A risk strategist’s perspective on Lebanese banking prior to the 2020 Financial Crisis

BY MOHAMMAD IBRAHIM FHEILI 

Lebanese officials walked out of Paris in November of 2002 with $4.5 billion in soft loans. This represented, at the time, 25% of the country’s GDP. It was desperately needed but it was not properly utilized. In subsequent years, Lebanon’s political elite made little effort at structural reforms.

The nature and magnitude of Lebanon’s debt problem couldn’t be made more clearer when in February of 2012, François Bassil, a prominent Lebanese banker, came out against continuing efforts to prop up the government with loans. At the time it was clear that Lebanon’s public debt was getting out of control and was no longer sustainable. And while this was nearly 20 years ago, this problem is ongoing.

With banks operating in Lebanon bearing half of the public debt in foreign currencies, and over two-thirds of the debt denominated in domestic currency, that put them in the eye of the storm. The government’s disorderly default in early March 2020 turned Bassil’s legitimate fears into a horrible reality. The nature of the crisis and its magnitude makes a government rescue and recovery plan very complex, and it will most definitely fall short of dealing with the causes of the crisis.

The banking landscape

Lebanese banks have under-estimated the risks associated with buying Lebanese government debt instruments and over-invested in these securities. It is time to ask if the state of banking in Lebanon is sustainable. Lebanese banks need to revisit, look long and hard to identify weaknesses, and effectively deal with them which they haven’t.

The excessive reliance on deposits as the only source of funds for banks makes managing liability more challenging relative to a banking sector with more diversified sources of funds. Banks, in recent years, spread their wings very thin knowing the volatility of their sources of funds.

The banking model deployed by most Lebanese banks is rigid and outdated. In addition, it strictly relies on short- to medium-term deposit funding; it’s very restricted with respect to banks’ ability to convert assets into cash; and weak in properly and effectively assessing the risks associated with the uses and sources of funds. I attribute that to the false sense of security that banks have received from the country’s regulatory authority. I recommend that every bank should intentionally differentiate between what is required for regulatory compliance and effective risk management. In fact, the data produced by banks is done just to satisfy central bank reporting requirements.

The Lebanese central bank failed to effectively supervise banks because of the manner in which the sitting governor planted the seed of this relationship and helped it grow. With the blessing of the Banking Control Commission, banks left it up to the regulators to size their risks. In effect, this recent crisis illustrates that commercial banks and the central bank of Lebanon are reflections of each other, and the activities of both are inextricably intertwined, and the institutions undeniably share a commonality of interests.

Additionally, central bank supervision of commercial banks contributed to the health of the industry and to the trust and confidence upon which banking depends. This quickly tumbled on that morning after the crisis ignited, a testimony of failure.

Looking ahead

A clear plan to reschedule and/or restructure public debt is undoubtedly necessary, but it is not sufficient and probably too late. A strong prerequisite for improving Lebanon’s capacity to recover and reclaim its economic power is a sound banking sector. Banks have failed to properly assess the risks associated with their sources and uses of funds. Today, banks are carrying loads of troubled assets which severely constrained banks’ ability to meet deposit outflows; and it most likely will drain their capital at a time the government is completely handicapped and not capable of providing a much-needed bailout. Prompt restructuring and adequate recapitalization are a must, although there shall be consequences!

Recapitalization involves a major change in the way banks are funded, and it essentially involves providing the banks with new capital. This improves the banks’ balance sheet and prevents them from going under. Since the start of the economic crisis and the resulting credit crunch, banks operating in Lebanon have lost money for a myriad of reasons.

First and foremost, the government of Lebanon took the irresponsible decision to default on its debt in the absence of a plan to restructure or reschedule the debt. Banks operating in Lebanon are major creditors. Banks hold 50% of the debt denominated in foreign currency and over 70% of the debt denominated in domestic currency.

The central bank’s decision to continuously bail out the government with depositors’ money made the problem worse and rendered the central bank’s capacity as lender of last resort nearly impossible.

The recession was exacerbated by un-legislated capital controls and led to more defaults by individuals and business entities which expanded the portfolio of non-performing loans.

The credit crunch meant that banks were no longer able to lend to each other. They cannot meet the demand for deposit withdrawals, and they lost confidence. This created the need for recapitalization. Recapitalization is necessary, but not sufficient, for the rescue and recovery of banks.

Lebanese banks should pursue several reforms. Briefly, here are a few:

Accurately assess the true volume of non-performing loans and maintain reasonable levels of lending since excess lending created problems in the first place.

Ensure proper identification and assessment of all risks on all placements and freeze the payment of bonuses and dividends until capital is restored to an adequate level.

Consolidate, downsize, and/or merge. What is important at this juncture is the health of the financial sector and not the health of any one particular financial institution,

Reassess the capacity of key management positions to deliver like Chief Financial Officer, Chief Risk Officer, Treasurer, Chief Internal Audit, and Head of Branch Network.

Reassess the composition of the Board of Directors, and the capacity of each member to deliver as expected and required.

Limit the period of engagement between each financial institution and its external auditors to no more than five years.

Cleanse your institution of all political contamination and detach from dependency on politically corrupt persons.

An infusion of funds can help improve a bank’s liquidity, but it doesn’t necessarily improve nor sustain its performance. There is more to the healthy banking sector than just recapitalization and fresh funds.

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Banks, as profit-maximizing firms, did not fail on the profit-maximizing objective but they fell short of effectively considering the constraints encountered in this optimization process. Managing risks and abiding by regulatory guidelines constrain banks to strive for profits. The regulatory authorities and bank management have always claimed success on the regulatory front.

However, the state that banks are in today clearly points in the direction of an utter failure when it comes to managing risks: on lending, banks went for volume and played down the importance of quality; they were fully aware of the corruption which infested the political landscape, but despite that, they continued on lending to the government; on the liquidity front, they did not do any better.

With the recent crisis, serious problems in the banking model and the conduct of bankers emerged and recovery is no longer about what the government should do. Restructuring and reorganizing the Lebanese banking sector has become urgently needed.

Mohammad Ibrahim Fheili is currently a Risk Strategist, and Capacity Building Expert with focus on the financial sector. He has served in a number of financial institutions in the Levant region. He served as an advisor to the Union of Arab Banks, and the World Union of Arab Bankers on risk and capacity building. Mohammad taught economics, banking and risk management at Louisiana State University (LSU) – Baton Rouge, and the Lebanese American University – Beirut. Mohammad received his University education at Louisiana State University, main campus in Baton Rouge, Louisiana.

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