How a central bank’s failings led to Lebanon’s financial collapse

Lebanon's parallels with a great crisis from history

University students will one day study the Lebanese crisis and it will be seen as a singular event in the history of financial, banking, and monetary policy disasters. The central bank holds the primary responsibility for it.

History shows that the sources of financial crisis are not always as clear-cut, but these run-downs also have lessons for Lebanon. One of the biggest chapters in the books on financial crises will always go to the 1929 economic crash in the US.

Although the recession and subsequent depression is often attributed to the Federal Reserve, it is more accurate to say that its involvement was limited to exacerbating the crisis after it had already occurred. The Fed was reluctant to offer prompt and adequate aid to struggling banks, which made matters worse, but the origins of the crisis lay elsewhere.

During a House of Representatives session held on 10 June 1932 to discuss the role and responsibility of Fed, Republican Representative Louis Thomas McFadden from Pennsylvania said:

 "We have in this country one of the most corrupt institutions the world has ever known. […] This evil institution has impoverished and ruined the people of the United States; has bankrupted itself, and has practically bankrupted our government. It has done this through defects of the law under which it operates, through the maladministration of that law by the Federal Reserve Board, and through the corrupt practices of the moneyed vultures who control it."

These words could just as easily be applied to the detrimental role played by the Lebanese Central Bank in the disaster that befell Lebanon.

Reckless and short-sighted policies

By adopting reckless and short-sighted policies, the central bank lured local banks with interest rates that exceeded Libor – the main global benchmark interest rate – by a staggering 4% to 6%.

This enticing margin drew banks to withdraw their deposits with each other and invest funds in certificate of deposits with the central bank. But they were issued unlawfully, in contravention of express prohibitions on paying interest on deposits made at the central bank.

According to the Money and Credit Law, borrowing in foreign currencies should only occur from international banks and financial institutions for a short time and specific purposes.

Deposits that broke the rules

It meant deposits at Lebanon's central bank in foreign currency reached approximately 70% to 80% of the total, contravening both the International Monetary Fund's recommendation to shield banks from government debts and the Money and Credit Law, which mandates that banks provide financing to economic entities rather than engage in business banking and focus their investments on long-term issues.

There were also violations of guidance covering the maximum limit on financing for a single debtor and the distribution of risks and liquidity ratios.

The Central Bank deviated from accepted norms not just by seizing the majority of bank deposits – unprecedented for any contemporary central bank – but also by unlawfully using these funds to back a corrupt and unyielding public sector.

Napoleonic tactics

Although the country's Money and Credit Law allows Lebanon's central bank to finance the government at its discretion, it specifies that such financing must be limited to "exceptional dangerous cases and cases of extreme necessity" and must be presented to parliament beforehand for approval through borrowing contracts.

However, during Governor Salameh's tenure, the central bank intentionally and repeatedly gave continuous financial support to the state without borrowing contracts and with mutual consent.

It was a tactic with roots in European authoritarian regimes. During the discussions to establish the Bank of France, Napoleon Bonaparte wanted it to offer facilities to the French government, rather than credit.

A century later, one of Napoleon's countrymen and the winner of the 1988 Nobel Prize in economics, Professor Maurice Allais, pointed out that without functional independence, central banks might as well be closed up and rolled into finance ministries.

The Lebanon central bank's transgressions have generated official complaints against its governor. Among the accusations are that he issued circulars to amend and disrupt the free economic system stipulated in the nation's constitution.

He is also accused of impeding the fulfilment of contractual obligations between banks and depositors, claiming that Salameh colluded with banks to confiscate deposits and funds by allowing banks to repay deposits in Lebanese pounds at exchange rates much lower than those in the original transactions.

Additionally, some of the complaints related to illegal enrichment, money laundering, bribery, forgery, counterfeiting, tax evasion, moral falsification of the central bank's budget.

Investigations into illegal operations have been initiated since 2020 in various European countries, including Switzerland, France, Germany, Belgium, Luxembourg, Liechtenstein, and Britain, backed by Eurojust, the agency of the European Union dealing with judicial cooperation in criminal matters.

The investigations are primarily focused on suspicions of money laundering activities conducted  for the benefit of the governor, as well as a group of his associates and close allies.

European countries conducted investigations into the fate of more than $330 million that originated from a contract made between the central bank governor and an offshore company, Forry Associates, owned by his brother, to promote public bonds issued by the Treasury and the Central Bank.

According to a Reuters report dated 21 February, 2022, the Central Bank charged commercial banks commissions for purchasing government securities using standard contracts without specifying the beneficiary.

According to the report, these commissions were deposited into a clearing account, then transferred remotely from the central bank to Forry Associates' account with HSBC Switzerland, and finally distributed to different destinations, including real estate, front companies, investment firms, and bank accounts, in favour of the governor and a network he oversees.

A lengthy article published in Le Monde on 18 March, 2023, provides more details on this matter. 

The European and Lebanese investigations stand apart, with the Lebanese people regarding the former as more thorough, competent, and unbiased, given its presiding judges, notably French Judge Aude Buresi who has summoned the governor to attend a crucial hearing in Paris on 16 May, which could either consolidate his status as a witness or incriminate him.

Salameh's response

Salameh has responded to the claims.

He says, firstly, that the commissions were paid between two private parties and not from public funds; secondly, the distribution of commissions was transparent; thirdly, his wealth came from his previous work at Merrill Lynch and was verified by an auditing firm; and lastly, he was the target of a smear campaign to make him a scapegoat for Lebanon's financial collapse.

Salameh did not see anything wrong with contracting with his brother, despite the International Monetary Fund's Code of Good Practices on Transparency in Monetary and Financial Policies requiring central bank managers to avoid conflicts of interest.

According to Paul Volcker, a former Federal Reserve governor, "The truly unique power of a central bank is the power to create money, and ultimately the power to create is the power to destroy." When a central bank violates the laws and regulations governing its administration and operations, it is a clear indication of a destructive trend.

Lebanon's Central Bank has violated the law by using foreign currency resources from banks to engage in currency market speculation, financing corrupt politicians, and paying out illegal commissions.

Scrutiny of commission allocations brings to light a blatant conflict of interest, hinting at a motive to inflate borrowing and financing activities for the sake of maximising commissions.

This was facilitated by an administrative framework with loopholes opened the way for irregularities to occur, as the governor and his deputies dominated decision-making and execution, with the governor deciding who among them did what.

An example from Israel

One big-name central banker set a better example in recent history. Stanley Fischer, the former deputy managing director of the International Monetary Fund, became an Israeli citizen and was appointed to run the country's central bank.

A few months into his role, Fischer, speaking to Israeli lawmakers, attacked the extent of the broad powers he held in his office, which were not as extensive as those held by Lebanon's central bank.

He called for the separation of decision-making power from executive power and said an independent auditing body should monitor the Israeli central bank's accounts and operations.

Lebanon's equivalent auditing body has always reported to the governor.

Missed opportunity from the IMF

When the IMF reached terms on a agreement with Lebanon, it would have been preferable if the deal went beyond reforms in the commercial banking sector to include a restructuring of the central bank. It could have aligned administrative functions to modern standards, in particular European ones.

This would involve limiting the central bank's responsibilities to monetary matters and delegating the tasks of organising, supervising, and controlling banks to an independent, specialised body.

 This approach would be instrumental in preventing a recurrence of the current crisis in Lebanon, where people's savings were easily accessed and appropriated by a corrupt political class, as publicly admitted by some leaders themselves.