The affinity of Lebanese banks for government Treasury bills and other fixed income securities has always been strong, but the love affair intensified significantly in the early 1990s with the Hariri-inspired Horizon 2000 reconstruction program, which forced the government to resort to domestic and foreign issues of government fixed income securities or bonds to finance the project.
Rebuilding the country and the pound
Back then the country was in tatters. Not only was there an urgent need to rebuild, but the Lebanese pound, which by the fall of 1992 nearly hit LL3,000 to US dollar, also had to be saved. Rafik Hariri was quick to realize that the only way to obtain fast financing was to resort to debt via the issuance of domestic, Lebanese pound denominated Treasury bills. Loans from international banking institutions or supranational organizations such as the World Bank or the IMF would have been too slow to come in, too expensive and insufficient in terms of amount. On the other hand, Treasury bills in local currency, provided they carried a very attractive yield, would be easy to print, issue and place in a large domestic banking sector, which, although under-developed, lacking in significant human resources and strategic guidance, did have sufficient funding that needed optimization.
The banking sector at the time had succeeded in attracting around $6 billion in deposits from expatriate Lebanese but did not have the human resources or managerial quality to employ these new funds efficiently. Banks urgently needed to allocate their funds in such a manner as to boost their stagnating profitability and hence increase their capital base, which at the time was extremely insufficient and well below the international capital adequacy ratio of 8%. By subscribing to high yielding Treasury bills, the banks would not only help finance the government and the reconstruction program, but also buy themselves valuable time for the development of their own banking activities.
The government used the domestic banks to the full and issued significant amounts of Treasury bills, distributing them among the 83 banks from 1992-1996. Although the national debt level was increased significantly and debt service began eating up most of the government’s revenues, the reconstruction program was well under way and would be used as the main marketing tool for the government in its efforts to issue dollar-denominated Eurobonds. The first Lebanese Republic Eurobond of $400 million in 1994 was voted Bond Deal of the Year 1994 by the international bond community and was placed evenly among Lebanese and foreign investors. It would be the first of many to come in subsequent years, although the investor base for this particular instrument became 100% Lebanese (mostly Lebanese banks) as foreign investor enthusiasm waned.
Trading in government securities
Since then the Lebanese banking sector has increased its profitability significantly and boosted its capital adequacy to better cover the risks of the domestic operating environment. Some banks even made it their specialty to trade in government securities, while the sector as a whole started to appear more as a sector of deposit and savings banks rather than a real commercial banking sector.
Until recently, Lebanese banks appeared as financial institutions whose main function is to attract retail deposits and to place such deposits in government Treasury bills and Eurobonds. The diversification of activities, the expansion of typical banking activities such as retail banking, and the diversification of revenues are more recent developments for the Lebanese banking sector, which for a long time relied on the yield of government debt securities to finance and develop traditional commercial banking activities.
For a long time, the lebanese banking sector relied on the yield of government securities
What developed was a tacit understanding between the banks and the government, whereby the government would reward the banking sector with high yields, which would be instrumental in strengthening this vital economic sector, while the banks would use their funding to continuously follow the government in its reconstruction and now debt management efforts, and to support the stabilization of the local currency.
Non-Lebanese investors take part
Non-Lebanese banks and investors also took part in the Lebanese government’s fixed income securities issue drive. Indeed, by the mid 1990s, many Gulf banks and high net worth investors had subscribed to the high yielding Lebanese T-bills and Eurobonds (interest rates on T-bills denominated in LBP had reached 45% by 1995), considering these instruments to be a risk worth taking. The rating of Lebanon for the first time back in 1996 (ratings of B+ by Standard & Poor’s and Ba3 by Moody’s first came out, but were subsequently brought down by four notches to the current level of B-) did not make a difference in terms of yield and certainly did not decrease the appetite of Lebanese and Arab investors. Only Western investors, who are significantly more risk-minded, withdrew, considering Lebanon to be risky over the medium term. For Arab investors, it was a case of being well rewarded for taking on Lebanese risk, while some reciprocation would be reflected by investments in Lebanese real estate and projects.
By the end of the 1990s, more than 35% (35.8% in 1999) of the balance sheet of Lebanese domestic banks was accounted for by government Treasury bills and Eurobonds denominated in both Lebanese pound and foreign currency (mainly in US dollars). At one stage, in the mid 1990s, the proportion of government debt securities to total assets for most banks, including the larger ones, stood well above 50%. The government debt securities to total assets ratio for the banking system has gradually decreased since the mid 1990s, having gone as low as 23.2% in 2003 and 23.6% in 2004, in the aftermath of the Paris II donors’ conference, when interest rates on assets and deposits were decreased significantly by both the government and the banks. By February 2006, the ratio had gone up again to 25.9%, although it remains significantly below the proportions seen in the mid and late 1990s.
Since the Paris II conference, the Lebanese government has changed its attitude toward its borrowing and debt security issues policy. Pressured by international donors and relieved by cheap financing (around $4 billion in subsidized and soft loans), the government and the central bank had to improve the overall liquidity and foreign currency reserves by encouraging local banks to reduce their exposure to government debt securities and by requiring that a certain proportion of deposits (15% of foreign currency deposits for instance) be allocated in regulatory cash reserves at the central bank. By the beginning of 2006, cash reserves and deposits at the Banque du Liban (BDL) accounted for almost 30% of total consolidated assets for the banking sector. Such cash reserves coupled with the stock of government debt securities make up for almost 60% of total consolidated assets, leaving little room for local banks to lend to the private sector. Loans to the private sector accounted for around 23% of total consolidated assets by the end of February 2006.
Government exposure remains high
Coverage of almost 30% of customer deposits remains very high by international standards and the balance sheet of Lebanese banks appears to be reassuringly liquid. However, exposure to the lowly rated Lebanese government remains extremely high. If we add reserves at the central bank to government debt securities, then we can only realize that the banks’ exposure to the government dangerously approaches 60% of total consolidated assets. Furthermore, given the very difficult operating environment in Lebanon that makes lending to the private sector very onerous, any excess liquidity the banks might get is automatically invested or placed in cash reserves at the central bank or in Lebanese Treasury bills or other bonds issued by the government.
Today, the exposure to the government or cash reserves, deposits at the BDL and government debt securities account for around 8.5 times the banking sector’s consolidated shareholders’ equity. This means that any significant devaluation of the Lebanese pound or the US dollar, and/or a drop in the value or yield of government debt securities as a result of a rating downgrade (which remains a constant possibly) by 10% or more, would wipe out the banking sector’s equity base. What is also worth mentioning is that the significant maturity mismatch between funds and assets (in other words deposits carrying an average maturity of around 1.5 months and assets such as Treasury bills carrying a maturity of more than 15 months) makes Lebanese banks very vulnerable to any potential hike in interest rates. Indeed, if Lebanon is downgraded as a result of a failure to carry out economic reforms and privatization, then interest rates on deposits would have to be raised at a time when returns from assets are not yet available. This would erode the banks’ shareholders’ equity and reserves, and affect profitability.
Doomed from the start?
Hariri’s fiscal brainchild would indeed have been perfect were it to be accompanied by economic reforms, privatization, economic diversification, long term strategies, plans to eradicate corruption, racketeering, and so on. In their absence, the state is suffering from over-indebtedness; there is little government revenue and economic diversification and the non-bank private sector is suffocated by insufficient economic growth and inefficient and corrupt public utilities. The banks have had to continue operating in a constraining operating environment and are still heavily exposed to a sovereign which carries one of the lowest ratings on the planet. They also suffer from low revenue and asset diversification, are exposed to interest rate risk, and have low economic capital.
Perhaps it would have been more judicious to privatize public utilities immediately through Built Operating Transfer (BOT) and/or concessions (a longer term form of privatization), or even outright sale rather than borrow significant amounts to rehabilitate a still inefficient infrastructure. Privatization, even on the cheap, would have modernized the country at no expense, left debt levels very low, brought in revenues for the government (in the form of taxation and concession/BOT fees), and created jobs, while simultaneously diversifying the economy. But again, maybe we all lost the plot and confused the end of the shelling with the end of the civil war back in 1990, not realizing during the last sixteen years that the dice were loaded and that our reconstruction funding plans were doomed from the start.
