A World Bank official once described Lebanon's economy as "defying gravity." That defiance is now under pressure as the government has declared an "economic emergency," with local banks at the center of the crisis due to their exposure to Lebanese sovereign debt.

Amid mounting concerns that the country's methods to manage its vast debts and defend its dollar peg are unsustainable, ratings agencies have taken action in 2019. Moody's downgraded Lebanon's rating in January and put it under review in early October. Fitch Ratings did similar in September, downgrading Lebanon's long-term foreign-currency rating and also Bank Audi SAL, the country's largest bank by assets.

S&P Global Ratings revised Audi's ratings to negative from stable in March and said more recently that the lender's ratings cannot exceed those on the sovereign due to its "credit risk largely [being] concentrated and skewed toward Lebanese sovereign debt."

The economic crisis, declared in September, had already affected Lebanon's bank performance in the first half of 2019, with the profitability ratios at Audi, BLOM Bank SAL and Byblos Bank SAL all deteriorating.

Parallels with Greece

Lebanon's banking sector is comparable, by asset size, to the Greek system, and its woes have also been compared to those of Greece before the financial crisis. And like Greece then, Lebanon now is contending with twin fiscal and current account deficits.

The Banque du Liban, Lebanon's central bank, has helped the government fund the twin deficits by offering high interest rates in order to attract local- and foreign-currency deposits and investments in various instruments. This provided Lebanese banks with an easy means to make relatively low-risk profits by reinvesting customers' deposits in these assets as well as public debt.

Lebanese lenders' "liquid assets are made up of Lebanese sovereign paper or central bank certificates of deposit," S&P Ratings said, warning that liquidity "could prove uncertain" in a worst-case scenario.

"More and more, the liquidity available at banks is going to finance the public sector, which is badly managed and ravaged by corruption and inefficiency," said Sami Nader, an economist and director of Beirut's Levant Institute for Strategic Affairs. "The dwindling usable reserves are a big worry," he said

S&P Global Ratings warned that Lebanon's usable reserves will shrink to $19.2 billion by the end of 2019, down from $25.5 billion a year earlier and $32.5 billion at 2017-end. These should be enough to fund the country's balance of payments deficit over the next 12 months, but more dangers lurk.

"The downgrades aren't positive for confidence or deposit growth," said Elena Sanchez-Cabezudo, head of MENA financials, equity research at EFG Hermes in Dubai. "It's confirmation that the situation in Lebanon is quite difficult and there needs to be further government reforms to correct the imbalances."

Markets have priced in higher risk, with Lebanon's five-year credit default swaps soaring to almost 1,400 basis points, more than double what they were in March.

Strained finances

Higher risks come amid a backdrop of public debt amounting to more than 150% of GDP, according to the IMF. Lebanon's budget deficit widened to 11% of GDP in 2018 — up from 8.6% a year earlier — and the current account deficit increased to more than 25%. Saad Hariri, Lebanon's prime minister, said the United Arab Emirates could provide relief or investment to the country as it struggles to contend with low growth, a massive debt burden and a lack of investor confidence.

Strained state finances are putting pressure on the Lebanese pound's peg to the dollar, with the black-market dollar rate now around 1,620.00 pounds to the dollar, said Nader, while the official rate is 1,507.50.

"The peg isn't sustainable in the medium term, because the tools the central bank has long used to support the peg are weakening," he said. "Lebanese banks are so overloaded with treasury bills in Lebanese pounds that any devaluation would mean their balance sheet would lose a huge amount of its value."

While devaluation is a future risk, steadily increasing interest rates have weighed on profitability, with rates for pound-denominated savings and term deposits held at commercial banks hitting 9.45% as of March 2019, the most recently available data and up from 7.20% a year earlier.

Interest rates on dollar-denominated savings and term deposits rose to 6.31% from 4.56% over the same period. Similarly, rates on three-, six- and 12-month treasury bills have also risen.

"Given the current competition between banks to attract dollars, the squeeze on net interest margin will continue," Saad Azhari, chairman and general manager of Blom Bank, told an analyst call in August. Blom's average cost of deposits, which was around 4.0% in January, increased to 5.7% in June, Azhari said.

The Lebanese financial sector's net foreign assets, including those held by the central bank, have declined by $6.82 billion since the start of 2018, according to the BdL. Around 70% of banking sector deposits are denominated in dollars.

Deposits under pressure

Deposits at Lebanon's banks by foreign investors have historically been stable with only two instances of notable outflows this century — following the assassination of former prime minister Rafik Hariri in 2005 and the Israeli assault on Lebanon in 2006. On both occasions, outflows represented less than 5% of total deposits, said Sanchez-Cabezudo.

Another worry is the mismatch between bank customers' mostly short-term deposits and lenders' longer-term investments in the likes of local- and foreign-currency bonds and treasury bills. "Although the situation is fragile, most of Lebanon's debt is held by domestic investors so you won't see similar amounts of outflows that we've seen from Turkey or Egypt," she said.

"Lebanon's volatile history means that most deposits are very short term. ... It's risky to have such a maturity mismatch, but as long as there aren't big interest rate changes or deposit outflows, it should be manageable," said Sanchez-Cabezudo.