April 2020
Future Value Recovery for Depositors: A Question of Equity and Aligning Incentives

What does the “equitable” allocation of losses mean in a country facing near total loss?
 
It is a question with few good answers, but one that is hugely consequential. It is, in fact, as much a philosophical and social question as it is an economic one. The country is facing catastrophic losses, and the decisions we make today will determine the fate of the next generation. Our estimates of the loss range from $80 billion to $100 billion, higher than the estimates in the government’s leaked plan. There is no plausible way to spare depositors from absorbing the bulk of this cost. This is a reality that we, and decision makers, need to come to terms with. The sooner we do, the faster we will get on the road to recovery.
 
Unless we quickly remove these large deposits from the banking system and place them into some type of value recovery instruments, the economy will not recover, the banking system will be paralyzed, the Lebanese pound (LBP) will rapidly depreciate against the dollar, price inflation will accelerate, and both depositor or unbanked, will realize even larger losses.
 
The crisis demands a rapid and united national response. The public discourse has veered far off track, while we should be focusing on the allocation of losses instead: How do we provide certain depositors, selected using objective criteria, with the possibility of long-term value recovery in a way that is fair and equitable and does not impede the economic recovery, but incentivizes it?
 
The focus of this article is on the top 2% of depositors who will be directly implicated in the recapitalization of the banking system, according the Prime Minister Hassan Diab. However, the decisions that are made in respect of these depositors will have grave implications for the bottom 98% of depositors, directly with its impact on the LBP’s real value and indirectly through the overall impact on the economy. The bottom 98% of depositors are unlikely to recover their deposits in dollars as there simply is insufficient dollar liquidity in the system. To protect these depositors—dollar and LBP account holders alike—the real value or purchasing power of their funds in LBP would have to be maintained, as that would be the only way to truly protect them from a haircut, as promised by Prime Minister Diab. The decisions made about the top 2% of depositors goes to the heart of that.
 
Most of the direct loss will, by necessity, be shouldered by the top 2%, the wealthy members of our society. This is by virtue of the scale of the losses and the vast income and wealth inequality that exists in the country. Many of them have earned their wealth fairly. This includes members of the diaspora, which has financed this country for the last 30 years, and business-owners and entrepreneurs who are critical to any economic recovery. These communities must remain actively involved in the country’s recovery. One way to encourage this is to provide them with the possibility of some value recovery from the gains of a sustainable economic expansion.
 
The unfortunate reality is that there are very few sources of future funds that can be used to provide such value recovery, even in the event of an economic revival and new foreign currency inflows. Whatever the approach, expectations must be managed. The loss is exceptionally large, and full recovery is unlikely (and partial recovery is likely to take some time). But there are no other options.
 
The Conditions for Sharing Public Profits
 
Every plausible source of value recovery to depositors—aside from bail-ins for bank shares—will constitute a transfer of wealth from the poorest members of society to the wealthiest. Once we distill the ultimate sources of these funds, we find that there are only two sources: The government and Banque du Liban (BdL).
 
The assets and profits of state-owned companies and BdL (which I will refer to as Public Profits) belong to all Lebanese people, and not to any particular person or depositor. Transferring wealth from the poorest to wealthy depositors, in a country with a 50% poverty rate and enormous wealth inequality, and where 50% do not have a bank account, is, on the face of it, morally unjustifiable.
 
However, the ultimate goal of the bank restructuring is to facilitate a sustainable economic model, where all members of society share in the country’s wealth. To the extent the loss allocation falls exclusively on the diaspora and wealthy depositors, this could discourage their future participation in the economy and curtail the recovery.
 
If sharing future Public Profits with these depositors—to make up some of the loss they absorb today—incentivizes them to continue participating in the economy and to pressure future governments to pursue sustainable economic policies, then sharing Public Profits with them could become morally justified. It would be, in effect, a sharing of the upside, wherein all members of society benefit.
 
There must, therefore, be strict conditions around how, when, and with whom such Public Profits could be shared to ensure that they are properly incentivized. These conditions should be based on the following:

1. Depositors who earned their wealth honestly should be provided with the ability to recover value from Public Profits in the future. This allows certain depositors, including the diaspora, businesspeople, and entrepreneurs who financed the country over the last 10 years and who are critical to the success of any economic recovery, to maintain skin in the game. An objective set of criteria (based on the source and amount of wealth, removing excess interest earnings, etc.) should be established to determine which depositor is able to share in such value recovery and for what amounts. An independent, forensic audit of accounts above a certain threshold will be needed to determine whether the source of wealth is legitimate or ill-gotten, before any such account is permitted to participate. 
2. Sharing of Public Profits should only be available once specific economic and social metrics, which are indicative of a sustainable and broad-based economic recovery, are achieved, and not before.
3. The proportion of Public Profits that may be shared should be limited.
4. Value recovery should also be capped and of limited duration.
5. Exceptional transparency around the management and performance of any entity generating such Public Profits.

 
Using Public Profits, which ultimately belong to every Lebanese equally, to make up the losses of certain large depositors, outside of this strict framework or another designed to achieve the same, is not justifiable.
 
The remainder of this article will examine the various means of bank recapitalization and the sources of value recovery for depositors that have been discussed in the public:

1. Future foreign currency inflows into the economy or BdL
2. Future BdL profits
3. Transfer of state assets to large depositors and banks
4. Future profits from state companies
5. Recovery of stolen or corrupt funds
6. Freezing deposits for a period of time
7. Lirafication

 
Future Foreign Currency Inflows into the Economy or BdL
 
A sustainable economy will require that the country’s future external financing needs (such as to pay for imports) are met with sustainable inflows of foreign currency. In the past, the country’s external financing has come primarily from the inflow of foreign currency deposits. That financing structure has now collapsed: We can no longer borrow money from depositors to pay for our imports and other foreign currency expenditures.
 
Most of the dollar inflow into the country in the future will need to come from sustainable sources, for example, export receipts, foreign direct investment, and remittances. Could these foreign currency inflows be used to cover depositor losses? There is a gross misconception about this topic in the public.
 
The country is heading toward a de-dollarized economy in which transactions inside the country are executed in the local currency rather than dollars, and this includes the currency of bank deposits. This is generally a positive development as the foreign currency mismatch in the country (the difference between its foreign currency assets and foreign currency liabilities) has grown so large as to be unsustainable. It is a key cause of the current financial crisis. To avoid a recurrence of this crisis in the future, the majority of dollars that enter the local economy will need to be converted into LBP to be used for local transactions This is what we call de-dollarization.
 
If the economy, in the future, starts generating significant foreign currency inflows from these sustainable sources (and the Balance of Payments—the difference between foreign currency inflows and outflows into the economy—turns positive, these dollars would, to simplify, be sold to BdL for LBPs, which can then be used for investment and other transactions in the local economy.
 
When such dollars are purchased by BdL, that dollar becomes an asset on BdL’s balance sheet. However, a new liability is also created as BdL must create new LBPs in order to purchase the dollar in the first place. In the first instance, BdL’s balance sheet balances. A new dollar asset is offset by a new LBP liability (the new LBP created to purchase the dollar) for the same amount.
 
While this new dollar constitutes a sustainable source of foreign reserves, it cannot be used to make up depositors’ losses because doing so would create a new loss on BdL’s balance sheet. We established above that, in the first instance, BdL’s balance sheet is balanced after it purchases the new dollar. If part of that dollar is transferred to make up depositors’ losses, BdL’s assets would decrease, while its LBP liability would remain unchanged. To keep it simple, the ultimate impact of this loss is a further depreciation of the LBP against the dollar, as that would be the only realistic way to reduce the value of BdL’s liabilities to make up for the loss on its asset side.
 
The impact on monetary policy and on the health of the economy of consistent long-term losses by BdL in this way is not sustainable. In fact, it is one of the causes of the crisis we are currently facing. It would not be appropriate to solve the current problem using the same tools that created the crisis in the first place. As a result, future dollar inflows, even from sustainable sources that are indicative of a healthy and sustainable economic recovery, cannot be used to make up depositor losses.
 
This, along with the section on BdL profits below, explains why it is impossible for BdL to ever recover the current foreign currency losses carried on its balance sheet, and why the central bank’s justification for its accounting of such losses as recoverable over time is grossly inappropriate. These losses are not recoverable, not now nor in the future.
 
Future BdL Profits
 
BdL, like other central banks, generates profits from its assets such as the dollars it purchases as described above. These profits come from BdL’s own investments. Central banks often invest their foreign currency reserves in US treasuries, for example, and earn a small return on such investment. The same is the case for BdL’s LBP assets.
 
This is considered a profit for BdL and does not come attached to a liability, but an increase in its capital. Under the current law, such profit, beyond a certain threshold, is returned to the Lebanese treasury under a “dividend rule.” In other words, these funds are not the foreign currency inflows described in the previous section, but the profits earned on such inflows.
 
Sharing these profits with depositors could incentivize the country to prioritize key sectors for export potential, attracting financing toward productive gains, rather than financing the bloated fiscal budget or unproductive real estate investments, as was been the case in the past. It will also enable a shift of jobs away from an over-saturated consumption-serving retail and real estate sector and into higher skills-based productive employment. However, it could also incentivize BdL to take large risks with its foreign currency reserves in order to achieve higher profits to return to depositors. This would need to be addressed through strict conditions on the types of instruments in which BdL may invest its foreign currency reserves.
 
While the amount of such returns is modest under any reasonable scenario, this is a possible source of funds that could partly be used to make up depositor losses. However, BdL profits constitute Public Profits that ultimately belong to the Lebanese public as a whole. Any sharing of these profits should be subject to the strict conditions to sharing of Public Profits.
 
Transfer of State Assets to Large Depositors and Banks
 
Another option being proposed is the transfer of state assets, including Middle East Airlines, Casino du Liban, public lands, Ogero, Alfa, Touch, Régie Libanaise des Tabacs et Tombacs, and Electricité du Liban, to the benefit of depositors facing losses today. Regardless of the commercial structure being proposed (such as direct ownership or ownership of shares in a “Defeasance Company” that holds the assets), the idea is that the beneficial ownership of these assets is transferred from the state to certain depositors and/or the banks.
 
Today, state assets are owned equally by all Lebanese citizens, those with bank accounts and those without. We are a country with massive wealth and income inequality, and the distribution of deposits is reflective of this reality.
 
As a result, the transfer of state assets to banks and certain wealthy depositors is effectively a bail-out of large depositors and/or bank shareholders by the poorest members of society. It is not justifiable, particularly at a time of high poverty, economic collapse, and when the valuation of these assets is severely distressed.
 
These assets will be critical to achieving future economic growth—by funding needed capital investments—and to support the country’s much-needed social safety net. Revenue-generating state assets provide nearly $3 billion per year in receipts to the treasury. While this is a modest amount relative to the losses depositors face (to appreciate the scale of the losses and why value recovery will be difficult, consider this $3 billion figure against the $115 billion of dollar deposits in the banking system), the society will face great harm if the state forgoes these funds, despite the endemic corruption and mismanagement that exists at all levels of the Lebanese government. Solving the problem of corruption and mismanagement should not be done at the expense of the poorest members of society by depriving them of a source of funding for social support. It should be solved through transparency and accountability.
 
Beyond that, governments are not like companies. They should operate for the public interest. Sovereign debt is not like corporate debt: Governments are not expected to liquidate themselves to pay their debts, nor to pay the debts of other, autonomous government agencies, like the central bank. Governments are expected to pursue economic reforms that result in future tax revenue with which debts can be repaid. Societal constraints also govern how a sovereign can behave in this respect. What good does it do a creditor if a government agrees to sell its assets to pay down a small portion of its debt, and the result is a crippled state and social upheaval that wrecks the economy?
 
It is also unlikely that foreign bondholders, with whom the government is engaged in restructuring talks, will accept that the state disposes of its assets to other creditors or parties without sharing in the proceeds. To bondholders, it would also be a question of equity. An unresolved default and protracted negotiations with bondholders would have a significant negative impact on the economic recovery by locking Lebanon out of the capital markets for an extended time.
 
The direct transfer of ownership of these assets from the state to banks and large depositors violates the conditions of equitable burden sharing and “incentive aligning” described at the beginning of this article.
 
Future Profits from State Companies
 
A softer version would be to use the profits from state companies for a certain period of time to partially compensate depositors under the strict conditions for sharing Public Profits. However, the ultimate ownership would remain with the state.
 
In the first instance, sharing any portion of the revenue from state companies is immoral. We must be clear about this. These funds belong to the people and should not be used to bail-out bank shareholders and large depositors, whose deposits are not secured against state assets but only covered by deposit guarantee insurance.
 
However, a case can be made for sharing a portion of this revenue under certain strict conditions. Sharing a portion of these Public Profits with selected depositors—and under no circumstance to cover the losses of bank shareholders—once all of the conditions are met, could incentivize the government to restructure and effectively manage these assets, as there would be significant public pressure from different segments of society to do so.
 
Given the limited duration of such potential profit sharing, this could also produce urgency on the part of the government to carry out reforms. Though Public Profits would be shared with a limited segment of wealthier depositors for a time, in the long term, the Lebanese public would benefit from having well-functioning state companies.
 
There are many structures that can be used to achieve this, but governance and transparency are paramount. The state could transfer the selected assets into a commercial vehicle that is managed by an independent and external third-party, with each asset further audited by another independent and external third-party.
 
Recovery of Stolen or Corrupt Funds
 
To the extent the government is able to recover ill-gotten funds, these also belong to all the
Lebanese and not only certain depositors. These funds should be viewed as Public Profits, the same as BdL profits or profits from state-owned companies.
 
However, if the same conditions to sharing Public Profits are met, then the potential sharing of a portion of these funds could incentivize the government to pursue their recovery, as a result of public pressure from various segments of society. The benefit to Lebanese society of sharing such proceeds could then outweigh the nominal cost.
 
I would caution against treating the recovery of stolen/corrupt funds as a panacea for value recovery, an idea that is being widely propagated in the press and political parties. Any recovery of stolen funds is likely to involve protracted legal processes and is unlikely to generate significant returns.
 
Bail-in for Bank Shares
 
A bail-in for bank shares has been proposed in the government’s leaked draft plan. Certain deposits would be converted into shares in the insolvent banks. The bailed-in depositors would recover value from future bank profits, or from selling their shares to investors. Once the bank balance sheets are cleaned up and the economy begins to recover, banks are expected to eventually generate profits again. The bailed-in depositors would be first in line to benefit from these profits.
 
This approach has the benefit of removing these deposit liabilities from the balance sheets of the banks without the need to meet the strict conditions to sharing Public Profits. There is no plausible way for the banks to meet these liabilities, not now nor in the future. By keeping them on the banks’ balance sheets, the country will end up with “zombie” banks that cannot function, whose liabilities would grow every day due to the accruing interest, and that no investor will be willing to recapitalize with fresh money. Recapitalization of the banks with fresh money, without which they cannot resume their role as financial intermediaries, is needed to resume economic activity in the country. These deposits must be removed from the banking system as a prerequisite to any economic recovery.
 
Among all the mechanisms discussed in this article, this is the most equitable compensation instrument for depositors as it does not unjustly infringe on the rights of other segments of society. It is customary for shareholders of insolvent banks to be the first to absorb losses before depositors. This should be the first target of loss allocation.
 
Over the last several months, some banks have offered their clients a voluntary bail-in through the conversion of their deposits into instruments other than shares, such as convertible bonds or preferred shares. These offers infringe on the rights of the bailed-in depositors by converting their deposits into non-voting equity-like instruments that may continue to earn interest that the banks cannot pay. In the event the bank becomes insolvent in the future—a likely scenario the absence of a comprehensive bank restructuring and recapitalization—these new instruments would incur losses before deposits, as they rank lower in the capital structure. In effect, the bailed-in depositors would have forfeited their seniority by agreeing to the voluntary bail-in. Bank bail-ins should be done as part of a comprehensive banking sector restructuring to avoid this scenario.
 
Conditions do differ from bank to bank. Banks that were prudent with depositor funds should be offered the opportunity to recapitalize and restructure themselves. Others will need to be merged or liquidated. To facilitate this process, a bank resolution commission should be tasked with overseeing the overall restructuring of the banking sector, including the process for a national debt workout to limit banks’ losses from non-performing loans, ensure that homeowners are not evicted from their homes, and businesses remain solvent. In the future, proper oversight and regulation will be critical if we are to avoid a repeat of today’s banking crisis.
 
Freezing Deposits for a Period of Time
 
There have been proposals to freeze deposits for a time until the economy recovers – whether by freezing the deposits themselves or converting them into interest-bearing bank-issued certificates of deposits backed by state assets. Freezing deposits does not address the problem that we are facing.
 
Indeed, when such deposits are unfrozen at some point in the future, there still needs to be a source of funds to pay them out, and freezing deposits does not generate new funds. It is a superficial fix that only delays the problem to a future date. In fact, it may increase the size of the problem if the funds continue to accrue interest.
 
There is simply no plausible source of funds to pay these deposits. The dollar deposits were invested mostly with BdL, and to a lesser extent with the Lebanese government debt and loans to the private sector. Freezing deposits for some time could have worked if these were illiquid (i.e., not convertible to cash in the short-term) or temporarily impaired investments whose value could recover in the future as economic conditions improve.
 
These investments, however, are completely impaired and can never recover their value because they were not used productively to generate a future return. They were spent mostly on consumption that did not generate long-term value. Once those dollars were spent on consumption, the possibility of future value recovery became zero. This is why proposals to freeze the deposits until the asset recovers value will not work. There is no asset there in the first place.
 
Lirafication: The Path of Least Resistance and Most Dangerous Outcome
 
Depositors’ losses could be made up by converting their deposits into LBP. While the simple conversion of deposits to LBP does not, in and of itself, make up the loss, it does allow for the possibility of a bail-out of depositors by the state or BdL as the country could simply create new LBP to pay these deposits. This cannot be done if the deposits are in a foreign currency that the country is not able to create. Proposals that describe a bail-out of depositors or of banks by issuing Lebanese government treasury bonds or allowing depositors to withdraw their dollar deposits in LBP at the market or official rate are different ways of describing Lirafication.
 
There are nearly $115 billion of dollar deposits in the Lebanese banking system. That is three times the country’s GDP. These depositors are being gradually converted from dollars into LBP through the individual actions of banks and successive BdL circulars that allow dollar account holders to withdraw their funds in LBP at a market rate, subject to certain withdrawal limitations.
 
In fact, the status quo has been the gradual conversion of these deposits into LBP. It is the path of least resistance which requires the least amount of political decision-making.
 
Converting even a small proportion of these deposits into LBP could have catastrophic consequences on the LBP:dollar exchange rate as we are witnessing today, particularly if it occurs at a time when people have lost trust in the currency.
 
Further, as BdL is unable to provide most importers with dollars at the official exchange rate of LBP 1,500 per dollar, importers have resorted to the exchange houses to source dollars at the parallel market rate (more than LBP 4,000 per dollar at the time this article was published). The consequence of a depreciation in the LBP:dollar exchange rate is an increase in consumer prices and, thus, a decrease in the real value of the currency. In this way, depositors and LBP-earners and savers have already lost 60% of their money’s value—this is a regressive haircut.
 
The end-result of this approach is to solve the problem of foreign currency losses by creating an even larger problem of massive local currency losses, and, ultimately, a collapse in the local currency value. Runaway price inflation is an extremely difficult problem to solve, and it has catastrophic consequences not only for all depositors but also for anyone with LBP earnings or savings, whether inside or outside of the banking system. It solves one problem by creating another, bigger one.
 
Under this scenario, large and small depositors, banked and unbanked individuals, all will realize a massive loss of value and purchasing power with no possibility of future value recovery. There are no winners under this approach, except those with foreign currency income from abroad.
 
The Path Forward
 
Any bank restructuring and loss allocation plan from the government may be judged based on how effective it is at achieving the following:

1. Aligning incentives of different segments of the society to maintain pressure on successive governments to pursue sustainable economic policies.
2. Incentivizing the diaspora, wealthy individuals, and business-owners to participate in the economic recovery by linking their deposit value recovery to the results of a sustainable and broad-based economic expansion.
3. Minimizing the unjust transfer of wealth, while providing some means of value recovery for selected depositors (i.e., through bail-ins for bank shares, a fair and justifiable sharing of the upside with respect to Public Profits).
4. Providing exceptional transparency around the management and performance of entities generating Public Profits.

 
Finally, without immediate steps toward accountability for those who led the country to the current crisis or were unjustly enriched at the expense of the public, there can be no path forward. The public is unlikely to accept any of the difficult solutions this crisis demands without immediate accountability, transparency, public engagement, and the courage to take difficult decisions. This is clear from the resurging protest movements across the country.
 
This crisis requires creative solutions from us, solutions that align the incentives of all members of society in such a way as to pressure the current and future governments to pursue sustainable economic policies without unduly punishing the large depositors who have earned their money honestly and whose participation is needed to create an economy that works for everyone.