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Calculating The Cost Of Lebanon's Bank-Sovereign Doom Loop

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Calculating The Cost Of Lebanon's Bank-Sovereign Doom Loop

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More than a year after the Lebanese government defaulted on its foreign currency obligations, pressure on the banking system is still mounting. This is not least because of the COVID-19 pandemic's economic impact, the Beirut port blast last August, Lebanon's ongoing political deadlock, and a run on deposits that's only been partly slowed by Lebanon's ad hoc capital restrictions.

S&P Global Ratings believes the true extent of Lebanese banks' losses will materialize only once government debt restructuring takes place. In April 2020, the government under Prime Minister Hasan Diab put forward a restructuring plan. However, the plan was not implemented because of political wrangling, leaving markets in the dark about the potential cost of Lebanon's financial crisis. The proposal envisaged writing down government debt and discounting banks' deposits with the central bank (Banque du Liban; BdL).

The main stumbling block to restructuring appears to be that Lebanon is currently functioning with a caretaker government without authority to agree terms with creditors. The prime minister-designate since October 2020, Saad Hariri, has been unable to form a government because of disagreements with the president and other political parties over the filling of cabinet positions. There is also significant discord among key political institutions regarding the cause and scope of the country's debt distress and the path to restructuring, including the treatment of depositors.

While not predicting the steps the government will take, we have developed three scenarios involving various write-down assumptions. We estimate that the cost for banks of restructuring their holdings with the BdL, Lebanese government debt instruments, and other asset write-downs could range from 30% to 134% of Lebanon's estimated GDP for 2021, before the impact of potential currency devaluation. Due to the size of the problem, we believe shareholder or external funding alone will probably be insufficient to absorb those costs. At this stage, bailing in depositors--for example by paying them below-market exchange rates, or converting deposits into equity--seems highly likely.

Without a resolution, Lebanese banks could find it difficult to sustain their operations as deposit outflows continue and foreign correspondent banks sever relationships. Failure to restructure the financial system could leave Lebanon with banks unfit to support an economic recovery.

Sovereign Exposure Poses One Of The Greatest Risks For Banks

Lebanese banks have traditionally enjoyed high foreign-currency deposit inflows, primarily from the sizable Lebanese diaspora. Banks used these inflows to buy government debt or deposit with the BdL to earn high returns. The BdL then subsidized the government's large fiscal deficits. These banking practices have created direct and indirect links between the creditworthiness of Lebanese banks and the sovereign.

Although the Lebanese government has suspended payments on its Eurobonds, it reportedly remains current on domestic debt obligations as of May 2021. The BdL has reportedly been fulfilling the government's local currency debt repayments by printing money, which contributed to inflation rising to 158% in March 2021, year on year. As of March 31, 2021, domestic banks held about 60% of their assets in the form of BdL deposits and certificates of deposits (CDs), and 11% in government treasury bills and Eurobonds (see chart 1). In turn, the BdL held about 44% of government debt, and commercial banks 26% directly at year-end 2020.

Chart 1

image

The Cost Of Default Could Surpass 100% Of GDP

After the government defaulted in March 2020, it proposed a restructuring plan that envisaged haircuts on foreign and domestic government debt. The plan also included a write-down of domestic banks' deposits and CDs with the BdL, which has sustained losses of about $60 billion largely from its financial engineering operations since 2016. This plan has not been agreed on or implemented.

We don't think restructuring foreign currency debt alone would put the government's finances back on a more stable footing, since that debt comprised only 38% of total sovereign debt at year-end 2020 (see chart 2). Even a write-off of all Eurobonds and official debt would leave the government with debt amounting to 107% of GDP, based on year-end 2020 figures. We therefore believe local currency government debt will likely be part of any debt restructuring program.

Chart 2

image

Moreover, although banks' placements at the BdL represent 6.5x the banking sector's equity, we expect these will be restructured to some extent, given the size of the BdL's losses. We also anticipate impairments on private-sector bank loans amid a weaker economic backdrop, where we estimate a real GDP contraction of 10% this year after a 25% drop in 2020.

To estimate the potential costs for Lebanese banks, we created three scenarios for losses on government Eurobonds, local currency government debt, BdL deposits and CDs, as well as private-sector loans. We base these scenarios partly on our observations of 17 emerging-market sovereign defaults between 1999 and 2010, where the average haircut on government debt stood at 42%:

Scenario 1:   50% haircut on banks' holdings of Lebanese government foreign and local currency debt, a 10% write-down of BdL placements, and 5% losses on private-sector lending. We assume a slightly larger haircut than the 42% average since the government's debt is currently trading at a much higher discount.

Scenario 2:   75% haircut on Eurobonds (pushing more of the burden onto foreign investors), 60% on local currency debt, 50% on BdL placements, and 15% on private-sector lending. The Lebanese government's 2020 restructuring plan proposed a similar write-down of banks' deposits and CDs at the BdL.

Scenario 3:   90% haircut on Eurobonds, and 70% on local currency debt and BdL placements. Although investors may reject this in practice, this scenario would likely be more favorable for the government debt's sustainability and the BdL's recapitalization, in our view. Lebanese Eurobonds are trading at 11 cents-15 cents per U.S. dollar, suggesting that the markets are pricing in an 85%-89% reduction of the face value. We also assume 30% losses on other lending.

Lebanese Banks: Scenario Analysis Based On Loss-Given Default Assumptions
Scenario 1 Scenario 2 Scenario 3
Asset write-down assumptions (%)
Lebanese government Eurobonds 50 75 90
Lebanese government local currency debt 50 60 70
Banks’ exposure to BdL 10 50 70
Banks’ private-sector lending book 5 15 30
Cost of asset writedowns
Asset write-downs amount (bil. LB£) 33,980 109,811 153,476
Asset writedowns/equity (%) 133 430 600
Asset writedowns (after equity depletion)/foreign currency deposits (%) 5 51 78
Asset writedowns (after equity depletion)/total deposits (%) 4 41 63
Asset writedowns/2021 GDP (%)* 30 96 134
*2021 GDP is an estimate. The outcomes for 2020 and 2021 GDP are uncertain because of insufficient data on economic activity and deflators, given the sharp movements in prices. Source: S&P Global Ratings.

Banks' Equity Is Depleted Under All Three Scenarios

Our scenarios suggest that the cost of restructuring Lebanon's banking system could range from $23 billion (using the official exchange rate) under Scenario 1 to $102 billion under Scenario 3. This amounts to 30%-134% of nominal GDP. By comparison, Ireland's banking system faced recapitalization costs of about 37% of GDP over 2008-2009 and Greece's about 25% of GDP over 2008-2019. Absent other sources of funding, restructuring the banking system could affect 4%-63% of the deposit base after Lebanese banks' equity is exhausted.

Restructuring costs could be even higher in the event of a currency devaluation. Lebanon's currency peg to the U.S. dollar has failed because of the country's reduced access to external financing and foreign currency deposit outflows since 2019, resulting in a steady decline of foreign reserves. What's more, foreign exchange shortages and restrictions on foreign currency deposit withdrawals and transfers have led to rapid exchange rate depreciation in the parallel markets, and to the emergence of at least four exchange rate practices.

Lessons From Other Sovereign Debt And Banking Crises

Strong political will and cooperation between key stakeholders, including the legislative and executive branches, the BdL, and the banking association are prerequisites for Lebanon to resolve its current situation. Some of the strategies other sovereigns in a similar position explored include:

Write-offs of shareholders' equity.   In the event of government banking system bailouts, private shareholders are likely to lose all or most of their equity investment. Under our three scenarios, we assume shareholders' equity will be lost following restructuring of BdL placements, government debt, and other asset write-downs. Lebanese banks were among the main beneficiaries of high interest rates and the BdL's financial engineering operations in the past. The BdL instructed banks in August 2020 to increase their capital by 20% by the end of February 2021, and raise an additional 3% of deposits in U.S. dollars. Even if all banks were able to meet these increased requirements, we believe this is unlikely to stabilize the banking system.

Bail-in of depositors.  In certain other countries that experienced a banking crisis, such as Cyprus, foreign depositors were bailed in. For Lebanon, a bail-in would primarily affect resident or nonresident Lebanese nationals since we believe the proportion of non-Lebanese depositors is very small. Depositors could be asked to convert deposits into equity or subordinated debt, but we don't think they would do so voluntarily. Customers could also be asked to convert their foreign currency-denominated deposits at a lower exchange rate than is available in the market. There is a recent precedent for this, since the BdL's Circular 151 of 21 April 2020 allows depositors to withdraw up to $5,000 in local currency at LB£3,900 to $1, which is much lower than the prevailing market rate.

It's conceivable that the authorities might target deposits of high-net-worth individuals to reduce the impact on the low-income population. Significant sums have reportedly been transferred abroad despite capital restrictions since October 2019. We understand the BdL is urging customers that have moved more than $500,000 out of Lebanon since July 2017 to deposit 15% of that amount (30% for bank shareholders and senior management, and politically exposed persons) in a five-year special account at domestic banks. However, there is no legal means to enforce the repatriation of funds. Authorities may choose to target the remaining deposits of such customers in Lebanese banks.

External support.  In 2010, the Irish government received financial assistance under a €85 billion program from the European Commission and the International Monetary Fund (IMF), with up to €50 billion for fiscal needs and up to €35 billion of banking support measures over 2011-2013. External support may still be an option for Lebanon, even though talks with the IMF have stalled due to the current political impasse. Without the formation of a credible recovery plan and political commitment to reforms, donor support from the IMF, or from international partners that pledged $11 billion at the Cedre conference in 2018, will likely remain elusive. In any case, it is unlikely that external funding will be available without significant burden sharing.

Setting up an asset-management company or "bad bank".  Some market participants have proposed a recapitalization of the BdL by creating an asset-management company. In Ireland, the National Asset Management Agency (NAMA) was set up in December 2009 to restructure the balance sheets of five distressed banks (see "National Asset Management Agency," published Dec. 21, 2020). NAMA acquired banks' distressed assets at an average discount of 57%, in exchange for government-guaranteed securities. However, in the case of Lebanese banks, the suggestion is that a bad bank acquire distressed assets in exchange for a claim against proceeds from state assets such as real estate and infrastructure (ports), which may be difficult to value; or a claim against the country's gold reserves, which could further reduce their availability to support the government's external position.

Consolidation.   One typical measure taken in a financial crisis is banking sector consolidation. For example, Cyprus' banking sector shrank to 3.5x GDP at year-end 2013 from 7.5x GDP in 2009, reflecting the sale of Cypriot banks' foreign branches and subsidiaries, and the write-down of head office loan books. The Lebanese banking system is overbanked, with 47 commercial banks serving only 7 million people, although we note that the number of nonresident Lebanese nationals is several times larger than the local population. Thus far, we have not seen any mergers or closures of Lebanon's banks, although we expect this may change in 2021-2022.

Editor: Bernadette Stroeder.

Related Research

Primary Credit Analysts:Zahabia S Gupta, Dubai (971) 4-372-7154;
zahabia.gupta@spglobal.com
Mohamed Damak, Dubai + 97143727153;
mohamed.damak@spglobal.com
Secondary Contact:Trevor Cullinan, Dubai + (971)43727113;
trevor.cullinan@spglobal.com
Research Contributor:Juili Pargaonkar, CRISIL Global Analytical Center, an S&P affiliate, Mumbai

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