A&M BDL’s Audit Report: FX Reserves Spent and Cost of Financial Engineering:

The preliminary Forensic Audit Report of BDL by Alvarez and Marsal Middle East was released by the Ministry of Finance last week. We will focus in this economic digest on two points raised by the report: the FX Reserves Spent by BDL between 2010 and 2020 and the Cost of Financial Engineering between 2015 and 2019.

The table below provides a summary of how BDL’s FX reserves were used to meet the “requirements” of the Lebanese government between 2010 and 2020:

As we can see, the FX spent was $47.9 billion, more than the average GDP for the period. The three biggest items were transfers to EDL, followed by requirements of the public sector and then subsidies to vital imports. The irony is that after all these major expenditures, the country remains at more than 20 hours a day in the dark, public institutions are in shambles, and basic poverty at more than 50%.

In 2015, BDL reported that it is taking action to bolster the supply of USD to the banking system through a scheme referred to as Financial Engineering. It was designed to achieve two objectives:

• Provide the conditions to allow banks in Lebanon to attract USD deposits
• Further encourage local banks to deposit these USD with BDL

BDL’s “Financial Engineering” was accomplished in two phases: Phase 1 from 2015 to 2018 known as Swaps with Commissions; and Phase 2 from 2017 to 2019 known as Loans under Leverage. For Phase 1, Swaps with Commission, it involved the following:

• BDL acquired Lebanese TBs from banks at a premium equivalent to the value of complete coupons to maturity
• This was conditional on banks investing in Eurobonds
• In return, BDL charged a commission of an amount to be determined by the Governor and credited to deferred interest expense
• The premium was amortized and refunded over time from proceeds of interest until maturity without generating future income which would have otherwise been realized over time.

In 2017, BDL introduced the scheme Loans under Leverage. It involved the following:

• BDL granted banks loans in LBP at an amount equivalent to 125% of USD term deposits placed by banks, subject to a fixed interest of 2%
• Banks were required to invest the loan proceeds in TBs or time deposits acquired from BDL at the prevailing interest rates.
• As a result, banks acquired total loans equal to 41.8 trillion LBP and in return had undertaken $21.8 billion FX investments at BDL

The costs of the above financial engineering operations were as follows:

• The cost of the deferred interest and foreign exchange costs amounted to about 85 trillion LBP
• The premiums paid on TBs and CDs reached about 30 trillion LBP.
• The cumulative cost of financial engineering adds up then to 115 trillion LBP

Interestingly, when presented of these costs by A&M, BDL commented: “the amount of 115 trillion LBP referred to as cumulative cost of financial engineering covers both costs channeled to the deferral pool (85 trillion LBP) and premiums on TBs and CDs (30 trillion LBP). It is worth noting that the 30 trillion LBP …. Will be fully offset by coupon revenues till maturity of the said TBs and CDs. Hence, the cost during 2015-2016 is around 85 trillion LBP and not 115 trillion LBP”.

Additionally, BDL reported offsets to the above, arising from: amortized interest, commissions, seigniorage currency, seigniorage financial stability, and seigniorage-TB swaps, amounting to about 80 trillion LBP. As a result, if we accept BDL’s above justification and offsets, the net cost of financial engineering will be: 85 – 80 = 5 trillion LBP or about $3.3 billion. And this figure seems to agree with anecdotal evidence from banking circles in Lebanon.

In retrospect, whether the cost of financial engineering was $3.3 billion or more is largely immaterial. Its more permanent and significant damage is that it had enabled BDL to acquire depositors (mostly FX) money and used it to fund wasteful public expenditures, instead of BDL confronting the state and insisting that it reforms itself so as to generate its own hard-earned  financing!