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A few days ago, preliminary talks began between the IMF and the Lebanese delegation entrusted with working on the government’s financial plan in preparation for the negotiation sessions between the two parties, which are supposed to start this month officially. In principle, Lebanon seeks to obtain a loan from the IMF worth more than $2 billion dollars through these negotiations. At the same time, the IMF will attempt to impose a set of conditions and reforms on the Lebanese state that guarantees its ability to fulfill its obligations in the future and thus ensure that it pays off to the IMF later.
The most critical issues on which the IMF will force negotiation will be the accumulated losses within the budgets of the Lebanese banking system, which includes both private commercial banks and the Banque du Liban. Concerning the IMF, Lebanon cannot embark on the path out of the financial collapse unless these losses are transparently identified and remedies started, primarily since they currently represent the main reason for the failure of the entire Lebanese financial system. This stumbling prevents attracting remittances from outside Lebanon due to the lack of confidence in the banks, which damaged the banks’ ability to pay their dues to depositors, and represented a significant reason for the collapse of the lira exchange rate. On the other hand, since the beginning of the financial collapse, Lebanese banks and the Banque du Liban have waged a battle to evade identifying all these losses at once to reduce the value of cropping that will accrue to the capital of major shareholders within the banking system.
Despite the importance of this file, which will be at the centre of any future financial recovery plan, and despite all the controversies that have revolved around it over the past year, many inside and outside Lebanon are still not aware of the details and nature of these losses. And discussing these losses is crucial because they are the main culprit in what is now classified as the largest banking failure in modern history. Practically speaking, the world has witnessed many comprehensive economic and financial crises that have affected different countries and financial markets, which have affected unemployment rates, economic growth rates and other indicators. However, the Lebanese case was exceptional in terms of the quality of the banking failure that crippled the entire financial system and the size of banking losses compared to the size of the local economy and the value of banks’ assets.
For all these reasons, the Lebanese banking losses are worth studying by defining its nature, knowing how they occurred and the reasons that led to them, and the lessons learned in terms of the relationship of monetary and economic policies to the safety of the banking system, and the risks that affect depositors. There is also something worth studying in terms of the intersection between political and financial interests that, since 2019, have prevented the process of identifying and recovering from losses, which has exacerbated all the repercussions of the financial collapse in the country.
The Problem Roots in the Nature of the Financial System
In 2019, the whole world heard about a major and sudden banking collapse in Lebanon. Scenes of depositors protesting for not being allowed to withdraw their disposits from Lebanese banks or transfer them abroad surfaced to the media. But, as in all major economic collapses, this sudden collapse was an exposure of a mass of gaps and loopholes that had accumulated silently over many years before it exploded in a single moment in the form of a massive banking crisis.
First, discussing losses necessitates returning to the monetary policies followed in Lebanon from the 1990s, mainly based on fixing a unified exchange rate at the limits of 1507.5 lira for the U.S dollar. Setting the exchange rate practically meant relying on the Central Bank to intervene in the currency market, to sell or buy dollars when necessary to maintain this exchange rate. But the most crucial thing in the matter is that the dollars that the Central Bank uses for intervention are nothing but the foreign currency deposited by the banks from depositors’ money, which represents the so-called “foreign currency reserves” in possession of the Central Bank.
Since the 1990s, the model has been going well nominally, in parallel with the flow of dollars from abroad towards the Lebanese banks, coming from Lebanese expatriates and foreigners who wanted to benefit from the boom of real estate speculation. At that stage, banks were benefiting from the high-interest rates granted to depositors, compared to the regular rates abroad, to attract more foreign transfers. Precisely for this reason, the fixed exchange rate policy had yet not begun to cause any troubles for the Central Bank, given the number of dollars flowing into the local market, supporting the lira exchange rate.
But this model, which seemed natural and sustainable, was accumulating mines that would explode one day. Throughout those years, and due to this type of operations, the size of the Lebanese banks inflated abnormally compared to the local economy. Also, the value of their assets finally exceeded 4.4 times the size of the GDP, which is very high and illogical for an economy that does not have productive sectors capable of borrowing and investing this liquidity. To invest their assets profitably and pay the high interests to depositors, Lebanese banks loaned 70% of these assets to the Lebanese state and the Banque du Liban.
With time, the size of the banks inflated in an unhealthy manner, in parallel with the inflation in the size of the public debt, which rose to exceed 171% of the GDP before the collapse. In short, everything that happened was forming a giant bubble carrying its mines that were bound to explode one day, especially after the volume of public debt exceeded the reasonable level that a country like Lebanon could bear. This model carried huge profits for bank owners who benefited from the high returns of their banks’ investments in public debt and the Banque du Liban, but at the same time, it was leaving depositors’ money twisting in the wind.
The Crisis Beginnings
Many consider that the vast explosion of the banking crisis occurred in October 2019, but the mass of losses had begun to accumulate more than nine years before this date, while the issue remained out of sight all this time.
As we mentioned, the Lebanese financial model has been based on attracting foreign transfers to finance the fixed exchange rate since the 1990s and inflating bank budgets, which were funding the inflation of the public debt. At the same time, the state relied on paying off the instalments and interests of this debt through borrowing again from banks. But in 2011, a significant transformation occurred to the financial system, as the Lebanese balance of payments began to record continuous deficits over all subsequent years, except in 2016. The balance of payments represents the economic indicator that summarizes the net financial transfers between a specific country and abroad over a particular period. Thus, the Lebanese financial system began to face the first challenges that confronted the sustainability of attracting foreign transfers to finance the fixed exchange rate and borrowing, especially since this deficit means that the outflow of dollars from the Lebanese financial system is greater than the inflow.
Under normal circumstances, and in the absence of the fixed exchange rate policy, a deficit of this kind is supposed to lead to a limited decline in the exchange rate of the local currency as a result of the decrease in the dollar quantities available in the markets. This decrease in the local currency exchange rate should restore balance to the balance of payments after the value of imported goods rises, and their demand declines, decreasing the volume of transfers abroad. But in Lebanon’s case, and with the fixed exchange rate policy, the balance of payments deficit meant draining the reserves of the Banque du Liban to defend the fixed exchange rate by providing the dollars required to intervene in the market and compensate for the liquidity that left the country. And since the Central Bank’s foreign exchange reserves are depositors’ money deposited by banks in the Central Bank, the squandering of reserves was the beginning of losses within the banking system.
Mass Losses in Numbers
Thus, the mass of losses within the banking sector altogether accumulated out of the limelight between 2011 and 2019, where this mass represented the difference between the sector’s obligations towards depositors in foreign currencies and the remaining dollars in the banking sector after a large part of it was squandered in the operations of financing the fixed exchange rate. The acceleration of the accumulation of losses occurred specifically between 2015 and 2019 when the deficit in the Central Bank’s net foreign reserves increased from $1.9 billion in 2015 to more than $55.5 billion in 2019. That deficit represents the difference between the obligations and assets of the Central Bank in foreign currencies, and it is precisely the size of the losses that affected depositors’ money in banks, which they deposited in the Central Bank.
In late 2019, the liquidity crisis exploded inside Lebanese banks, and well-known decisions imposed restrictions on cash withdrawals and transfers abroad. Since the state relied on banks from the 1990s to borrow to finance its spending and pay off its outstanding debt securities, the banks’ stumbles soon followed the government’s announcement in March 2020 to stop paying sovereign debt bonds denominated in foreign currency. Thus, the banks’ crisis aggravated, as the banks invested 70% of their assets by lending to the state and the Banque du Liban, which turned the situation into a major banking collapse.
Because the fixed exchange rate policy is connected to the size of foreign reserves in the Central Bank, which can be used in the Central Bank’s interventions in the currency market, Banque du Liban has lost the ability to maintain the exchange rate of the lira since the financial collapse. With the suspension of transfers from abroad to banks, due to the loss of confidence in them, the Lebanese lira was swept in a spiral of rapid deterioration. Consequently, the banking crisis unleashed a parallel monetary crisis.
Losses Identification Evasion
The latest figures indicate that the mass of losses in the Banque du Liban and commercial banks together rose by the middle of this year to about 77.88 billion dollars, with the loss of Eurobonds value (sovereign debt bonds denominated in foreign currency) owned by banks and the Banque du Liban. To understand the enormity of this figure for a country like Lebanon, it is equivalent to 2.3 times the value of the Lebanese GDP.
During the past year, the former Lebanese government hired a foreign financial consultant to prepare a financial plan detailing these losses and proposing measures to deal with them. One of these measures is transferring part of the losses to the banks’ capital, that is, the shares of their shareholders, given that banks owners have benefited since the 1990s from the enormous gains resulting from their investments in public debt and deposits in Banque du Liban. And according to the rule that says that they are responsible for the investment decisions made by their institutions.
But the former government’s attempts were futile, especially after the vast majority of parliamentary blocs mobilized to reject the plan and prevent these losses from being clearly and explicitly identified. Evading the identification of these losses conceals in its folds a keenness to avoid dealing with them, as addressing the losses means cutting the capital and shares of banks owned by the influential people in the political and financial systems. Simply put, the issue of dealing with the banking sector losses became linked with the case of the financial and political elite, who refuse to bear any of the financial collapse losses. On the other hand, the low-income residents pay the cost of this collapse through the deterioration of the local currency exchange rate, the devaluation of their wages, and their inability to withdraw their deposits from the faltering banking system.