In May 2016, Banque du Liban (BDL), Lebanon’s central bank, completed the first phase of a swap operation with the Ministry of Finance (MoF). Following that, BDL pulled the financial engineering tool out of its bag. It proceeded to banks with an offer to enter into a transaction in which they would have to bring in money against fresh US dollars inflows. With their existing or new funds, banks could opt to purchase any of three tranches of Eurobonds held by the central bank since their interaction with the MoF, and/or CDs issued by the central bank at the same maturities and same coupon rates as the Eurobonds.
The precise total of Eurobonds and CDs which the central sold to banks is not yet compiled but it is generally assumed to be above $10 billion. Also not known is the ratio between money that banks pulled in from correspondent accounts and fresh funds that they could attract from investors. An indication for the latter, however, is the growth rate of deposits. Before the financial engineering this rate stood at 3.7 to 3.8 percent; after the engineering the growth rate was reported at 5 percent, meaning that growth has increased due to the financial engineering.
Incentives and rewards
It is important to understand that the central bank did not entice commercial banks to buy Eurobonds by selling them at a discount or awarding banks with higher coupon rates on Eurobonds. The tool used by the central bank to encourage banks’ participation in the operation was to offer voluntary discounting of LBP T-bills and CDs with maturities of 12 years or less at 0 percent with a haircut of 50 percent. If banks sold LBP denominated T-bills (or T-bonds) with remaining maturities of eight years and less or CDs, the central bank would buy these papers at no discount (zero percent) but with a reduction in their coupons (haircut) of 50 percent.
In discounting at zero percent, the central bank offered to the commercial banks to provide them ad hoc with the total accumulated amount that they would normally earn over time in annual coupon payments. In applying a 50 percent reduction on the amount that is due from the discount date to the maturity date of the respective T-bill, the central bank at the same time wanted the banks to settle for a “haircut” equal to 50 percent of the amount that they would have gained when holding the T-bills to their maturities. What looked at first sight like a non-recurrent windfall gain in the billions of dollars for the commercial banks was in actuality a non-zero sum (win-win) interaction with the commercial banks by the central bank on one hand and a boost of BDL’s foreign currency reserves on the other.
Instead of having to service coupon payments twice every year until maturity, the central bank provided commercial banks with these amounts upfront (the premium), but minus 50 percent of nominal value. The central bank as the new holder of the treasury bills was of course entitled to collect the annual coupon payments to 100 percent, so that by time of maturity the BDL would have recouped the full amount given to the commercial banks as premium, plus the other income (50 percent of the coupons) that was due from the T-bills.
[pullquote]It is important to understand that the central bank did not entice commerical banks to buy Eurobonds by selling them at a discount or awarding banks with higher coupon rates on Eurobonds[/pullquote]
On the side of the commercial banks, money-now was clearly preferable to money-in-future, even at a 50 percent reduction compared with what they would have earned over years in future. Given the magnitude of involved amounts – dollar billions – some banks could report non-recurrent, not interest-based incomes to have shot up by several hundred percent in Q3 of 2016 when compared with the same quarter in 2015. This was truly a rare opportunity for any large bank, or even a small one.
To safeguard the intended usage of their advance premiums by the commercial banks, the central bank issued directives that this income was not to be included in their Profit & Loss statement and potentially allocated to distribution (as dividend for shareholders) but should be added to Tier-2 capital.
Background and context
The background against which this financial engineering played out is not a crisis or recession as the events that triggered quantitative easing measures by the Federal Reserve System after 2008 or by the European Central Bank during the current decade in the course of various national crises in euro-zone countries. The context of BDL’s action was a threefold scenario of past indicators in combination with a future outlook mixing elements of uncertainty and predictable events on the side of upcoming rules and regulations – a drama but not a crisis.
The three unfriendly past developments were a slide in foreign currency reserves at the central bank (in 1H 2016), a deterioration in Lebanon’s balance of payments (ongoing since 2010), and a slowing in the growth rate of deposits. The elements on uncertainty specifically entailed prospects for remittances for Lebanese diaspora. According to World Bank data, remittance inflows remained strong at over $7.5 billion and are projected to be 1.6 percent higher in 2016 when compared with 2015. However, the dependence or forced reliance on inflows coming from the Lebanese diaspora is a perennial source of concern in financial planning, which is exacerbated by observations of oil price weaknesses and liquidity squeezes in the Gulf.
The predictable regulatory events in global finance and their impacts on Lebanon first involve future requirements under the IFRS 9 accounting standards. These new standards mandate that provisions for loans are made in the capital of banks at the moment of issuing a loan, not, as previously only when a loan turns sour. A second predictable event will be implementation of new solvency requirements under the Basle III framework (15 percent capital adequacy ratio instead of 12 percent today); also on the horizon is a requirement for two percent in general reserves on any bank’s loan portfolio.
[pullquote]Senior BDL staff spent hours on phone calls either answering financial engineering-related questions from banks or even calling banks that had not responded to the offer[/pullquote]
With the financial engineering, Lebanon preemptively positioned its banks to have higher capital bases (cumulative increase estimated at $2.5 billion) as they transferred non-recurrent income from the financial engineering operation to Tier-2 capital. Other measurable outcomes are a jump to central bank forex reserves to a historic high (around $41 billion, not counting gold reserves at the end of October 2016), a turnaround of the balance of payments from a deficit of roughly $2 billion before the financial engineering to a surplus of $555 million, and the aforementioned widening in the growth rate of deposits.
In terms of central bank activities, one can divide 2016 into three phases. First was the swap phase involving BDL and MOF. This was wrapped up tight within one month, May 2016. Next came what could be called a negotiation or subscription phase, during which BDL opened its channels to commercial banks for enrolling in the transaction process involving the discount of LBP-denominated T-bills and CDs by banks to BDL and the banks’ simultaneous purchase of foreign currency denominated paper from BDL.
During this phase, which lasted for about ten weeks from early June until mid-August, all banks participated in the financial engineering exercise, even as it was acknowledged by market insiders that certain banks acted faster and smarter than others.
Following upon the close of the offer in mid-August was then an execution phase that lasted until late October, at which time the positive outcomes of the financial engineering were highlighted by central bank Governor Riad Salameh in a number of speeches and addresses at events such as BDL Accelerate. One month later, at the end of November, not all details have been computed by BDL but overall dimensions of moved amounts are estimated in the market at $11 or 12 billion, in equal parts benefiting the central bank (through reserves) and the commercial banks (through boosts to Tier-2 capital and some revenue gains). The harvested benefits and their allocations to capital and other uses differ from bank to bank and are not proportional to each bank’s size or ranking by assets. In addition, there are the macro-economically relevant numbers relating to the shift in the balance of payments and increased deposits growth rate.
The announcement of the financial engineering’s outcomes and huge dimensions led to a flood of questions and comments, including both conspiracy allegations and legitimate queries. What may have also contributed to confusion, besides the inherent complexity of unconventional central bank measures in general, is that the operation involved many details, sidebars and deceptively low interest rate benefits. For example, viewing the 1 percentage point increase in the growth rate of deposits in context of the total size of deposits, which is in the dimension of $160 billion, makes it clear that the gain is substantial in absolute terms, and would be equivalent to the immigration of one to two billionaires with all their assets. In another example of an effect with actual implications that are not directly meeting the eye, central bank sources told Executive that BDL is granting banks the opportunity to place long-term deposits in LBP with the central bank if they commit to five-year deposit terms at 5 percent interest. At this cost, BDL will have funds available that it can use when the Lebanese Republic issues paper – normally issued with a 6.74 percent interest rate – thus reducing the burden on the sovereign.
Motivations, objectives and effects
Cognizant of the notion that one encounters three expert assessments in any assembly involving two economists, Executive notes that an infinite number of interpretations of this BDL financial engineering is possible. World Bank assessments, as published in the fall 2016 Lebanon Economic Monitor (LEM) list several advantages and disadvantages of the exercise, such as, on the part of BDL, increased exposure to foreign-denominated sovereign debt and expansion of liabilities in foreign currency and in local currency as disadvantages versus a boost in its stock of foreign exchange reserves and enforcing of confidence in Lebanon’s exchange rate and financial system as advantages.
For commercial banks, the LEM lists as advantages their increased capital positions and increased liquidity in local currency along with a drop in their sovereign exposure in local currency and as disadvantages a decrease in their liquid foreign-currency assets placed with banks abroad as well as an increase in their sovereign exposure in foreign currency. From the macroeconomic point of view, the World Bank sees disadvantages in potential liquidity management challenges, a potential decrease in the appetite of banks for Eurobonds in the primary market and a corresponding enforcement of BDL’s role in mediating government paper, an increase in foreign exchange risk (mirrored in a disadvantage for the Ministry of Finance in form of increased sovereign exposure to exchange rate risk) and a transfer of rent – money not worked for – from the public sector to the private sector. The sole advantage listed by the World Bank economists for the macro economy is a (weakly formulated) prospect for increased private lending in LBP.
[pullquote]The central bank’s own list of impacts and objectives behind the financial engineering is all benefits and mentions no risks[/pullquote]
From BDL’s perspective, many of the disadvantages outlined in the LEM have been and are seen simply as normal effects that come with its operations in a country with Lebanon’s profile. The central bank’s own list of impacts and objectives behind the financial engineering is all benefits and mentions no risks.
As for the seven benefits detailed on its web site, they are (1) strengthening of its forex assets, (2) a beefing up of commercial banks’ capital bases, (3) increasing liquidity in local currency and undertaking quantitative easing to provide public and private sectors with financing at optimal costs, (4) improving the government debt profile, (5) increasing the balance of payments status, (6) nudging inflation (previously around zero percent) upwards to BDL’s 2 percent inflation goal, and (7) improving Lebanon’s outlook and ratings with international ratings agencies.
The central objective and “golden term” in BDL’s thinking was indubitably an enhancement of confidence in the Lebanese system, without which the central bank rightly sees it as not possible to attract deposits from abroad, either by institutions and professional asset managers or by Lebanese expats – noting that the Lebanese diaspora is important as source of inflows and that future inflows might be affected by factors such as troubles in international economies, for example in Latin America, on top of the aforementioned effects of oil price weakening and liquidity squeezes on Gulf Cooperation Council (GCC) economies. This squeeze showed effects not only in issuance of sovereign bonds by countries in the GCC but also in the financial markets where banks have begun to aggressively hunt for deposits and thus are hiking deposit interests to rates comparable to those offered in Lebanon.
In the end, some of these objectives and impacts might be viewed differently by economists depending on their various ideological or socio-political persuasions and some impacts might be related to causal factors that are not in the purview of the Lebanese central bank. There is new confidence and more time for Lebanon, but reasonable minds know that a price will be due. Into one direction, the Lebanese Republic can press down the road of structural reforms. Going down any other road will bring the country closer to ruin. It is worth repeating: for this improved appearance of the Lebanese economy to turn into a permanent advantage, the country needs to embark on a rigorous regime of structural reforms on the fiscal side and has to activate political decision making processes that have lain dormant for far too long.