Henri J. Chaoul-Ph.D., Managing Partner, Levantine Partners
Henri J. Chaoul-Ph.D., Managing Partner, Levantine Partners

“La force de la verité est la seule arme du peuple” Anonymous

All credible policy choices derive their legitimacy only from their acceptance by the wide public.  Unfortunately, the real situation of the state of public finances and of the health of the financial system were hidden from citizens by public officials and by banking representatives for so long.  This article is written for that wide public, so that they carry the flag of the reforms required for a fundamental and systematic change of the national institutions and the system that govern Lebanon.

So, let us start with the truths as hard as those may be: the State has financially collapsed and needs a major restructuring of its debts to survive and to put the economy back on a healthy path; the Central Bank is insolvent and its remaining liquidity extremely tight; the commercial banking sector is both illiquid and insolvent; an important part of the depositors money is nothing but an accounting entry on the books of the banks. 

This is the situation that comes out from the Government Reform Plan report that was leaked days ago.  Further, it states that the losses to the financial system approach $83 billion, roughly divided as follows:  $43 billion due to losses at the Central Bank[1]; $37 billion due to the restructuring needs of the sovereign debt and $12 billion for losses due to private sector loan impairments. 

En français : Pourquoi un “bail-in” des banques est nécessaire

Two points are to be retained from this simple assessment.  The first is the concept of loss and the second is the quantum.  A loss in the financial system means that the equivalent amount of money has in fact vanished and therefore someone or a group of people in the society must carry that loss.  The fact that the financial system refuses to recognize it in its books is irrelevant.  That amount is gone.  This is a reality that Lebanon must adjust itself to, must accept its consequences and must attempt to look forward to building a better future despite all the pain that it entails.

Second, quantifying such losses is important because it will be in direct relationship to the pain that the society will have to endure while it absorbs that loss.  Let us put the $83 billion of losses in perspective:  this is twice the annual economic activity of the whole country (the GDP) or four times the capital of the aggregated commercial banking sector or nearly 60% of all deposits in Lebanon.  No matter how you look at it, the loss in the financial system is of Gargantuan proportion and unless dealt with it swiftly and harshly, the future of the country will be bleak:  a financial sector in continuous Zombie-like situation, huge economic contraction, social chaos, a new wave of immigration and poverty that will lead to civil unrest.  No investment would take place in such a frozen situation.  Liquidity and fresh hard currency will only drip into the country.  It will be a lost decade or two before Lebanon can re-emerge from this crisis if we decide to continue the short-term policies followed over the last 20 years or so by the monetary authorities and the political apparatchik that govern the country or if we continue with the band aid approach followed currently by the Central Bank.  Financial wizardry does not build a country.  It only postpones that day of reckoning. 

So, how did we get here?  This is a crash of epic proportions fueled by mismanagement and corruption in the public spheres; a failure of governance and supervision by the regulatory bodies of the financial sector; the lack of willingness of the public sector to implement reforms; a commercial banking sector moved by profit-making motives through risky investments at the cost of depositors safekeeping; and, a total disregard and violation of existing laws and regulations that, had they been followed, would have avoided all this crisis.  This was allowed to happen through the development of a Ponzi-like scheme at a national level that kept the deposits flowing through the financial system and blinded depositors attracted by high rewards unmatched globally, whose interspersed questioning were faced with continuous untruths from the Central Bank and from politicians as to the real financial situation of the country, the stability of the currency and the sustainability of the financial system.  Throughout all this period, the leaders numbed the average citizen with a higher purchasing power granted to it by a costly over-appreciated currency policy.  

At this stage, what matters is what we do next.  The Government Reform Paper is clear about the path: a full IMF program.  We needed it yesterday.  Only an IMF program can (i) provide the liquidity needed to sustain our future needs of hard currency; (ii) impose a financial discipline through the implementation of fiscal reforms including privatization programs; (iii) unlock additional international funds badly needed for infrastructure and development plans and the establishment of proper social safety programs ; (iv) accompany the implementation of structural reforms; (v) ensure the implementation of a stable monetary policy; (vi) help Lebanon as it frees its national currency; (vii) assist Lebanon in the modernization of the laws that govern the financial sector; and (viii) assist in a full rebuilding of the governance structure of the regulatory bodies to ensure transparency, independence, accountability and proper enforcement.

The IMF program will be conditioned on the willingness of the Lebanese to cleanse its financial system by implementing a program that puts the country on a sustainable debt path and eliminates all the financial losses.  How do we do that?

First, the amount of losses must be confirmed.  They may end up being higher than the current level estimated at $83 billion.  This confirmation can only happen by a proper audit of the Central Bank and of the public sector at large.  The former has been requested by the government.  It should be completed by international audit firms located outside of the country with forensic assistance and expertise in central banking reserves management and accounting.  This will allow to have a definitive position to disallow how the Central Bank accounts for its losses in such an unorthodox manner; an approach clearly contradicting IMF principles in terms of size and duration, without any amortization possible in the near or medium term.  A similar full audit of the public sector must be started: the finances of all persons involved in public life in leadership or senior management positions over the last 30 years and of those that have been granted a public contract during that period for an annual amount exceeding $1 million have to be audited.  As a result of this audit, the proper actions must be taken to return any ill-gotten funds.  This is the first line of defense in absorbing the losses in the financial system. 

Second, we must perform an exercise of fair allocation of losses of the financial system.  This is not a simple exercise and it will take time to develop and implement.  The government of Lebanon must ensure that no regressive action is taken in this regard and that very clear principles are set out.  The first of such principles is very clearly documented in the Government Reform Plan by stating that “no full bailout option” can be considered.  Indeed, asking the taxpayer to pay, through a swap of state assets or the promise of future revenues from such assets or the issuance of any kind of financial instrument backed by the government, is completely unacceptable.  Following the Greek sovereign crisis, the European Union has issued regulation effectively banning bailout of banks by taxpayers and regulating the bail-in mechanisms.  Bailouts are regressive, especially in Lebanon where an estimated 55% of the population do not even have a bank account.  So, involving them in the saving of a financial system they had no part in violates all equity standards.  Any attempt to provide a bailout solution will be opposed by the population at large, and rightfully so.  It also does not have an economic basis: over the period 2002-2018, interest payments account for 94% of the debt of the country and in 2019 for 50% of fiscal imbalances, thus showing that the beneficiaries of the largess of the State were indeed the bondholders – banks and indirectly, depositors.  Legally, neither banks nor depositors have recourse to such assets or associated revenue streams, and it will complicate the discussions with international creditors who may claim for a similar treatment.  Finally, a bailout is tantamount to an increase in debt to GDP ratio, which contradicts the objectives of the debt restructuring program.

The concept of a bail-in is quite simple and it encumbers effectively on the participants of a financial system to bear the burden of the crisis, as they are the ones with the contractual obligations.  In a similar manner that a debt restructuring process imposes haircuts on foreign creditors, domestic participants to the financial system -shareholders and depositors- must bear the burden of financing the losses.  This exercise must be done on a bank by bank basis and will require a high degree of transparency and reliance on advisors to perform all necessary asset quality review and additional audit reviews.  The bail-in assumes a hierarchy of lines of defense that will have to be very strictly observed, as follows:

- The first to shoulder such pain are the shareholders (and preferred shareholders) of the banks, whose whole equity is at risk.  Given the magnitude of the numbers, and while the exercise will be conducted on a bank by bank basis, it is safe to assume that most if not all of the banks, would lose their equity.  Shareholders responsibility in the participation to the bail-in does not stop here.  There are a number of additional pockets of funds that will have to be called including a full dividend claw back at least since 2015, as well as a claw back to management compensation to the extent that these were excessive or tied to swaps and financial engineering schemes.  Banks should also be forced to sell all of their affiliates overseas and a real assets on their books that have a potential capital gain.  Any potential future participation by the current shareholders in the banking system must be contingent on full compliance with this bail-in step.

- Any debt provided to the banking system will be the next line of defense. 

- Once the equity and debt pockets have been fully exhausted, unsecured depositors will be asked to chip in.  First and foremost, transfers out of the banking system must be analyzed for the last 3 years to allow equal treatment of all depositors without unduly penalizing those who stayed in the banking system or did not benefit from favoritism.  Second, a detailed study at a depositor level must be undertaken to eliminate all excess interest paid to depositors and specially all those that resulted from financial engineering schemes. This may be applied irrespective of account size.

- Concomitantly with the audit of the finances of the state mentioned above, all accounts with balances over $1 million must be forensically audited to determine the source of money.  There are roughly 20,000 such accounts and they can be systematically audited. Any ill-gotten gains present in the banking system would have to be written off immediately and judicial proceedings must be followed to bring any of such ill-gotten assets shielded overseas.

- A haircut on unsecured depositors is the final step after taking into consideration a number of items: (i) the possible exemptions of a number of accounts; (ii) the consideration of a lower limit below which no haircut is applied (the government has indicated the protection of 98% of account holders).  Whatever haircut resulting from this step can and should be compensated with the prosecution of ill-gotten asset probes identified earlier.  In fact, this group of big depositors have all the means and power to put pressure on the politicians to pursue the prosecution of ill-gotten assets described earlier as for every return of ill-gotten dollar their haircut is reduced by a dollar.

In democracies, we hold people accountable for their actions.  It is impossible for any nation to be confronted with the magnitude of the financial crisis that Lebanon is witnessing without proper accountability across the whole spectrum of the political, regulatory and financial landscape.  Lebanon needs a new political system -effectively a new social contract- where oligarchy is no longer permitted.  Let us take advantage of this crisis so that the future generations are given their fair chance in building a real economy based on competency and accountability.  

[1] In order to soften the blow, the Report recommends keeping some losses at the Central Bank so that the net losses are $34 billion rather than $43 billion.  Since the Report was leaked, an additional $1 billion of losses has been added in 15 days.