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Lebanon’s banking crisis can only be solved with political reforms

Lebanon bank crisis Reuters
Lebanese police stand outside the entrance of the Association of Banks in downtown Beirut
  • Real GDP will be 47% smaller in 2022 than it was in 2017
  • Inflation rate was 168.5% in August with food prices up 240%
  • Restructuring banks requires capital for depositors to get back cash
  • Lebanon not yet meeting IMF’s requirements for support package

Lebanon’s banking sector is in ruins, with little progress made in reforming the ailing industry, whose collapse has helped plunge four-fifths of the country’s population into poverty and forced many citizens to take up arms to withdraw their own savings from banks.

Having imposed unofficial capital controls following an unravelling of the Lebanese pound’s longstanding dollar peg, the finance ministry’s latest attempt to unify the country’s multiple dollar exchange rates will fail without meaningful change, analysts warn.

“It’s a systemic political crisis. The main challenge is to overcome the failure of the state itself – it’s not only a problem of bad political, economic or fiscal decisions, it’s bigger than that,” said Sibylle Rizk, director of public policies at Kulluna Irada, an independent self-funded NGO lobbying for political reform in Lebanon.

“The institutions that manage the economy and society have been totally captured by a mixture of former and current militia leaders, sectarian leaders, financiers and business people.

“Meaningful and effective reform, so that we have a society where we have jobs, schools and a decent healthcare system, where Lebanese want to stay in Lebanon, isn’t possible in the current political system.”

Lebanon’s banks had long enjoyed easy profits, reinvesting customers’ dollar and local currency deposits in central bank instruments that the regulator then spent in part funding Lebanon’s worsening budget and current account deficits, subsidising imports and making interest payments.

Interest rates on pound accounts hit a 17-year peak of 9.4 percent in November 2019, while rates on foreign currency accounts followed a similar trajectory, despite US interest rates remaining around historical lows.

“Why take a risk on corporate or retail lending when you’ve got supposedly the best credit in the country, which is the government, giving you a spread of several percentage points?” said Khaled Abdel Majeed, a fund manager at London’s SAM Capital Partners.

“I had conference calls with banks’ managements teams where they made exactly that point.”

Tourism spending and remittances from the Lebanese diaspora – which peaked at 26.4 percent of GDP in 2008 – enabled Lebanon to run current account and budget deficits year after year.

Yet, as both these revenue sources slumped last decade, banks upped the interest rates they paid on local and foreign currency accounts to continue to attract money from home and abroad. The central bank did likewise for its creditors.

Eventually, the central bank could no longer service its debts, while in March 2020 Lebanon defaulted on a $1.2 billion Eurobond, its first ever sovereign debt default.

“It was all lost trying to maintain the pound’s dollar peg,” said Rizk.

Lebanon banking crisis
A man walks past a closed Blom Bank branch in Sidon, Lebanon Picture: Reuters

The consequences are stark.

Lebanon’s real GDP will be 47 percent smaller in 2022 than it was in 2017, S&P Global Ratings estimates. Over the same period, unemployment has risen five-fold and per capita income is down by two-thirds.

Lebanon’s annual inflation rate was 168.5 percent in August. Food prices are up 240 percent, the second-biggest increase globally according to the World Bank.

“An entire generation has been condemned to destitution, with families skipping meals, children compelled to work, women facing increased violence,” a United Nations report states.

In May, Lebanon’s cabinet passed a financial recovery plan. This revealed the central bank and commercial banks had combined net losses of 154 trillion pounds, based on an exchange rate of 3,500 pounds to the dollars. Eurobond holders will also face “significant losses”.

Total public debt, which includes foreign currency debt valued at the official exchange rate, was 131.2 trillion pounds ($87 billion) as of April, nearly double that of a decade earlier.

Banks had put around 80 percent of their dollar deposits into central bank instruments, according to a September report by the Konrad Adenauer Stiftung institute, that estimates $51.2 billion remains unaccounted for.

“Lebanese commercial banks, though bankrupt with negative equity, continue to function as normal operating concerns,” the report adds.

As Bank Audi explains in a recent earnings statement, there is now a concept of “local dollars” which customers cannot withdraw from their accounts due to unofficial capital controls. Several Lebanese have held up bank branches to demand their money this year.

Lebanon banking crisis
Lebanon’s poor are having to borrow to buy bread. Picture: Reuters

“Eventually, everyone – shareholders, depositors, bondholders or whomever – will have to take a haircut, and the government will write off a lot of its debt,” said Majeed, a Palestinian-Jordanian who grew up in Beirut.

“The bigger the deposit, the larger the haircut, but the problem there is that the big depositors are the ones with the influence. So, again, nothing happens.”

More than 50 percent of deposits are held by just one percent of customers, according to a report by Lebanese academic Ghassan Dibeh.

Wael Menhem, partner at London-based Lundy Investors with offices in Beirut, described the banking system as stuck in a stalemate.

“The government hasn’t yet presented a concrete plan that the international community considers viable to restructure the financial sector and balance the current account and budget,” he said.

“Restructuring the banks will require new capital and a clear plan for how depositors will get back some of their money over a period of years.”

Tie, Accessories, Accessory
Lebanon’s current President Michel Aoun’s term runs out on October 31

IMF $3bn support package subject to reforms

Lebanon’s government in April reached a provisional agreement with the IMF for a 46-month support package worth around $3 billion, subject to the country implementing certain reforms.

The IMF also called for Lebanon to implement a “realistic”, unified exchange rate. Currently, there is the official rate of 1,507.5 that still applies to certain staples; a bank rate of 8,000 at which depositors can withdraw small amounts from dollar accounts, but receive pounds; the “Sayrafa” rate, at which the central bank will provide dollars and is currently 29,800; and the black market rate, which is around 39,300.

Lebanon’s finance ministry on September 28 announced said it would change the pound’s official dollar rate to 15,000 from November 1, should a government financial recovery plan be approved.

“Part of the restructuring needs to include a plan to converge all these rates together normally,” said Menhem.

“To get the various rates to converge, you need to conduct and complete reforms so that you reach a path where you can create sustainable economic growth and have a plan to reduce the FX burn on the trade and budget side. Just fixing the rate at a new, higher level isn’t the solution.”

Should the government fail to implement sufficient reforms, the pound’s black-market value could fall substantially further, Menhem warned.

Under the government’s plan, banks would recover excessive interest income paid to depositors, while the central bank’s losses would be absorbed by a “bail-in” – ie, forfeiture – of unspecified amount of banks’ deposits and certificate of deposits at the central bank.

Lebanon’s banking association in April said it “completely rejects this disastrous plan”, complaining that it violates the country’s constitution and regulations. The association did not respond to further request for comment.

In a disorderly bank restructuring, where Lebanon receives no financial support from the IMF or other countries, all depositors would likely suffer a “haircut” – or loss – of 70-75 percent on their savings, according to Lundy calculations.

A best-case scenario, where the IMF and foreign donors provide meaningful financial support, would still leave customers with deposits of less than $100,000 facing haircuts of 55-60 percent, while customers with deposits over $100,000 would lose 80-90 percent, Lundy estimates.

“In terms of the banking system, there is more pain to come. Banks may close permanently if they aren’t recapitalised because they’re running out of liquidity,” said Menhem, noting that many lenders have offered corporate borrowers discounts of up to around 85 percent on their loans if they repay in full so as to provide the banks with much-needed cash.

“They’re already taking massive haircuts on their assets, and they’ll get to a point where their assets don’t generate any liquidity anymore. The sector must separate good and bad assets and create new banks to hold the good assets and attract new deposits.”

A 1956 banking secrecy law, similar to the rules that governed Switzerland’s banking system, has long protected the clients of Lebanon’s banks from scrutiny.

Lebanon banking crisis
The IMF has called for Lebanon to implement a “realistic”, unified exchange rate. Picture: Reuters/Johannes P. Christo

In July, parliament approved reforms to the controversial law, but in September the IMF said these were insufficient and warned that more changes were required if Lebanon was to fight corruption, eliminate impediments to banking industry restructuring, investigate financial crimes and recover illicit assets.

“Lebanon’s political system is based on impunity – impunity for war crimes, for the August 4 explosion, for financial crimes, embezzlement, corruption, tax evasion et cetera – and the banking secrecy law is key to enabling this impunity,” said Rizk. “So, changing this law would open the door to a new system in Lebanon.”

The government plan suggests creating a Public Asset Management Company (PAMC) to hold key government assets including its real estate holdings and equity stakes in state-owned companies but excluding potential oil and gas revenues.

Profits from the PAMC would then fund capital increases at the central bank, allowing it to fulfil its remaining obligations to banks after a certain amount of its losses had been written off.

Banks’ direct and indirect losses could total 186 trillion pounds, according to the plan which proposes a 31 trillion capital write-off that wipes out all shareholders.

Customer deposits seized for the bail-in will be transferred to a deposit recovery fund in which holders would be entitled to receive revenue.

“This twist was imagined to avoid forcing the biggest depositors to take a straight haircut and it seems this might fly,” added Kulluna Irada’s Rizk.

“None of the restructuring plans include any figures, so we don’t know exactly what will be the final scheme, but whatever its eventual form one thing we know will be absent is accountability. It’s as if this crisis was a natural catastrophe for which no one is responsible.”