Banks in Lebanon are more than just banks. Their size relative to the national economy (assets are over 3.5 times GDP) and their history of funding reconstruction, catering to the diaspora and supporting the private sector have made them the epicenter of the Lebanese econom y and its pillar of stability.
But today the fast-changing global economic conditions combined with the continued deterioration of the domestic macroeconomic framework  constitute the most pressing challenge to the banks and to financial stability in Lebanon. In fact, the overall macroeconomic framework that has developed since 2011 in Lebanon has not been in favor of the banks, the first time such a thing happens since 1992.
The best way to understand this is to recall what is known in economics as the impossible trinity, i.e. the impossibility to have at the same time in any economic system a fixed exchange rate regime, free movement of capital and total freedom in setting the local interest rates. We can think how this impossible trinity applied to Lebanon by considering three periods: 1992-2001, 2002-2010, and 2011 until the current time.
In the first period, between 1992 and 2001, the country ran large fiscal deficits due to the large reconstruction needs between 1993 and 1998 and then because of the recession between 1999 and 2001 that was caused by the ill-fated policies of the first government in the era of President Emile Lahoud. Capital flew into the country for most of this extended period albeit at a volatile rate due to the continued political setbacks and the repeated Israeli aggressions. Lebanese authorities managed to maintain the currency peg in the context of large deficits and volatile capital flows by offering high interest rates on government debt. The banks performed well in this period as they funded the reconstruction and the rehabilitation of the economy as well as the current expenditures of the government, earning good returns on their local Treasury bills investments in the context of a stable exchange rate regime.
But high interest rates and downward pressure on the peg that was met with fast declining reserves risked the collapse of the system by 2000-2001 and drastic measures were needed.
The second period between 2002 and 2010 started with seminal fiscal reforms such as the introduction of the VAT, and was marked by two crucial donors’ conferences, Paris II in 2002 and Paris III in 2007 that allowed Lebanon to refinance its debt at much lower rates in exchange for the promise to push ahead with key reforms on the fiscal but also on the structural front. This period witnessed much lower interest rates than the previous period; despite the political and security earthquakes that were caused by the assassination of Prime Minister Rafik Hariri, who embodied the image of reconstruction and stability in Lebanon and the destructive July 2006 war by Israel on Lebanon. In fact during this period, the pressure was up not down on the lira, which was further accelerated by the global financial crisis in 2008. This turned out to be to the benefit of the Lebanese banks, who emerged unscathed from the crisis, and Lebanon saw consequently massive capital inflows into its banking system.
As a result of all these factors, the twin deficit of the fiscal primary balance and of the balance of payments that reigned in the period 1992-2001 was reversed into a twin surplus in the period 2002-2010. Foreign exchange reserves loss toward the end of the first period was also reversed and the country witnessed a remarkable reserves accumulation run, and lower interest rate unleashed unprecedented growth in the credit to the private sector.
During this second period, the banks also performed very well, mostly driven by this renewed lending to the economy which during 2007-2010 grew an average rate of 8.5 percent, supported by sound fiscal policy and a responsible overall economic policy. However, and because of the political circumstances, there was a failure to implement the crucial structural reforms in the key sectors of transport, telecoms and especially power.
This failure to “make hay while the sun shines” will come back to haunt the Lebanese economy in the third period which started in 2011 and continues until today.
By: Dr. Mazen Soueid