building, next to the iconic Chain Bridge endowed by the government. Speaking at the ceremony, Finance Minister Mihaly Varga said the relocation had helped to raise Hungary's international profile as well as support its economic players.

US opposes bank from the outset

However, the IIB never really posed a financial challenge to the Western banking infrastructure. The bank remained tiny compared to the EU’s EIB or the Western-dominated European Bank for Reconstruction and Development (EBRD).

According to the IIB’s 2021 annual report, issued in February last year, the bank’s paid-in capital reached €424.9mn, compared to €6.2bn for the EBRD. Its assets amounted to €1.8bn, compared to the EBRD’s €34.3bn in operating assets. While it made a record ­– though still tiny – profit of €7.9mn, the EBRD made €2.5bn net profit in 2021.

Moreover, the United States had expressed grave reservations over the relocation from the onset, and quickly moved to make the bank's position impossible after the Russian invasion of Ukraine.

Washington successfully blocked the lender from having its HQ alongside the US Embassy in Hungary at the landmark Freedom Square, close to the parliament building. According to investigative news site Direkt 36, Orban assured then US Ambassador David Cornstein in May 2019 that the IIB could not pick a location for its office near the US embassy or any other Nato member country. Later, Cornstein told a congressional delegation visiting Budapest that US and Hungarian intelligence services would cooperate in monitoring IIB.

Critics warned that the IIB could serve intelligence and political purposes for Russia, particularly because of the diplomatic immunity granted to bank employees and guests.

In the spring of 2019, the government stipulated that much like the staff of other international financial institutions, IIB staff in Budapest would enjoy broad diplomatic immunities. However, it was forced to reduce the number of staff with immunity under pressure from the United States.

The family roots of the IIB chairman also added to speculation that the Russian-dominated lender would operate as a spy nest for the Kremlin. Chairman Nikolay Kosov’s parents moved to Hungary in the early 1970s when his father was appointed head of the operation of the KGB, the Soviet Union’s security and intelligence agency, in Hungary. The KGB office was on the same floor as the Ministry of the Interior in the centre of Budapest.

Hack attack reveals IIB’s financial woes

As a multilateral institution, the bank was not directly hit by the sanctions introduced against Russia for its annexation of Crimea. However, the IIB’s position quickly deteriorated. Bulgaria, Czechia, Slovakia and Romania announced plans to exit the bank.  The four EU members had €134.6mn in total paid-in capital in IBB and demanded it back.

Following the announcement of the exit of the four countries, Fitch Ratings withdrew the IIB's ratings, and Moody’s downgraded the bank to non-investment grade.

Worse, Belgian-based Euroclear, a financial service provider that registers and administers securities transactions, blocked IIB’s accounts linked to the EU sanctions against Russia, as the IIB account was opened by a Russian lender Rosbank. According to a 2022 year-end summary, €75mn of money in IIB’s accounts were blocked.

The impact of this on the bank’s liquidity was revealed in February, when hackers attacked IIB’s IT network, resulting in an unauthorised mass fake e-mail distribution on behalf of certain IIB officials. More importantly, hackers gained access to internal correspondence, documentation and sensitive information, shedding light on the bank’s financial troubles.

The leaked files, which included email correspondence and internal memos of the management, were reported on by regional investigative and news outlet VSquare. According to these files, the blocking of the IIB’s Euroclear account had created liquidity problems that were so severe that by March 2022 IIB was close to bankruptcy.

An internal letter to management highlighted the devastating effects of the decision: "IIB used up almost all other liquidity reserves in 2022 and as such, without access to its bonds in Euroclear, the bank will be forced to default or restructure its bonds as soon as May 2023," the leaked letter said. The letter claims that the bank faces a financial shortfall so severe that it is "a near impossible task" to make it better.

The leaked documentation also showed that the bank was seriously considering a"zero option" proposal of the management, in which the exiting shareholders would leave the bank empty-handed.

The exits had strengthened Hungary’s stake in the bank, which is based on paid-in capital of around €108mn. Hungary had 9.9% of shares when it rejoined the bank in 2015, which rose gradually to 17.3% in 2022, and after it took over the shares of Czechia and Slovakia it grew to 25.3%, making it the second-largest shareholder after Russia, with a 45.4% stake.

Hungary tried to assist the stricken development bank. There were discussions – now largely moot – about engineering the shareholdings so that Russia did not become a majority owner, which would have triggered EU sanctions.

Moreover, according to leaked documents, Hungarian Minister of Economic Development Marton Nagy lobbied to have the Euroclear accounts unfrozen in a letter sent to Belgian Minister of Finance Vincent Van Peteghem, and a Hungarian delegation was also ready to travel to Brussels to discuss the issue. The bank calculated that if they had access to securities, they could meet their obligations to their European and Russian creditors up until mid-2025.

However, Belgian authorities turned down the Russian’s request, saying several members of the IIB’s governing bodies are currently linked to the Russian government, like the Russian deputy finance minister, who is a member of the bank’s board of governors.

After the negative response, CFO Elliott Auckland outlined an "evacuation plan". The bank would agree with the European authorities to somehow get its money back from Euroclear, in return for which it would be used exclusively to pay off their European investors. This plan does not seem to have progressed and it now looks too late.

Last week the US placed the IIB and three of its senior executives resident in Hungary, Nikolay Kosov, Georgy Potapov, and Imre Laszloczki on its sanctions list.

IIB’s presence in Budapest enables Russia to increase its intelligence presence in Europe, opens the door for the Kremlin’s malign influence activities in Central Europe and the Western Balkans, and could serve as a mechanism for corruption and illicit finance, including sanctions violations, according to the US Department of the Treasury's Office of Foreign Assets Control (OFAC).

Given the US’s importance in the world financial system, these sanctions will make it impossible for the IIB to operate in the international environment. The IIB’s statement on April 17 merely recognises this fact.