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The government is unlikely to undertake necessary structural
reforms to address Lebanon's imbalances or receive sufficient
foreign support and has yet to offer a credible rescue plan.
A Lebanese pound devaluation would lead to banking sector
recapitalisation needs of at least 19% of GDP, although banks would
remain solvent.
A haircut of at least 18% on banks' exposure to the sovereign -
through direct holdings of sovereign debt and deposits held at
commercial banks, which are then lent to the government -would
require recapitalisation of at least 25% of GDP for banks to regain
solvency and meet regulatory requirements.
In January, protests resurged in Lebanon with a focus on the
banking sector, reportedly leading to hundreds of injuries during
the month as security forces fought back against protesters
vandalising bank branches, cashpoints, and the central bank's
headquarters. The recent re-escalation of protests and continued
deposit flight led the central bank to place formal limits on
capital movements with additional measures under consideration to
solidify and regularise controls implemented on a bank-by-bank
basis. The resurgence of protests and escalation of sovereign risks
have led IHS Markit to consider the banking sector effects of
potential scenarios, including the formal devaluation of the
Lebanese pound and sovereign default
Currency devaluation
A Lebanese pound devaluation will lead to banking sector
racpialization needs of at least 19% of nominal GDP. This estimate
considers historical emerging market currency devaluations, the
current parallel rate (LBP2450/1USD) and high levels of foreign
currency lending (68.7% of total bank lending) in Lebanon to
project an estimated 60% fall in the value of the Lebanese pound,
followed by a 31-percentage-point increase in the sector-level
gross NPL ratio. The devaluation will affect banks' capital buffers
through three significant risk channels. Firstly, as the foreign
currency portion of banks' risk-assets increases in value in terms
of local currency, their risk-weighted assets will increase,
putting downward pressure on capital adequacy ratios. Secondly,
there will be an increase in NPLs owing to indirect foreign
exchange risks, as borrowers will be less able to repay their
foreign currency-denominated loans, which have increased in value
in local currency terms. Finally, capital buffers will face further
downward pressure as banks write off newly accumulated NPLs.
Following the devaluation, banks will remain solvent but severely
undercapitalised, requiring recapitalisation of 19-38% of nominal
GDP to meet the Tier 1 capital adequacy ratio minimum of 8.5%. Of
note when considering the impact of a Lebanese pound devaluation on
the banking sector is the fact that banks' loan portfolios make up
less than 23% of total banking sector assets. As such, even under a
high-stress scenario such as a devaluation, banks' capital buffers
are likely substantial to absorb related loan losses.
Sovereign and central bank default
A haircut of at least 18% on deposits held at the central bank
and banks' holdings of sovereign debt would force banks into
insolvency, requiring recapitalisation of at least 25% of GDP. If
the same 18% haircut is preceded by a devaluation, recapitalisation
costs to reach the required Tier 1 capital adequacy ratio of 8.5%
could be as high as 55% of nominal GDP. Although banks' overall
exposure to the sovereign and central bank is high (68% of total
assets), the share of the banks' sovereign debt holdings (13% of
total assets) is relatively moderate. As such, commercial bank
reserves held at the central bank - which are then on-lent to the
government through the BDL's financial engineering system - make up
the bulk (55% of total assets) of banks' exposure. It is important
to note that although a currency devaluation or a sovereign default
will reduce pressure on the Lebanese government's stock of official
foreign exchange reserves, as long as it continues relying on
banking sector inflows as its key source of foreign currency
funding, risk is likely to resurge in the medium term.
Bail-in
The most feasible bank bailout scenario-barring foreign aid-
following default or devaluation is large depositor bail-in. This
would force depositors to convert their assets in commercial banks
into equity stakes as a capital injection. The bail-in strategy is
particularly viable in Lebanon, because of the enormity of deposits
(around 300% of GDP) and the significant deposit concentration (in
2017, the IMF reported that the largest 1% of depositor accounts
held 50% of banking sector deposits). Owing to this concentration,
if 38% of large depositors' funds were converted into equity
stakes, banks would have enough fresh capital to cover even the
most severe scenario discussed in this report. This would deplete
depositor confidence, limiting future capital inflows especially
from non-resident depositors, but it may be a palatable option for
political protestors, as large many depositors are likely members
of the class of ruling elites against whom they are protesting.
Lebanon does not currently have a bank resolution framework in
place, however, so any measures to forcibly convert large
depositors' funding will likely be met with drawn-out legal
action.
Outlook
Regardless of the Lebanese government's first steps to mitigate
the escalation of risks, it will continue to face deteriorating
debt-servicing capability if structural reforms - including the
elimination of the financial engineering system and the state's
reliance on banking sector deposit inflows for funding - are not
implemented in the near term.
To combat recapitalisation needs, the Lebanese government's
most likely strategy - assuming foreign or IMF aid is not available
- would be to convert large depositors' funds into equity stakes at
large systemically important banks to prevent undercapitalisation.
Smaller banks are then likely to merge to remain competitive and
solvent or be forced to close.
Posted 27 February 2020 by Gabrielle Ventura, Economist