Why the Restructuring of Lebanon’s Banking Sector Is Inevitable

Banks' losses appear to be huge on the eve of the country’s debt restructuring.

Soldiers deployed in front of a Beirut bank on January 16. Anwar Amro/AFP

Since Lebanon decided to default on its debt, local banks have been on the front-line, given their high exposure to sovereign debt risks. To survive, the banking sector will be forced to restructure and consolidate. Why is this process inevitable and what are the implications?

To Continue Operating

Lebanon’s sovereign rating has continued to decline in recent months, particularly since the country decided not to repay due debts, and this has also had a direct impact on the banking sector.

In order to continue operating in the international financial system and even to pre-serve their relations with correspondent banks, Lebanese banks must continue to respect the capital adequacy ratio set by Basel III International Regulations. Oth-erwise, correspondent banks will simply cease to deal with them.

The capital adequacy ratio (the capital-to-risk weighted assets ratio) should be 8.5% and ideally 10.5% for any banking institution. According to the latest known estimates, the ratio suddenly fell from 16% to 12% for the entire sector at the be-ginning of the liquidity crisis in September, and is now certainly below the re-quirements for many institutions. One reason is that risk weighting (of banking as-sets, including Eurobonds and certificates of deposit) is automatically revised up-ward as a result of a decrease in rating of a country and its banking sector. But another and most important reason is that a bank must cut losses it incurs from its own capital.

Huge Losses

Banks' losses appear to be huge on the eve of the country’s debt restructuring. In-deed, the banks are the main holders of the government’s dollar-denominated bonds: Eurobonds worth about $13 billion out of a total of $31.3 billion are direct-ly held by local banks. These bonds are currently worth 18-20% of their nominal value in the secondary market.

Lebanon wants to negotiate an agreement with its creditors to restructure the dol-lar-denominated debt. In general, debt restructuring means that new Eurobonds are issued with longer maturity dates, lower interest rates and often smaller principals. The existing issues are then exchanged for new ones. If applied, a reduction in the debt’s principals will therefore amount to a haircut on Eurobonds. So, assuming that the principal is cut by 60% (this is a mere example, not speculation), banks will lose no less than $8 billion.

But local banks’ exposure to sovereign debt is not only limited to their holdings of Eurobonds and Treasury Bills; it also includes investments (certificates of depos-its) by these banks with the Bank of Lebanon (BOL), which amount to about $80 billion. For a few years, the BOL has been acting as an intermediary. The state un-derwent debt by issuing bonds, which were then redeemed by the BOL. The central bank, in turn, issued certificates of deposit at higher interest rates, which were then redeemed by commercial banks. This ultimately enabled banks to finance the government without reflecting on their debt exposure level. In its most recent analysis of Lebanon, US bank Morgan Stanley recommended an end to the BOL’s interim role between the banking sector and the government by turning these certificates of deposit into government debt held by commercial banks. This would also enable its restructuring, and thus incurring additional losses for the banking sector.

Finally, in addition to its direct and indirect exposure to sovereign debt, the bank-ing sector must deal with an increasing amount of bad debts: of $47 billion in loans to the private sector, about 20% is considered non-repayable, according to estimates by Finance Minister Ghazi Wazni. This means that banks will incur losses of at least $9 billion, but the amount is expected to increase, various bankers said.

These losses will therefore impact the banks' capital adequacy ratio but will also and above all make the banking sector bankrupt. The capitalization of top banks (the country’s 16 largest banks, with more than $2B in deposits) was $22 billion at the end of December 2018, according to Bankdata Financial Services. The banking sector could thus be faced with losses representing more than half of its own capitalization.

In a circular in November 2019, the BOL requested from banks to increase their capitalization by 20%, or $4.4 billion, by the end of June, and to not redistribute their 2019 profits to their shareholders. The short-term goal was to respond to the dollar liquidity crisis, but the circular was also meant to strengthen bank solvency in the face of rising bad debts and to expand their “security cushion” in the event of a haircut. For the time being, most of the country’s major banks have announced their intention to respond favorably to BOL’s request. But even such an increase won’t be sufficient for bank recapitalization. According to Ghazi Wazni, the sector will need a cash injection of $20 billion to $25 billion to ensure its recovery.

Recapitalization, Mergers and Bail-in

Here surfaces the need to restructure the entire sector. What will restructuring entail? For now, each bank will try to improve its own balance sheet. The banks will seek to increase their own capitalization by looking for new investors (in theory, local or international investors or even governments). Some, like Bank Audi did, may sell their assets abroad to reinforce their capital in Lebanon.

“In fact, recapitalization needs vary from bank to bank, with some banks highly exposed, others much less so. Therefore, it will be necessary to assess, on a bank-by-bank basis, the amount of recapitalization needed to achieve the minimum 8% solvency ratio required by Basel Regulations," wrote Jean Riachi in a column published in March’s edition of Le Commerce du Levant. "Some banks may survive without any need for recapitalization, while others, including small family banks, may provide the necessary funds themselves.”

The role of the Finance Ministry, Lazard (mandated by the government to advise it in the debt restructuring process) and the Central Bank will be decisive. In addition to assessing the situation of each bank, policy-makers will have to make strategic decisions, including measures to foster mergers among banks.

One may be the creation of a bad bank (or a defeasance structure).“One may also consider the outright closure of banks estimated as unsustainable and transfer of their toxic assets into a defeasance structure, while viable assets may be transferred to large surviving banks, with a corresponding amount of deposits. The deposits remaining in the defeasance structure may then be transformed into shares in this structure. Lebanon has already experimented this method with the liquidation of Intra Bank,” Riachi said.

But there is a problem: If this type of structure is used to protect to some extent the interests of depositors, it is often the state that takes the largest stake in a bad bank and thus assumes the risks.“There are, however, international funds that are generally interested in bad banks: Distressed asset funds. These funds buy toxic assets from banks at generally very low prices relative to their initial values, and renegotiate partial repayments with borrowers. This, nonetheless, enables them to make significant profits. For example: A fund buys from a bank a bad debt at 30% of its value. The bank therefore accepts a loss of 70%, but improves its balance sheet and capital adequacy ratio. Then, the fund negotiates with the borrower to recover 40% of that bad debt, and thus achieves a 40% margin,” said a banker, interviewed by L’Orient-Le Jour.

But it is only after this restructuring process is complete, with healthy surviving banks in place, the banks can offer a bail-in to their depositors, said the banker, who expected this operation to be voluntary and will not be forced. Major depositors would thus be offered to convert some of their deposits into equity in the banks where they originally placed these deposits. This is what’s commonly referred to as a “bail-in.”

It goes without saying that the banking sector may face tough years before it can fully recover. In the meantime, mechanisms can be provided by Lebanon’s traditional donors to enable direct financing to businesses through lending, because banks may not be able to lend to the private sector during their consolidation phase. “Organizations, such as the European Bank for Reconstruction and Development or the International Finance Corporation (part of the World Bank Group), are accustomed to this type of mechanism," a source close to the case told L’Orient-Le Jour. "In recent years, the EBRD launched six initiatives for small to mid-size enterprises based on the same principle. The European Investment Bank and Proparco (part of the French Development Agency) may also participate.”

But again, the conditions remain the same: “A bailout plan by the International Monetary Fund and a transparent restructuring of all public debt, including the BOL’s balance sheet,” the source concluded.

(This article was originally published in French in L'Orient-Le Jour on the 6th of April)

Since Lebanon decided to default on its debt, local banks have been on the front-line, given their high exposure to sovereign debt risks. To survive, the banking sector will be forced to restructure and consolidate. Why is this process inevitable and what are the implications?

To Continue Operating

Lebanon’s sovereign rating has continued to decline in...

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