Banking sector 2020 overview

What’s left to bank on?

Where does one even begin? From the inability to withdraw deposits, to the depreciation of the Lebanese currency, and the default on the  Lebanese Sovereign Debt (held in big part by the banking sector), Lebanese banks’ balance sheets have suffered a blow, in addition to self-imposed capital controls on withdrawals.

 The future of the Lebanese banking sector is puzzling: mandated or voluntary mergers of commercial banks, bankruptcies, restructuring, haircuts on deposits… All of these proposals have been put on the table in 2020, though discussions with the International Monetary Fund have been halted on the side of the Lebanese Government. What appears as a financial crisis has a strict political component: it is difficult to separate economics from politics in Lebanon.

Capital controls and bank runs

As soon as the October revolution began, panic hit Lebanon. The Lebanese rushed to banks to retrieve their deposits. The October revolution shook whatever remaining confidence people had in the Lebanese economy. The turning point can be said to be August 2019. A Fitch report downgraded the rating of the Lebanese sovereign debt to CCC, a term signaling that the country is currently vulnerable and dependent on favorable business, financial, and economic conditions to meet its financial commitments. During this time, the US State Department’s Office of Foreign Assets Control (OFAC) also listed Jammal Trust Bank, a Lebanese bank, on the US Sanctions list – signaling that the bank was sanctioned by the State Department for allegedly providing support to Hezbollah. These events helped erode confidence in the Lebanese banking sector. In fact, since early 2019, Lebanese commercial banks had recorded a higher than usual series of outflows, highlighting a lack of depositor confidence.

 Due to Lebanese banks’ lack of available liquidity, supplying the Lebanese with their money held as deposits proved impossible. Deposits are held as loans, investments and deposits at the Central Bank of Lebanon (BDL). Immediately then, banks had to impose controls on withdrawals, and depositors could only retrieve a portion of their savings.

The situation is close to bank runs occurring in different countries over the years (such as Iceland and Cyprus), and reminiscent of the bank run that had hit Intra Bank (the largest Lebanese Bank in the early 1960s) in 1966. This has cast doubts as to the amount of liquidity available in the banking sector as a whole.  Depositors since then have been wondering whether they will ever see their money again. 

Under the Basel III requirements set up by the Basel Committee On Banking Supervision, banks must maintain a certain liquidity ratio, calculated as sufficient high-liquid ratios over total net liquidity outflows occurring during 30 days. According to Nassib Ghobril, Chief Economist at the Bank Byblos Group, liquidity ratios vary according to banks, with some having a higher level of liquidity than others prior to the crisis, and it is therefore misleading to not look at individual instances in the sector. With 80% of deposits being in foreign currencies, mostly dollars, the dollarization rate of the Lebanese economy is extremely high. “It’s a psychological result of the experience of the 1980s,” says Ghobril, referring to the rapid depreciation of the Lebanese Pound in the 1980s and the beginning of the daily use of US dollars for transactions (as the Lebanese Pound was depreciated in the 1980s, the Lebanese started to transact in dollars, deemed a safer currency).

 In most bank runs, the sense of panic is such that there is not enough liquidity to cover a higher than average withdrawal demand. A typical solution in this situation is for governmental authorities to impose temporary limits on withdrawals: capital controls. Such a measure has until now, not been taken by the government and had added to pressure on banks, to handle the crisis on their own. 

“Definitely there is a need for official capital controls, since September 2019,” says Ghobril. “We are not the first country to have a bank run, and not the last”. In 1966, within a week of the liquidity crisis of Intra Bank, capital controls had been imposed, only to be lifted about one month later which helped banks resume normal operations and restore confidence. For Ghobril, the lack of trust in the financial sector can be blamed in part on inaction on the part of the government. Had a capital control law been enacted at the start of the crisis, he argues, accusations regarding the flight of capital since October 2019 would not have occurred.

 The need for a capital controls law has been a key demand of economists and various politicians. Lack of such law could result in various lawsuits from depositors, and this has been happening lately as many Lebanese alpha banks (top Lebanese banks with more than $2 billion dollars in deposits) have been sued by foreign depositors unable to withdraw deposits. 

As a result, trust in the banking system has been severely hit, with many fearing that their deposits are mere accounting entries. Depositors have been channeling money into real estate since November 2019 and for most of 2020, but also into consumer goods such as cars, watches, paintings, statues, and others, due to the fear of a haircut, especially after the government defaulted on its foreign obligations and issued its financial plan. Very little of this money, according to Ghobril, was channeled into investments such as agriculture and industry. With regards to pre-crisis deposits in USD, these dollars can only be withdrawn at an e-board rate (currently of LBP 3,900 to one USD) and in limited quantities.

 Some banks have prioritized liquidity and asset quality over the expansion of their balance sheet over the years  according to Ghobril, who stressed the need not to generalize with regards to the health and outlook on the banking sector. Overall, the real health of the banking sector will be better assessed in February 2021, as it would have reached a milestone: compliance with BDL circulars regarding the need to recapitalize banks at 20 percent, and the need to insure a minimum of 3 percent of liquidity to equity. At this moment, banks that would have been able to recapitalize would be known as those that are safer, while others will probably not reach that milestone, and will have to face the possibility of halting operations.

Non-performing loans

The issue of non-performing loans has also been at the forefront. With a depreciation of the Lebanese Pound and the poor economic climate, many activities do not reward investors with high or even any yields, and many companies facing severe difficulties, threatening the health of banks’ loan portfolio. 

According to a World Bank report dated December 1, 2020, there is a sharp deterioration of credit performance at Lebanese banks, reflected as a measure of non-performing loans (NPLs). These NPLs are estimated at 30 percent of total loans, of which 50 percent of NPLs to total loans are related to contracting and construction. If true, this would be a heavy drag on the banking sector, as banks are required to take provisions equal to the value of these NPLs. 

For Ghobril, there are many question marks, as the World Bank report has a distinct anti-banking flavor, and, in his opinion, is indifferent to the plight of the banking sector. Since October 2019, the fear of a haircut on deposits has resulted in a rush to buy real estate and land, which in turn, has resulted in benefits for companies in the construction and real estate sector. Consequently, many have settled their loans before maturity, and the level of NPLs has been brought down in these sectors. The report, on the other hand, mentions a spike in the NPL ratio between October 2019 to June 2020, from 13.3 percent to 28.3 percent – hence Ghobril’s doubt as to the validity of the report.

Eurobonds cross-default 

On May 8, 2020, Lebanon cross-defaulted on its Eurobond obligations (sovereign debt labeled in US dollars), a first in its history. This default resulted in a complete stop in payments by the Lebanese Government to debt holders, and it massively affected banks’ liquidity, as $11 billion worth of Eurobonds are held by local banks. As these payments were made to banks, the default highly affected the latters’ liquidity, adding pressure on the sector.

 The decision to default in itself was controversial. Lebanon defaulted on a $1.2 billion issuance due March 16, 2020, but the government could have avoided a default had it agreed on restructuring terms with coupon holders prior to the non-payment. This would have required the approval by vote of 75 percent of holders of each Eurobonds series.

In principle, Lebanon could have requested such a negotiated default by entering into negotiations with the holders of this issuance to reschedule and/or restructure it without affecting the other payments of issuances. In this case, failure to act in time resulted in a cross-default that affected all Eurobonds issues. 

As a result, Eurobonds are currently trading on average at 15 cents per dollar, in default mode, and have heavily hit the balance sheet of banks: according to International Financial Reporting Standards (IFRS-9) published by the International Accounting Standards Board, banks have to take provisions on such issuances according to their market value. Also, these payments of Eurobonds were a main source of liquidity for banks, and such default resulted in limiting liquidity available for banks. 

According to Khalil Toubia, a political consultant and activist, the decision was premeditated. “The whole scenario is premeditated, and it is the same as the vacuum from 2014 to 2016,” related to the election of current President Michel Aoun, which was the result of the Free Patriotic Movement and Hezbollah willingly boycotting the presidential election session in parliament and avoiding a quorum to be held, therefore making it impossible for an election to take place. 

Eurobonds do not constitute the whole of sovereign debt, as T-Bills (sovereign debt labeled in Lebanese Pounds) are also auctioned and held by banks and qualified investors. Unlike Eurobonds, T-Bills are labeled in Lebanese Pounds and therefore less potentially subject to a default, as the BDL can print the currency and reimburse creditors (at the risk of greater inflation). 

Many accusations have surfaced on the consequences of the Eurobond default, with many considering that this has resulted in cutting Lebanon from access to financial markets. On the other hand, prior to this cross default, Lebanese Eurobonds were trading at 40 cents to the dollar. This was already a signal that Lebanon may default due to its worsening credit rating and fears in regards to its ability to service its debt.

To date, negotiations with the IMF have been halted since August. According to Ghobril, the government’s disorderly default on its foreign obligations has been “a historical mistake, as the entire economy has been suffering from it”. In addition, according to him, “the executive branch has not taken a single decision since the start of the crisis to restore confidence or to stop the deterioration of socio-economic and financial conditions”, signaling paralysis on the level of government and the lack of political will among major political parties.

How would Lebanon be able to access international markets again and repay Eurobonds Holders? It would be feasible to restart negotiations with the IMF and to agree to restructure the dollar-denominated sovereign debt: at this stage, BDL Circular 567 requested banks to set aside amounts equal to 45 percent of provisions on the Eurobonds. According to IFRS-9 auditing standards, provisions should be relative to the trading price of such debt: eurobonds are as of December 21st, 2020, trading 15 cents to the dollar, and so in principle provisions should reach an 85 percent level. 

Certificates of Deposits

The main issue that might affect banks in the long run is the treatment of certificates of deposits  (CDs) held at the Central Bank. The accounting for certificates of deposits is in itself complicated: they are mentioned as assets on the balance sheets of banks, and have not matured yet, with first maturities starting in 2022. The BDL in fact, in its Intermediate Circular 567, dated August 26, 2020, has asked banks to take provisions on certificates of deposits at a much lower rate than for eurobonds, and does not consider them to be in default. Nevertheless, from October 2019 to August 2020, BDL lowered interest rates offered on banks’ LBP and USD deposits by 556 and 553 basis points (5.56 percent and 5.53 percent) respectively, signaling a lack of liquidity.

Starting in 2016, there was an increased desire by banks to deposit money at the BDL, in part due to attractive interests offered by the BDL, and BDL’s balance sheet accounts for $108 billion of financial sector deposits ($72 billion and the rest in Lebanese pounds). Then again, each bank had its own strategy, according to Ghobril, with some having chosen a more conservative approach and maintaining higher levels of liquidity. CDs also have long maturities (6-8-10 years) and it is therefore difficult to assess their financial soundness. 

This rush to deposits at the central bank was also a consequence of changes at the regional level: starting in 2013, with Hezbollah’s entry in the Syrian civil war, inflows from the Gulf countries started dropping, and from 2011 until now, with the exception of 2016, Lebanon’s balance of payment has been negative. A negative balance of payment usually results in depreciation of a country’s currency. In order to defend the peg and attract dollars to Lebanon, the BDL launched its financial engineering in 2016, by which banks were lured into depositing their money held abroad in correspondent banks to the BDL in exchange for attractive interest. This resulted in a bigger concentration of deposits held at the BDL in general; not taking into account certain banks that had been more skeptical of the move. 

The balance sheet of the BDL as of December 15, 2020, reports $108 billion as financial sector deposits (in USD and LBP), of which 72 billion are estimated to be in dollars. On the assets side of the balance sheet, the BDL reports $17.5 billion as reserves. Overall, this results in a net negative financial position of around $54 billion. This negative position reflects badly on the financial soundness of the CDs. Though the BDL does not publish income statements, it is difficult to assess how this negative position came to be, and it has been estimated that a lot of this money has been used to defend the peg of 1,507 LBP to the dollar, for example on transfers to Electricite du Liban (averaging $1.5 billion per year in the past 15 years to import fuel for electricity plants).

 At this stage, it is difficult to assess how, with such a negative financial position, BDL would be able to repay the CDs to banks. One way would be to reimburse them in LBP, but with the depreciation of the latter, even if CDs were to be reimbursed at market rate, this could result in more inflation and therefore a haircut on deposits. 

Restoring confidence could, in theory, help attract foreign deposits and investments to Lebanon. Such attraction was the norm before Hezbollah’s interference in both the Syrian and the Yemeni civil wars. As a result, a political decision was taken by Gulf countries authorities, amongst others, to restrain from such investments in a show of non-confidence towards Lebanese authorities. Such an attraction of investments and remittances from the Gulf amounted in billions annually, and such inflows to the Lebanese banking sectors in the form of deposits could help bolster bank liquidity, according to Toubia. 

IMF Negotiation and Politics

According to the December 1st, 2020, World Bank report, net losses for the banking sector are estimated at $44 billion. Inflation, cross- default on dollar-labeled sovereign debt, bankruptcies, and other factors, make it necessary to reach out to the IMF for financial support to put Lebanon on the path to economic recovery. In the case of the banking sector, February will be an important milestone, as it will be known which banks have been able to recapitalize and which have not.

 Consolidation of banks will be necessary and has been mentioned in a report by the World Bank. Though many banks will avoid being merged, having already limited their exposure to the Central Bank, sold foreign assets (for example, Bank Audi is in the process of selling its Egyptian operation for a reporterted $600 million) and/or recapitalized. Nevertheless, the fact is many banks might not be able to reach the necessary milestones. In this scenario, many banks might consider merging to strengthen their equity and reduce operating costs (by closing down certain agencies and reducing their workforce). Many banks are currently in the process of closing down regional agencies and reducing their workforce. However, there is a lot of uncertainty and it is not clear which banks have been able to strengthen their equity.

This restructuring of the banking sector cannot occur outside of clear macroeconomic solutions. The situation of the banking sector cannot be separated from the cross-default on sovereign debt, its exposure to BDL, but also from the much-needed negotiation with the IMF. Negotiating with the latter would help provide much-needed foreign liquidity that could help stabilize the LBP and unlock a series of reforms that would bring Lebanon back on the road to economic growth.

 The situation with the IMF is nevertheless not so much economic as it is political. According to Toubia, the government’s decision to default was part of Hezbollah’s plan, as any reform engaged with the IMF would result in reforms aimed at ameliorating transparency, fighting corruption and downsizing the state of the public sector, objectives that are not necessarily in Hezbollah’s interests. 

Any reform package agreed on with the IMF would include reforms of governance of ports, the airport and customs, taking into account that Hezbollah has been accused of profiting from smuggling into Syria. In Toubia’s view, President Aoun and the current government are protecting Hezbollah’s interests, a view that  has been echoed in diplomatic circles and foreign media. Hezbollah spokespersons have mentioned in the past that Hezbollah was open to negotiations, but under certain conditions, as long as it would not harm “national interest”, according to Hezbollah Secretary General Hassan Nasrallah, in a televised speech on March 10, 2020. 

Hezbollah is not the only party accused of helping stall the negotiations, as civil society activists are more prone to consider that reforms are not welcome by most of the political class, which they deem corrupt. French President Emmanuel Macron even mentioned being “ashamed” of the Lebanese political class, accusing Lebanese politicians of “collective betrayal”. In addition, any IMF negotiation package would entail an application of four United Nations Security Council resolutions (resolutions 1559, 1595,1680 and 1701) related to the dissolution of all militias and border controls, according to Toubia. 

In conclusion, the banking sector’s future rests on foreign aid that would allow for economic reforms in Lebanon, but also on a much-needed restructuring that could include mergers and even a possible haircut on deposits (akin to the case of Cyprus), or even a possible bail-in (an exchange of depositors’ money for shares in their bank). 

Lebanon as a whole cannot exist without a well-functioning and effective banking sector, where trust is an important element. Restoring the banking sector from an economic standpoint may appear the easiest, but trust will need to be rebuilt. 

Such trust is cross-sectorial and depends on much-needed reforms related to governance and integrity on the part of the political establishment. 

On May 8, 2020, Lebanon cross-defaulted on its Eurobond obligations, a first in its history. It massively affected banks’ liquidity, as $11 billion worth of Eurobonds are held by local banks. 
Restoring confidence could help attract foreign deposits and investments to Lebanon. This was the norm before Hezbollah’s interference in both the Syrian and Yemeni civil wars.

Many banks might consider merging to strengthen their equity and reduce operating costs.

In conclusion, the banking sector’s future rests on foreign aid that would allow for economic reforms in Lebanon. This could include mergers, a haircut on deposits, and/or a bail-in.

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