One year into Lebanon’s economic crisis, there has been no sign, until now, of any possible solution or measures to be taken in order to help alleviate the banking sector crisis. With country’s 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 report of April 2020 (at a foreign exchange rate estimated at 3500 Lebanese Pound to the Dollar). This results from losses at the 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.
Nevertheless, the means to ensure such banking sector restructuring have, until now, rarely, if ever, been publically 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 in the next few years.
In this regard, the BDL has started preparing the way for such restructuring, mainly in its Circular 154, where it required from the banks an increase in their capital by 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 assumes that failing to meet those requirements, the BDL will start classifying the banking sector in readiness for its restructuring.
Knowing that the capital of banks pre-crisis was estimated at 20 Billion dollars (now 16bn) (part of it also being in Lebanese pounds), it seems difficult, 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 of losses.
The first is the loss due to Non-Performing Loans (NPLs), which were estimated in April of 2020 to be around 18 percent over a portfolio of around 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. However, it should be noted that the NPL ratio did not grow further because some are secured loans (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 2 years from 40 billion dollars to 20 Billion dollars, due to early settlements, it is estimated that losses in this portfolio can reach 5 billion dollars applying Basel III provisions’ requirements.
The second is the loss from the Eurobonds government default on March 9th, 2020. Ever since the default on foreign currency denominated debt, of which 10 to 12 billion were held by Lebanese banks, Eurobonds have been trading on average at 15 cents to the dollar, and therefore at an 85 percent trading loss. Overall, at an 85 percent discount, such losses can be estimated to be around 8 to 9 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 (around 30 billion dollars in CDs and 32 Billion dollars in term deposits) at the BDL at an average of a ten-year tenure, 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 exposure for local banks of around three times their capital in foreign currency to a single entity, which is labeled as an issue called “single borrower exposure breach”.
According to International Financial Reporting Standards (IFRS9), such exposure to BDL should be provisioned to a minimum of 25 percent as per practice while BDL required banks to take only 1,89 percent. Hence, in reality, banks should take an additional 10 billion dollars of provisions.
With banks’ equity, being currently valued today at 16 billion dollars before the application of BDL circular 154, banks still need to raise 24 billion dollars in provisions (while their capital is 16 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 good assets of the initial bank’s 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 the transparency of the core bank’s performance according to the 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 of 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 attracting 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 of the banks’ balance sheets and therefore for more flexibility afforded to banks.
A “Banking resolution Law” needs to be voted to govern the bank restructuring process, this includes the lifting of the bank secrecy and a forensic audit across all financial institutions along with the Quality Asset Review (QAR) process handled through the BDL would first have to be done 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 the specially created SPV 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 propose exchanging part of their deposits in favor of becoming shareholders of the bank. In a bailout approach, the rescue of the bank will be by increasing its capital through external financial institutions, foreign banks, or through the capital market, or private equity funds. This will result in injections of fresh money to reconstitute the needed capital of the bank. One idea would be to use USD1 billion of our USD17bn of gold to capitalize on the good bank; this will give the needed trust to external investors to capitalize further on the new Lebanese banking sector which will support the “salvation” economic growth plan. (gold should only be used to create value not to offset losses of debts)
In the case of a bail-in, as was the case in Cyprus in 2013, depositors became 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 the 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 happens in the early 1990s with the French Credit Lyonnais, where an SPV called Consortium de realization “CDR” was created to restructure the bad assets of the Credit Lyonnais.
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 70% over the last two years.
The Need for 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 strictly requires full independence of the Banking Control Commission (BCC), as well as the Special Investigation Commission (SIC) and the Capital Market Authority (CMA) entities in Lebanon and limits their mandate to 1 term not renewable as it is common practice in other trusted financial jurisdictions (for example, the Securities and Exchange Commission in the USA, Autorite des Marches Financiers in France, Capital Markets Authority in Kuwait).
In addition, commercial banks will have to increase their number of independent board members and insure that no cumulating 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. Ensure that board members’ mandate is limited to max 2 non-consecutive terms. (Same for the Central bank governor and his vice-governors).
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, 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 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 their 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 the 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.