Lebanon’s Economic Recovery Plan Part 2: Banking

Opinion Analysis by Sandro Joseph Azzam, Staff Writer

July 1st, 2020

This article is part of a more general series discussing Lebanon’s Economic Recovery Plan. Each piece tackles a different aspect of the reality of current events, explains the economic or financial principles behind it and provides the real solutions that Lebanese citizens deserve to see implemented. Readers are strongly encouraged to read “Lebanon’s Economic Recovery Plan Part 1: Exchange rate”, prior to reading this article.

This article tackles the fundamental issues that would arise in the Lebanese banking sector, should a devaluation of the Lebanese Lira be implemented. 

Lebanon’s banks hold their capital in Lebanese Lira. Bank capital is simply the net worth of the bank, so its assets minus its liabilities. They build up their capital by purchasing Lebanese treasury bills denominated in Lebanese Lira. A 50% devaluation of the Lira would mean that the net worth of Lebanon’s banks decreases by 50%. If banks’ capitals are too low, they can be locked out of international markets pursuant to the Basel III agreements. Current minimum capital adequacy ratios (that is, bank net worth divided by total deposits) stand at 8%, so for every $100 you give a bank, its shareholders must have $8.

Let’s assume that all of Lebanon’s population is represented by Nabil (try reading this name backwards) and that there is only 1 bank in the whole country. When Nabil goes to the bank to deposit 1000USD, the bank registers a liability of 1000USD because it is going to need to give Nabil his money back at some point. If these 1000USD used to be worth 1.5 million LBP before the devaluation, then the bank’s total liabilities would have been those same 1.5 million LBP. Bank A used to have a capital of, let’s say, 150.000LBP. Their capital adequacy ratio is 10% meaning that for each 1000 Lebanese Lira of liabilities that the bank has, its shareholders have 100LBP, not atypical for financial institutions. Now let’s say a 50% devaluation occurs and 1USD is now worth 3000LBP. The bank still has 150.000LBP of net worth (now only worth 50USD) but still owes Nabil 1000USD, or 3 million LBP. The capital adequacy ratio of the bank is slashed to 5%, lower than the 8% threshold. 

Banks now need to make up for their lost capital. Where do they find the money? Nabil’s deposit. 

That’s how haircuts work. The bank needs to restore its 8% capital. Since it cannot increase its own net worth, it has to reduce its liabilities. How? Well, by literally taking the money from Nabil’s account. He had 3 million LBP but the bank needs 100.000LBP to recapitalize. Nabil now magically has 2.9 million LBP, or 966USD at the new rate, and the bank has 250.000LBP, granting it a capital adequacy ratio of just above 8%. 

The IMF asking for a devaluation is thus conditioned upon Lebanon’s depositors taking a haircut. PM Hassan Diab announced that 98% of depositors would be safe from this haircut, leaving Lebanon’s richest to pay the price. While some found this to be the best solution, it is far from ideal. By “robbing” Lebanon’s richest, you are discouraging foreign investment. If American depositor John Appleseed was considering depositing money in a Lebanese bank or starting a business there, he would likely think twice because of the non-insignificant chance of him losing part of his money in a haircut. Making Lebanon’s biggest depositors pay might seem like the best option, but it is a short-term solution that will make the long term even worse. Imagine governments installing air conditioners around the world in a bid to fight global warming. It will get cooler at first but in the long-term you’ll need to produce more electricity and burn more coal. Just like making the top 2% of depositors pay, this is simply unsustainable. 

The way to think of a long-term solution would be to make all of Lebanon’s depositors pay their fair share through marginal haircut rates. Whilst this may seem like an ultra-capitalistic ideal, it is what is best in the long run as foreign investors run less of a risk by investing in Lebanon. Lebanon’s wealthy diaspora will also see this as a step in the right direction in a bid to restore confidence in the banking sector, prompting them to send part of their wealth back to the Land of the Cedar and constituting the massive inflow of hard currency that the country needs.

Having discussed devaluations and a haircut, we will be taking a look at the central bank. This will be tackled in Lebanon’s Economic Recovery Plan Part 3: Monetary Policy