Home Banking & Finance The good, the merged, and the bad

The good, the merged, and the bad

by Nabil Makari

One year into Lebanon’s economic crisis, country total net losses are estimated at more than 44 billion dollars by the World Bank’s recent report as of early Q2 2020 and as mentioned in the Government reform plan of April 2020 (at a foreign exchange rate estimated at 3,500 Lebanese pounds to the dollar). This results from losses at the Lebanon central bank (BDL), losses in the banking sector, and losses at the government level mainly from the Eurobonds default. In this regard, the banking sector needs a deep restructuring to reorganize its assets and build back the needed trust from its internal and external clients.  

The BDL has started preparing the way to such restructuring, mainly in its Circular 154, where it required banks to achieve a capital increase of 20 percent, as well as securing 3 percent of banks’ deposits in “fresh dollars” by February 28, 2021. Banks have to comply with such requirements as a minimum recapitalization while ensuring liquidity with their correspondent banks. This presupposes that banks who fail to meet those requirements, the BDL will start classifying the banking sector in readiness for its restructuring.

Nevertheless, to date, the means to ensure such restructuring of the banking sector have rarely, if ever, been publicly addressed. In order to absorb such losses, bank mergers have been contemplated by economists and banking sector experts. Another possible solution would be to restructure the banking sector into “good” and “bad” banks, the latter of which would absorb the losses and take them out of the balance sheets of the banks to recreate a new banking sector, smaller but stronger to drive the Lebanese economy recovery’s in the next few years.

Knowing that the capital of banks pre-crisis was estimated at 20 billion dollars (part of it also being in Lebanese pounds), it seems unlikely, in view of the huge losses in this sector, that banks’ equity will be able to absorb such massive losses, in spite of the requirement to raise their capital by 20 percent.

Losses across the banking sector

Losses across the banking sector can be divided into three different types.

The first is the losses due to Non-Performing Loans (NPLs), which were estimated in April of 2020 at around 18 percent of a portfolio of 40 billion dollars of loans given by Lebanese commercial banks. Today, 18 months later, and according to Nicolas Chikhani, former chief executive officer at Arab Bank Switzerland, this NPL ratio is” higher in view of the increase in the unemployment rate and is estimated at circa 25 percent.” However, it should be noted that the NPL ratio did not grow further because some of the loans are secured (hence collateralized) and others are held by non-residents, which are less impacted by the economic crisis. Knowing that the level of total loans has gone down during the past year from 40 billion dollars to 35.5 billion dollars, due to early settlements, it is estimated that losses in this portfolio could reach 8.9 billion dollars applying Basel III provisions’ requirements.

The second is the losses from the Eurobonds government default on March 9, 2020. Ever since the default on foreign currency denominated debt, of which 9 to 10 billion are held by Lebanese banks as of April 2021, Eurobonds have been trading on average at 15 cents to the dollar, and therefore at an 85 percent trading loss. Overall, at such a discount, such losses can be estimated to be around 8 billion dollars if banks apply international accounting standards.

The third is the underlying loss incurred from the exposure of the banks on the BDL’s balance sheet mainly in the form of certificates of deposits (CDs). In summary, banks have deposited money (in CDs and in term deposits) at the BDL, in amounts estimated at around 60 billion dollars, at a 20 year tenure average, while clients deposits at the banks were at a lower tenure, creating a maturity mismatch risk, which has resulted in a liquidity problem across all the banking sector, as highlighted by Chikhani.

This is also subject to controversy as it resulted in an exposure for local banks of around three times their capital in foreign currency to a single entity, something labeled as an issue called “single borrower exposure breach.” According to International Financial Reporting Standards (IFRS9), such an exposure to BDL should be provisioned to a minimum of 25 percent as per standard practice while BDL required banks to take only 1.89 percent. Hence, in reality, banks should take an estimated additional 14 billion dollars of provisions.

With banks’ equity, being valued today at 24 billion dollars after application of BDL circular 154, banks still need to raise around 31 billion dollars in provisions (while their capital is of 24 billion) to ensure solvency and rebuild the trust with local and international stakeholders.

The road ahead: good and bad banks

The bank restructuring will require a process called “good bank bad bank”, as defended by Chikhani. In summary a “bad bank” is a bank that holds low-quality and high-risk assets, which will be isolated from the initial bank’s balance sheet. A “good bank” would only contain the remaining “good” assets of the initial banks’ balance sheet.

A working paper by international consulting firm McKinsey & Company, published in July 2009, “Bad banks: finding the right exit from the financial crisis,” highlighted the four different scenarios that would allow the segregation of these assets from one another:

The first is an on-balance sheet guarantee, by which the bank protects part of its portfolio against losses, usually with an implicit guarantee from the central government. In this scenario, the “bad” assets remain on the balance sheet of the banks but are guaranteed by the government and therefore no losses are recognized.

The second is through what is called an internal restructuring unit. In this scheme, the bank would centralize the restructuring of the “bad” assets in a separate unit, with its own board of directors and management, which allows for focus and effective management. Though this solution does not transfer risks efficiently, it does increase transparency of the core bank’s performance, according to the McKinsey & Company study.

The third is that of an off-balance sheet Special Purpose Vehicle (SPV). In this solution, part of the bank’s portfolio is offloaded to a separate entity, usually with government sponsorship, with said SPV being removed from the bank’s balance sheet but still related to it.

The fourth, and most effective way, is the “bad bank” spin-off, by which the assets are segregated and disposed into a fully legally separate SPV. Such an external “bad bank,” according to the study, ensures maximum risk transfer and increases the core bank’s strategic flexibility, which allows it to attract foreign investors.

Business Case: Lebanon

In the case of Lebanon, given the sizable losses on banks’ balance sheets, and due to the need to restore confidence both at the international level (with correspondent banks) and also at the local level (with Lebanese depositors), the fourth solution seems to be the most reasonable and effective one. It would allow for maximum transfer of risks off the banks’ balance sheets and therefore for more flexibility afforded to banks.

A Quality Asset Review (QAR) handled through the BDL would first have to be conducted in order to determine the losses incurred by each bank, and in order to assess the strengths and weaknesses of the balance sheets. Once this happens, banks with very high exposure to Eurobonds, NPLs and CDs would probably have those assets transferred to specially created SPVs that will be used for the restructuring of the same assets.

The good banks, which would contain the remaining “good” assets, will have to be bailed in and bailed out to be capitalized and make them solvent and trusted by the international banking system. In a bail-in approach, depositors would be offered the choice to exchange part of their deposits in favor of becoming shareholders of the bank. In a bail-out approach, the rescue of the bank will be operated by increasing its capital through external financial institutions, foreign banks, the capital market, or private equity funds. This will result in injections of fresh money to reconstitute the needed capital of the bank.

In the case of a bail-in, as was the case in Cyprus in 2013, depositors become shareholders in banks to the proportion of the value of their individual deposits to the full amounts of deposits that were deemed high risks. In the Lebanese case, this would make the depositors and creditors, whose deposits were transferred to an SPV, shareholders in the latter, a situation akin to the one of Bank Intra in 1966.

As a result, the surviving banks’ balance sheets will shrink heavily, but will be less exposed to high risks assets and will therefore be able to raise their equity later on without being heavily diluted because they will be financially sound. This is what happened in the early 1990s with the French Credit Lyonnais, where an SPV called Consortium de réalisation “CDR” was created to restructure the bad assets of the bank.

The SPV will have to engage in a restructuring process with the objective to reorganize its “bad” assets with the ultimate aim in Lebanon’s case to reimburse depositors. In this matter, the help of the International Finance Corporation (IFC), a division of the World Bank group, could be requested, as the IFC has a well-known expertise in the restructuring of bad loans.

According to Chikhani, it is estimated that after this process, “some Lebanese banks may cease to exist, others will be merged, and some will survive, and therefore the number of banks post-restructuring may be much lower and their new capital will reflect better the new GDP of the country that has decreased by circa 70% over the last two years.”

Governance reform in the new “good” banking sector

Should these reforms be implemented, and the good bank/bad bank scenario become a reality, “this would not be without serious governance reform in the banking sector and a reshuffling of the current supervision system of the banking and financial sectors in Lebanon,” according to Chikhani.

This scenario requires a full independence of the Banking Control Commission (BCC), as well as of the Special Investigation Commission (SIC) and of the Capital Market Authority (CMA) in Lebanon, as it is common practice in other trusted financial jurisdictions (for example, the Securities and Exchange Commission in the USA, Autorité des marchés financiers in France, Capital Markets Authority in Kuwait).

In addition, commercial banks will have to increase their number of independent board members and ensure that no accumulating of roles between chief executive officers and chairmen of the boards, all to ensure full independence and authority of the board with no conflict of interest ever with the executives.

In addition to that, a stronger internal control unit should be set up across all banks to ensure the application of processes and procedures in line with the “good governance standards.” This would ensure a reduction of potential conflict of interests, a proper monitoring of risks and a better auditing process. Also, Politically Exposed Persons (PEPs) would have their participation in the financial sector capped to avoid systemic and chronic conflicts of interest between the political and financial spheres.

Had these practices been put in place before, it is possible to say that a better monitoring of activities could have yielded more positive results with regards to banks’ single borrower exposure, but also to the maturity mismatch which has resulted in the liquidity crisis in the banking system with regards to assets, as well as a better highlight of risks by external auditors.

Overall, the road ahead is far from easy, and will require a political decision, with a government eager to implement reforms and a parliament ready to legislate on the necessary laws, as well as the BDL agreeing on the needed reforms to ensure independence of monitoring authorities. The solutions are available in order to restore financial soundness and salvage the banking sector, to make it functional again. Lebanon is not the first country to go through a banking crisis, and won’t be the last. But past experience has shown that the same solutions that have been put in place in other countries could be applied to Lebanon to save its economy, should there be a will to do so.

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