LexisNexis

Lebanon’s beleaguered banking sector

Emad Mekay, IBA Middle East CorrespondentMonday 18 July 2022

Lebanon used to attract Arab investors, intellectuals and artists but is now in the throes of an unprecedented economic meltdown. Global Insight assesses whether it can find its way back.

In the streets of Beirut, the once-welcoming open glass doors of the city’s commercial banks are now mostly shut and are fortified with intimidating prison-like iron bars. Three-metre-tall concrete slabs topped by military-style barbed wire barricade the country’s central bank, Banque du Liban (BdL). The institution’s long-time governor, Riad Salameh, hailed for his acumen in luring deposits through high interest rates over three decades, now moves under protection from heavily armed bodyguards in bulletproof cars.

Lebanon – once dubbed the ‘Switzerland of the East’ for its robust banking system – has fallen a long way, from attracting Arab investors, intellectuals and artists throughout the 1950s to the early 1970s, to a country firmly in the throes of an unprecedented economic meltdown. The Lebanese public point to an alliance between the country’s banking industry and the ruling elite as the main reason for the crisis.

Bankruptcy and war-like conditions

Since 2018, Lebanon’s banks have been the target of protests, Molotov cocktail strikes and angry graffiti. Throngs of depositors blame corruption and mismanagement in the banking industry for the loss of their lifetime savings. Many have endured unannounced withdrawal ceilings, limits on movement of their own money and prolonged bank shutdowns. In March 2020, Lebanon's economy tanked after it defaulted on about $31bn of Eurobonds in the wake of an acceleration of capital outflows.

As the country spiralled into a deep recession, the Lebanese currency lost 94 per cent of its value, wiping out savings, purchasing power and triggering social unrest. This year alone there were at least two reported incidents of men attempting to set themselves on fire in public in response to the worsening economic situation. Lebanon’s financial system has been facing major challenges in getting hold of dollars demanded by depositors or to even pay off debts.

The consequences for the country’s 6.8 million people have been far-reaching as they endured shortages in fuel, bread and medical supplies, as well as massive unemployment. Many say they couldn’t keep the lights on in their homes and had to sell their cars to be able to meet the basic daily needs of their families.

Lebanon, once dubbed the ‘Switzerland of the East’ for its robust banking system, has fallen a long way

In April, a boat bound for Europe, with 60 immigrants on-board, capsized – killing six people. The Lebanese navy says it had already returned hundreds of boats fleeing the country since the start of the economic crisis. Professional associations and universities report the largest brain drain since the war of 1975, with more professionals seeking to leave the troubled economy. Consumers face galloping inflation while the government, unable to tap global financial markets, has ramped up money printing to boost spending and pay civil servants.

Last year, the World Bank issued a stark warning that Lebanon’s financial crisis is likely to rank among the three most severe crises globally since the mid-19th century and that it showed signs of war-like conditions. ‘The World Bank estimates that in 2020 real GDP contracted by 20.3 per cent, on the back of a 6.7 per cent contraction in 2019. In fact, Lebanon’s GDP plummeted from close to $55bn in 2018 to an estimated $33bn in 2020, while GDP per capita fell by around 40 per cent in dollar terms’, the Washington-based lender said. ‘Such a brutal contraction is usually associated with conflicts or wars.’

Ray of hope

On 7 April, the cash-strapped nation initialled a long-anticipated tentative agreement with the World Bank’s sister institution, the International Monetary Fund (IMF). Under the agreement, Lebanon will get $3bn in exchange for a range of economic measures such as reforming state-owned enterprises (particularly the electricity company which was responsible for power cuts that at times lasted for up to 20 hours), strengthening governance and anti-corruption regulations and establishing a transparent monetary and exchange rate system. The aim is to reverse the nation’s economic decline, increase revenues and particularly to try to shore up confidence in the country’s opaque banking system.

Garbis Iradian is Chief Economist for MENA and Central Asia at the Institute for International Finance (IIF), a Washington-based global association of financial firms. ‘The staff-level agreement that the Lebanese authorities reached with the IMF brought a ray of hope’, he tells Global Insight. Iradian warned that improvements will happen only when Beirut takes the unpopular measures targeting transparency, corruption and fixing public companies. ‘The recent staff-level agreement with the IMF is aspirational in nature […] There is a 50 per cent chance that the Lebanese authorities will start implementing the urgent economic reforms, including the prior actions highlighted by the IMF staff.’

Experts agree, however, that the bailout may be the last chance to put back the troubled banking industry on track. ‘There is no doubt that the banking sector has been the backbone of the Lebanese economy for decades’, Iradian explains. ‘Lebanon’s recovery from the current crisis depends crucially on a solid and vibrant banking sector that can channel both domestic and foreign savings into productive investment.’

Lebanon’s recovery from the current crisis depends crucially on a solid and vibrant banking sector that can channel both domestic and foreign savings into productive investment

Garbis Iradian
Chief Economist, MENA and Central Asia, Institute for International Finance

The design of the deal includes specific pre-conditions that Beirut will initiate an externally assisted bank-by-bank evaluation for the largest 14 banks, by signing terms of reference with a reputable international firm. The new parliament, elected in May, will have to change the outdated bank secrecy law to allow for greater disclosure requirements as well as improving detection and investigation of financial crimes and asset recovery.

The IMF says it wants to see the long-delayed audit of the foreign asset position of the BdL, and further tightening transparency requirements. ‘Whenever there’s any serious doubt about the robustness of the banking system in general and the Central Bank in particular, which is often fuelled by or goes hand in hand with a lack of transparency, you will see exactly what happened in Lebanon – a large outflow of capital’, explains Marcel Willems, a Member of the IBA Insolvency Section’s Advisory Board. ‘That, in turn, leads to companies – and the government itself – being less able to attract funds for investing or, if they are able to do so, the funds come at a higher cost causing a general increase of prices and thus inflation. To stop and, subsequently, reverse this process, what the IMF wants, is clearly inevitable.’

The IMF programme in Lebanon will focus on the BdL because the central bank will need to earnestly go beyond fortifying its physical walls to strengthening its financial position. The bank will have to create conditions for disinflation including by moving to a new monetary regime, rebuilding its foreign currency reserves, which went down to only $11.2bn at the end of April, and maintaining a single market-determined exchange rate. This may help the financial sector contribute to better resource allocation in the economy, and allow for the absorption of external shocks.

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Healthcare workers hold flags and signs during a protest against banks restricting cash dealings for hospitals, in front of Lebanon's Central Bank building in Beirut, Lebanon, 26 May 2022. REUTERS/Mohamed Azakir

Iradian says that auditing and restructuring the banking system will be the most difficult part of a potential IMF programme. ‘It is crucial to complete expeditiously the audit of BdL’s accounts, including verifying the full details of its balance sheet and its cash and money flows. Restructuring BdL first is vital and will help it to conduct effective monetary policy’, he said.

Importantly, Lebanon will need to improve legislations to build a firewall between the BdL and profiteering politicians. This will include laws for banking supervision and resolution of money laundering and the financing of terrorism – financial crimes with dire economic effects.

Greece-based Dimitris Paraskevas, Special Projects Officer of the IBA Banking Law Committee, notes that the BdL needs special attention because it acted as a financier of the government rather than following a mandate of price stability and prudence. ‘Although price stability held well for many years with the pegged currency, the cost is now being paid with this severe crisis. There have to be tight rules on commercial banks. Banks have to be properly capitalised, not have a lot of expenses and be supervised thoroughly’, Paraskevas says.

Lebanon, he says, should draw lessons from the financial crisis in Greece, that the banking sector has to see consolidation as in the US and other markets. ‘Bad debt has to be transferred to a separate bank, the so-called ‘bad bank’ and banks' balance sheets have to be totally cleaned up’, he says. ‘The mistakes that happened in the case of Greece should not be repeated.’

The threat from within

As scores of Lebanese youth took to the streets to protest the financial crises, many say the elite agrees on nothing but profiteering. Despite the optimism the IMF deal brought, there remain strong doubts inside the country about whether the government, made up of different factions, will manage to comply with the programme they will sign.

The financial turmoil has hardly dented the hold of the sectarian elite on power in this small country. Previous suggestions for fiscal measures proved impossible to pass in the politically and ethnically fractured nation. Early in May, and nearly a month after the IMF agreement was initialled, the popular An-Nahar daily described the economic programme as politically ‘foggy’, indicating that it is not clear how it will receive political backing.

International donors have noted there was an evident lack of political consensus over effective policy initiatives while on the other hand there’s a political consensus to defend the bankrupt economic clientelist system, apparently because it benefitted a few for so long.

Power in Lebanon is shared along the country’s communal make-up, including between Christian, Druze, Sunni and Shia Muslim factions; an arrangement designed to quiet a 15-year civil war that started in 1975.

The president would come from Maronite Catholics, the largest Christian group. The prime minister is always a Sunni Muslim. The speaker is Shiite and the small but powerful Druze community, along with smaller factions such as Orthodox Christians, shared in military, ministerial and parliamentary positions.

That system often made leaders offer guaranteed employment to loyalists and members of their own community with little regard to merit, leading to rampant nepotism, inefficiencies and a sense of impunity among civil servants.

As this article went to print, exchange of blame was a non-stop affair in the country’s varied media scene. Hezbollah, which with its smaller allies constitute the largest and most organised political bloc in the country, blames the pressure from Israel, the US and their allies in the Gulf on their ‘submissive’ rivals for economic turmoil. In an interview with Al Jazeera in late April, Hussein al-Hajj Hassan, an MP for Hezbollah, said the economic crisis was brought about by policies of racking up debt adopted by his opponents.

His rivals counter that the Shiite armed group is using its military muscle to keep the country hostage to hostile Iranian policies in the Middle East against the will of many Lebanese.

Shiite cities and villages are not shy to display gigantic pictures of Iranian military and religious leaders while Hezbollah-controlled media front news about Iran, rather than local events. Hezbollah argues that if they disarm and cut Iranian backing, the country will be left with no real defence against Israel, which invaded in 1982 and still holds Lebanese territories.

Traditional backers like Saudi Arabia and other donors from the oil-rich Gulf countries are unlikely to chip in without seeing political, rather than economic, changes. The same may apply to the US, which has veto on many major fund decisions and views Hezbollah as a threat to Israel. For starters, they want less influence for Hezbollah.

Those long-running rifts are likely to mar any progress towards economic recovery and, if combined with the public’s deep perception of widespread corruption, Lebanon may be looking at decades of recovery that will need much more work than a one-time $3bn loan from the IMF.

Another step Beirut will have to take is restructuring its external debt with creditor input, which normally means extending debt maturities by a few years, to restore balance sustainability and close financing gaps. Willems says those prescriptions are likely to get Lebanon back in the good books of international investors and local customers. ‘These are definitely the right steps’, he says. ‘A system whereby creditors are guaranteed to be repaid deposits up to a certain minimum amount, such as this exists for instance in the EU, is essential to prevent small depositors – generally individuals – from avoiding the banking system altogether as much as possible and keeping their savings under the proverbial mattress.’

One should act as soon as possible. It’s better to slightly overreact than to underreact

Marcel Willems
Member, IBA Insolvency Section Advisory Board

Willems warns that delaying reforms when substantial recapitalisation is needed to restore public trust, as is the case in Lebanon, would defeat the purpose of the programme. ‘One should act as soon as possible’, he says. ‘It is better to slightly overreact than to underreact. If the measures taken appear not to have been necessary in their entirety, they can be undone. If, on the other hand, the initial measures appear not to have been stringent enough, the lack of trust in the system may be deepened instead of diminished which will be worsened further by the second wave of measures that become necessary then.’

Some of the changes proposed by Lebanese officials remain unpopular. These include converting dollar savings to the Lebanese lira and offering stocks in banks that will be formed to depositors instead of their savings. The government is reportedly working to consolidate the number of banks from 61 to just six and instead auction off some assets.

Paraskevas says the experience in Argentina and Greece’s financial crises demonstrate that a haircut must be severe for creditors too. ‘Creditors have to realise they have to bite the bullet and, if they don't, there is no difference as high inflation will have the same effect anyway’, he says. ‘The current trading level of Lebanon’s sovereign debt at low teens suggests already market expectations for a severe restructuring or a prolonged uncertainty.’

Paraskevas says it has been 12 years since Greece similarly restructured its debt but the problem has not been solved. Balance sheets have improved, but there are still issues, he notes. ‘New debt because of Covid and other reasons has been added on top and an entire society has refocused from making a new start to trying to save their homes in vain’, he says. Lebanon faces the same challenges.

The Lebanese public blames their ruling elite – many with outsized wealth – and the banking sector for saddling the small nation with unjustified external debt that went to unproductive mega construction projects such as upmarket high-rise apartment buildings and hotels. After the IMF agreement, many still fear they will be left holding the bag as the deal could mean overhauls to pensions, labour and civil service codes down the road, on top of losses on their savings.

Paraskevas warns that Lebanon will need to find a viable economic model. ‘Lebanon has long suffered from dual deficits – fiscal and current account – only covered by a bloated banking sector for balance of payments’, he says. ‘A sustainable economic model is as much in need as the debt restructuring.’

REUTERS/Fabrizio Bensch

Lebanon's Central Bank Governor Riad Salameh speaks during an interview for Reuters Next conference, in Beirut, Lebanon, 23 November 2021. REUTERS/Mohamed Azakir

He suggests that, by itself, debt restructuring – even if at a very high level – wouldn’t be enough for Lebanon. He says Lebanon would need to understand fully the reasons behind its economic collapse and ‘be prepared to do the right things for history not to be repeated’.

Emad Mekay is the IBA Middle East Correspondent. He can be contacted at emad.mekay@int-bar.org

Image credit: A barricade covered in barbed wire is placed in front of Lebanon's Central Bank building in Beirut, Lebanon, 29 June 2022. REUTERS/Mohamed Azakir