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The financial engineering of Lebanon’s central bank

Oct 09

The financial engineering of Lebanon’s central bank

Lebanon’s current economic “situation” is not just a US dollar liquidity issue, it is the product of a unique monetary policy. The context of our current economy is a story of accounting acrobatics and regulatory arbitrage, the outcome of which will either be a Hail Mary for Lebanon’s economy, or an economic debacle.

Accounting rules are derived from principles, which are themselves derived intentionally. It is this fundamental understanding of accounting that allows users of financial statements to modify them with the purpose of better understanding company fundamentals. Accounting is seldom introduced in such a philosophical context, but this is necessary in understanding the accounting acrobatics conducted by Banque du Liban (BDL), Lebanon’s central bank, and the regulatory arbitrage (capitalizing on loopholes) that has bolstered Lebanese commercial banks’ balance sheets.

In 2016, BDL initiated a series of highly unconventional policy measures that I call swapenomics, the most recent of which was conducted in the summer of 2019. This financial engineering was a three-step process, consisting of: the dollarization of Lebanese government debt, BDL’s sale of dollar certificate of deposits (CDs), and BDL’s purchase of Lebanese denominated treasuries from commercial banks—at a head scratching valuation. Each one of the steps comes with a panoply of consequences; this article will focus on Basel III capital requirements and International Financial Reporting Standard (IFRS) 9 provisions and reserves.

Lebanon’s attractive interest rates on deposits were able to offset the current account deficit (meaning imports are greater than exports) and maintain the currency peg. However, due to recent developments—the implementation of IFRS 9 in the 2018 financial reporting period, which affected financial institutions provisions and reserves against risky assets; Basel III capital requirements, with respect to the downgrade of Lebanese sovereign debt; and economic stagnation—Lebanese commercial banks needed help to remain compliant with international standards and remain in the loop with corresponding banks. This help came from BDL’s swapenomics.

The rise of deposits in the Lebanese banking sector in the context of a struggling economy gave banks few attractive investments, meaning they were likely to resort to buying government bonds. But because Lebanon’s debt is rated “junk,” the risk weighting was high. That meant that the commercial banks would have had to hold more idle money (money not being invested, and so not earning any interest or investment income) in the form of reserves (money set aside for future use) and provisions (money set aside to cover future liability). BDL gave them an alternative. The commercial banks would give BDL dollars in exchange for dollar CDs, which have a lower risk weighting and, as such, require less idle money. This alternative investment became so dominating in the financial sector that some banks are essentially narrow banks—a bank that only deposits its money at the central bank. This is evidently a problem because it causes credit in the economy to dry up, but, on the other hand, it allowed BDL to bolster its dollar reserves to maintain the peg.

The sale of lira treasuries by the commercial banks to BDL using unusual valuations gave the commercial banks significant gains on the transactions. To convince the banks to sell these already attractive assets, BDL offered to pay part of all future interest today. The profits made on these transactions could not be used to distribute profits to shareholders, banks had to phase them into their equity in the 2018 financial statements—the year new stricter accounting regulations set in. This boost in equity, coupled with lower relative risk weighting of assets, meant that commercial banks surpassed capital adequacy ratios and had sufficient provisions and reserves against expected credit losses (ECL).

Reading the financial statements of banks shows compliance and satisfactory cushioning against credit risk, but I see another story. I see systemic risk built up and hidden away in the financial statements. BDL’s CDs are classified as safer than Lebanese treasuries, but the central bank is heavily exposed to the sovereign—33.8 percent of its assets are either categorized as government securities, or in assets held from exchange operations. A meticulous analyst might want to reweigh those CDs held at the banks using the “junk” bond weighting and see how this affects capital adequacy ratios and ECLs.

The broader question that should be asked is the ethics of the operations. I am certain that these operations were necessary to buy the failing Lebanese government time to clean up its fiscal policy. I am also profoundly impressed by the ingenuity of swapenomics. But as we stand, the operations concentrated risks instead of mitigating them, in order to buy Lebanon time. This means that if the economy can overcome its lethargy, and the government can get its act together, then swapenomics will go down in the history books as a magnum opus of financial alchemy, otherwise we should brace for a dark decade.