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Sound Banking in Lebanon

Mises Daily: Tuesday, August 17, 2010 by


One of the countries that fared relatively well during the recent financial crash is Lebanon. Not only did it manage to completely escape the housing bubble, but has also shown overall immunity to the international downturn. Lebanese banks have even posted record profits in recent years, thanks to a massive growth in deposits, amounting to 67% between the end of 2007 and 2009.[1] Capital has been pouring in from abroad, as Lebanon is increasingly seen as a safe banking haven in the region.

Lebanese banks are at all times required to maintain a minimum 30% reserve ratio in cash, half of which is to be kept by the banks themselves, with the balance deposited with the central bank. While this is a far cry from the full reserves advocated by the Austrian School, they nevertheless constitute the highest in the world, far higher than any Western country.[2]

Lebanon's largest bank, Bank Audi, even reports that the actual loan-to-deposit ratio for Lebanese banks is currently just 34%,[3] meaning only 34% of total bank deposits are turned in to loans, resulting in an effective reserve rate of 66%. In comparison, the FDIC reported last summer that the mean national loan-to-deposit ratio for the United States was 93% in June 2008 — i.e., a 7% reserve rate — less than one-ninth that of Lebanon's.[4]

As the Austrian Business Cycle Theory points out, when banks maintain high (or, preferably, full) reserve rates, they are automatically prevented from expanding their lending practices far beyond their deposit levels. This discourages banks from making risky investments using their clients' money, thus avoiding bubbles fueled by malinvestments and speculation. In short, higher reserve rates lead to greater financial stability.

Apart from Lebanon's conservative lending policies, another key factor behind the country's financial well-being was the surprising insights of the governor of Lebanon's central bank — Riad Salameh — who in 2007 ordered the country's private banks to exit all mortgage-backed securities and brace for the financial crash he saw looming.[5] "You could have thought [he] had a crystal ball," said Edward Gardner of the International Monetary Fund (IMF) regarding Salameh's actions.

Of course, what might seem like crystal balls and witchcraft to the IMF should just be considered common economic sense, as displayed by the numerous Austrian-School economists who accurately predicted the financial crisis years before it hit. Salameh, too, felt that the flaws in mortgage-backed securities were a dead giveaway:

We could not really sense who would be responsible in the end to collect these loans … and we do not perceive banking as being a place to speculate on financial instruments that are not really concrete.[6]

In an economic survey of Lebanon from August last year the IMF does mention the banks' large "liquidity buffers" as a contributing factor to the country's financial stability.[7] However, these buffers are only credited for giving banks the ability to help finance government expenditures, not for their vital role in stabilizing the economy by preventing bubbles. The IMF never gives a proper explanation of Lebanon's economic performance. Instead, apart from the banks' ability to bail out the government, the report speculates that Lebanon benefited from its relatively small exposure to the global economy through its small export base, combined with increased political security in the aftermath of the Doha peace agreement of May 2008. Such meager explanations leave a lot to be desired.

Again, Salameh gives a more sober account of the situation:

I think I've proved my point. I have personally been stubborn about keeping a very conservative approach to banking, as I believe that this wild extension of credit, these high leverages in order to get more profits into financial institutions were against the very nature of banking.[8]

Unfortunately, despite Salameh's refreshing views on banking, he is probably not an "Austrian." One obvious giveaway is the fact that he has been in charge of a central bank for 17 years. Another is that he seemingly prefers fiat currencies combined with government regulation rather than a free-market monetary system. This comes with its fair share of problems.

As Lebanese banks withdrew much of their international investments, and calamities in Western financial institutions mounted, Lebanese banks saw a huge influx of capital into their coffers, with much of this money being converted into Lebanese lirat. Unfortunately, the central bank tried to accommodate this increasing demand for the lira by expanding the money supply. This was partially done by selling lirat and buying US dollars. Around $8 billion were bought in 2008 and around $3 billion during the first quarter of 2009. Dollarization in bank deposits subsequently fell from 77% in early 2008 to 64% in early 2010.[9]

Another method used was to issue five-year CDs (certificates of deposit), while the government also stepped up its issuing of treasury bills in lirat. Altogether this led to a sharp increase in time deposits, which caused M2 to skyrocket at a rate of 35% in 2008 and 27% in 2009.[10]

Monetary Aggregates for Lebanon
Source: Banque du Liban — The Central Bank of Lebanon

The stated reason for all this was to mop up some of the banks' new, record-high liquidity in order to avoid bubbles, speculation, and overinvestment.[11]

This demonstrates one of the many flaws with fiat currencies. What should normally count as a good thing — i.e., high deposit levels — actually constitutes a potential hazard where fractional-reserve banking is allowed. While Lebanon's relatively high reserve rates have no doubt helped the country maintain financial stability, they are still short of 100%, thus generating worries of overinvestments and malinvestments, as evidenced by Salameh's perceived need to soak up some of the banks' "excess" deposits.

When banks are flush with cash and lack the proper incentives to hold on to these funds, they can easily become "too solvent" and turn their large deposits into cheap loans that fuel bubbles and overinvestments. Hence the "need" for central banks and governments to constantly predict, chase, and ban all the specific investment types that are or will become hazardous. This has been the mentality adopted by governments around the world in the wake of the recent crisis. Given that there was only one central banker in the world, Salameh, who foresaw the dangers of mortgage-backed securities and took actions against them, this approach has a near-zero probability of success.

Raising reserve requirements even further to 100% would certainly help overcome the problem of credit expansion and overinvestments. However, even then central banks would still face the question of what the "correct" money supply and interest rate is at any given time, which is impossible for central planners to determine with regard to an entire economy.

Conversely, in the complete absence of a lender of last resort — i.e., a central bank — private banks would automatically lose their ability to create bubbles through credit expansion. They would have no other option but to keep a tight rein on lending and maintain not just high but full reserve rates with regard to demand deposits: failure to do so would instantly jeopardize their solvency and survival.

This would also render all banking regulation completely unnecessary. Banks would automatically be prevented from expanding credit beyond stable levels or get themselves involved in "toxic" and risky lending. Consequently, the financial regulations of Lebanon and other countries are not actually regulations of the market but of the behaviors that the central banks themselves have enabled by their very existence. It's like feeding a lion with one hand while fighting it with the other.

Up Debt Creek without A Paddle

While Lebanon's ever-increasing deposit levels can — ironically enough — become a potential problem, the darkest cloud on the country's horizon is the astronomical public debt. Stated at more than 140% of GDP in 2009,[12] interest alone consumes between 30% and 40% of government expenditures annually.[13] This huge debt stems primarily from government-sponsored reconstruction projects after each of Lebanon's numerous wars.

"In the absence of a lender of last resort, private banks would automatically lose their ability to create bubbles through credit expansion."

The main creditors of these loans are typically the governments of France, Kuwait, and Saudi Arabia. For example, following the Israeli invasion of 2006, Kuwait and Saudi Arabia were quick to provide Lebanon with generous financial support. This is problematic in the sense that it creates a habit of dependency, where the perception is that Lebanon will always be bailed out by regional neighbors and other friends with deep pockets, which in turn continues to encourage reckless government spending.

Another potential problem is that government could suddenly find itself unable to get favorable foreign loans. In this case the government could turn to the country's huge bank reserves as a tempting source of funding. The whole situation could become reminiscent of that of the old Bank of Amsterdam, which, after its incorporation in 1609, rose to fame for maintaining a policy of full reserve rates for nearly two centuries. After a long period of great economic stability and growth in the region, the city government of Amsterdam began demanding in the 1780s that the bank lend it large portions of its deposits to cover growing public expenditures. This forced stray from its traditional path of a 100% reserve ratio resulted in the bank's eventual demise, and paved the way for a new and far less stable banking system based on the principles of fractional-reserve banking.[14] In a worst-case scenario, the Lebanese banks could be running the danger of falling into the same trap, especially when one considers that they already own 57% of the government debt.[15]

The Lebanese government also sits on vast gold reserves, the second largest in the Middle East and North Africa, and trailing just behind the United Kingdom in international rankings.[16] The gold amounts to more than $11 billion in May 2010, or 16 trillion Lebanese lirat.[17] This corresponds to roughly three times M1, but only about 30% of M2.[18] The country has a long tradition of central-bank ownership of gold, dating back to the 1960s and '70s when the government bought large quantities of gold to add to the bank's coffers. Many attempts have been made by government officials throughout the decades to sell off the gold as an easy way to fund spending. Thus far, such plans have been thwarted by the parliament, and during the civil war the then-governor of the central bank — Edmond Naim — even slept in the vault to protect the gold from robbers.[19]

If the debt situation worsens, however, the gold reserves could once again be targeted by desperate politicians, as a full-scale sale would be enough to pay off over 20% of the public debt at current prices.

Mr. Salameh, on the other hand, has a rather interesting outlook on the future of the Lebanese debt situation. In December of last year he made the following statement in Lebanon's Executive Magazine:

The future expectations of inflation are going to diminish the real value of [the public] debt, which is stated today at around $48 billion. And the present value or the real value of that debt will look less important in the next four or five years, as the purchasing power of currency is going to be depleted worldwide.[20]

Put another way, the US dollar (and presumably other currencies as well) will lose a substantial part of their value due to inflation in the near future, thus shrinking the real value of Lebanon's foreign debt. This is a highly unconventional stance for a central banker, but is also in line with the forecasts of many Austrian economists, who anticipate high inflation in the wake of worldwide central bank "stimulus," i.e., vast monetary expansion.

If the predictions of both Salameh and the Austrians turn out to be correct yet again, the next couple of years will be interesting. However, such large-scale monetary destruction would also dispel any doubts about the need to abolish central banks and replace fiat currencies with sound money, which, for Mr. Salameh, could be a surprising revelation.


[1] Matt Nash, "Foreign cash buoys Lebanese currency," NOW Lebanon, 10 March 2010.

[2] Based on a 2003 survey by Dr. Pinar Yesin at the University of Zürich. See Yesin's lectureDownload PDF.

[3] Ben Gilbert, "Lebanon bankers cool in a crisis," GlobalPost, 14 Feb. 2009.

[4] FDIC, "Section 109 Host State Loan-to-Deposit Ratios."

[5] Gilbert, B., 2009.

[6] Borzou Daragahi. "Lebanon central bank chief got it right," Los Angeles Times, 21 Feb. 2009.

[7] Harald Finger and Carlo Sdralevich, "Resilient Lebanon Defies Odds In Face of Global Crisis," IMF Survey Magazine, 11 Aug. 2009.

[8] Natalia Antelava, "Lebanon 'immune' to financial crisis," BBC News, 5 Dec. 2008.

[9] The Daily Star (Lebanon), 13 May 2010.

[10] Banque du Liban, "Monetary Survey (2010)."

[11] Emma Cosgrove, "Riad Salameh speaks to Executive," Executive Magazine (125), Dec. 2009.

[12] "Fall in Lebanese public debt to GDP ratio spurs rating upgrades," The Daily Star (Lebanon), 1 April 2010.

[13] Cosgrove, "Debt and diligence," Executive Magazine (128), Mar. 2010.

[14] Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles (Auburn, Ala.: Ludwig von Mises Institute, 2006), pp. 98–106.

[15] Cosgrove, "Banking — Stuck to the sovereign," Executive Magazine (131), Jun. 2010.

[16] World Gold Council, "World Gold Holdings (June 2010)."

[17] Banque du Liban, "BDL Balance Sheet: a. gold."

[18] Banque du Liban, "Monetary Survey (2010)."

[19] David Kenner, "An embarrassment of riches," NOW Lebanon, 18 Mar. 2008.

[20] Emma Cosgrove, "Riad Salameh speaks to Executive."