Lebanon's central bank
Fears are mounting over the viability of Lebanon’s banking sector, which is over-exposed to state bonds, as the government begins what will likely be a drawn-out restructuring of its debt.
Legislation requiring large depositors to enter into a deposit to share-swap is the only way to prevent bankruptcy, a senior Lebanese banker tells Euromoney.
For years, Lebanese banks have served as a conduit for state funding, funnelling deposits back to the central bank Banque du Liban, which has, in turn, lent money to the government.
Now, FX reserves are running out and debt-to-GDP is unsustainable at 152%, according to the IMF.
After months of speculation and just days before the due date of March 9, Lebanon’s government said it would not repay the $1.2 billion Eurobond repayment, although details of the restructuring process have so far been scant and will likely be delayed by the onset of the coronavirus Covid-19.
There are 10 different ways to skin a cat, but a haircut in whatever form is unavoidable- Lebanese banker
Lebanese banks, which hold some 50% of Lebanon’s Eurobonds, could well be decimated by the process and stand to lose on aggregate between $20 billion and $40 billion, depending on the recovery value of the bonds in a restructuring.
“A good bank will lose its capital completely, while others will lose it twice over,” says the banker. “Either way, you are bankrupt. The Lebanese banks’ total equity pre-crisis is $22 billion. We’re deep in it.”
To prevent insolvency, he argues a depositor bail-in will be required to shore up the bank’s assets, alongside a restructuring.
Capital Economics estimates that if local banks incurred losses of 70% on their government debt holdings, their capital would be wiped out and recapitalization efforts would amount to around 25% of GDP.
The banker says: “A solution for me, the one thing I am advocating: we should take the large deposits over $100,000, which make up 75% of the total deposit base, and give a haircut of 20% to 25% and give them shares of the bank in exchange.”
This would balance the hit to the asset side of banks’ balance sheets from a write-down of sovereign debt holdings.
“You save the bank and smaller depositors, you rebuild the capital of the banks and you have given them shares of the bank,” he says. “You hit three or four birds in one stone, but it won’t be easily accepted.”
Direct exposure to the Eurobond default represented 6% of domestic banks’ balance sheets and about two-thirds of their equity at end-2019, but overall some 80% of sovereign debt is held within Lebanon, and most of it by the banks.
Lebanon’s banks off-loaded some $1.1 billion Eurobonds in January, needing liquidity and fearing default.
In a previous test case, the method proved to be effective when used by Cyprus in 2013 amid a bailout. In that case, after the restructuring shares in the banks recovered, depositors were able to recover the value of their funds.
“From the perspective of the depositors, it will be better to swap into shares rather than lose deposits,” the banker says. “All these deposits are blocked in the banks anyway. People may have $1 million, but they can only take out $300 a month.”
Other possible options to shore up assets include transferring dollar deposits into Lebanese pounds, or using a one-time tax of 10% to 20%, or blocking deposits for 15 years, he says.
“There are 10 different ways to skin a cat, but a haircut in whatever form is unavoidable,” he says.
However, imposition of the depositor bail-in and share-swap would require a government directive, which the banker believes is unlikely at this stage.
“It is highly politicized,” he says.
In addition, it would likely result in years of lawsuits against the government. Several depositors are still in the process of suing Cyprus for what they see as the unlawful use of their funds.
Michael Doran, a partner and restructuring specialist at Baker McKenzie, sees some similarities between Cyprus and Lebanon’s economic crises.
“As in Cyprus, a large banking sector [relative to GDP] has been largely funded by external dollar depositors attracted by high interest rates in Lebanon,” he says.
“The Cyprus banks were badly hit by the haircut imposed by the Greek government on its sovereign bonds. In the Cyprus bail-in, there were several missteps. I have no doubt the Lebanese authorities will pay close attention to this precedent in Cyprus while planning their next steps.”
Doran thinks it will be difficult to preserve the banking sector in its current size and shape in any sovereign debt restructuring, and it is likely to be reduced in size and scale. Banks may be nationalized or forced into mergers with other competitors.
“As part of any possible bailout of the sovereign, the IMF will, I believe, ask to see the bail-in of the banks’ unsecured creditors, uninsured depositors and shareholders, and reform of the banking sector,” he says. “Bail-in is now a standard bank resolution technique across EMEA.
“Too many banks are relying on this slightly unusual reliance on overseas deposits and paying high returns.”
Doran refers to the government’s predicament as a “Houdini-like escape”.
Another possibility to have avoided substantial losses on the banking sector would have been for the banks to exchange their bonds with the government for new, longer-dated, lower coupon debt. This may also have helped the government avoid a disorderly default.
Alternatively, the government could offer more favourable treatment to holders of Lebanon’s domestic debt – mostly the banks – than to the Eurobond holders.
While not impossible, it will be hard to implement a two-tier sovereign debt restructuring favouring domestic financial institutions over external creditors – as all are in effect one class of creditors holding unsecured Eurobonds.
The process, already complicated by the doom loop, which has seen a sovereign debt crisis become a banking crisis and vice versa, will likely be further hampered by the coronavirus.
Lebanon’s fight to contain Covid-19 has seen airports closed and movement restricted. And with global investors trying to stem portfolio outflows, protracted restructuring conference calls may be pushed back.
“Lebanon has to move things forward, they need to protect the banking system and the economy, and now it is a very difficult situation,” says Rodrigo Olivares-Caminal, professor and expert sovereign debt consultant.
“The same is happening with Argentina: they are about to restructure debt and they cannot even meet with the creditors.”
Lebanon’s government has hired Lazard and Cleary Gottlieb Steen & Hamilton as advisers, and the banks have appointed Houlihan Lokey and DLA Piper to advise on the process.
Analysts say the process cannot proceed without an IMF agreement. The Lebanese authorities have not requested financial assistance from the IMF, though the institution did complete a staff team visit in Lebanon in early March, says director of communications Gerry Rice.