'Zombie' banks rise from deathly grip of financial corruption

Lebanon's problems are the world's most severe banking crisis since the mid-19th century

While there are plenty of instances of zombie banks around the world, Lebanon stands out as the most extreme example of deliberate negligence and procrastination in banking reform
Eduardo Ramon
While there are plenty of instances of zombie banks around the world, Lebanon stands out as the most extreme example of deliberate negligence and procrastination in banking reform

'Zombie' banks rise from deathly grip of financial corruption

In under a year, the International Monetary Fund has released three research papers on “zombie” banks, showing the extent of top-level interest in the financial world’s equivalent of the living dead.

The first paper, published last June, focused on the resurgence in lenders that can only survive with the kind of support measures usually associated with times of emergency.

The second, released in September, examined the monetary policy channels used to keep them alive. The third paper, published in February, looked at what caused such lenders to become zombies in emerging markets and developing economies.

Such troubled financial companies have a significant amount of non-performing assets and avoid liquidation only because regulators leave measures in place to prevent collapse and prevent panic from spreading across the sector to healthier banks.

The term was coined by Edward J Kane of Boston College in 1987 during the savings and loan crisis in the United States.

That was when a wave of commercial mortgage losses became a significant threat to a range of banks, which the authorities supported to keep them afloat in the hope of a market recovery. But when the number of zombies tripled, the strategy was dropped.

Zombie banks can trap capital, which misses opportunities for more productive investments.

Life support

The concept of a zombie bank is straightforward, but identifying them can be difficult.

Requirements over financial reporting mean that the extent of problems within operations can be concealed, as credit to borrowers already in distress is extended, pushing the problem away without solving it.

Typically, a bank that sustains heavy losses fails. Administrators are appointed over its assets, which are sold to repay creditors as much as possible, with well-performing loan portfolios sold on. State guarantee schemes often protect deposits.

Support measures can mean that distressed banks are rescued over time. However, system-wide problems can occur if they are left in place for too long. Extending life support indefinitely is a relatively new approach, but there are still limits on how much exposure authorities can take on.

And then there are the subsequent questions on when it is appropriate to discontinue support or when it is right to stand back and let the usual market mechanisms work by allowing banks to fail.

The main argument for allowing zombie banks to keep going is to avoid causing a system-wide bank run from depositors when banks collapse. That can, in effect, paralyse economic activity.

Zombie banks can also be expensive and create further knock-on effects. Capital can become trapped, missing opportunities for more productive investments. The public subsidy or guarantee they receive can further misallocate resources and distort market mechanisms, weakening the entire financial system.

Zombie banks in history

There are plenty of examples of zombie banks over the last three decades. Japan kept insolvent banks going after a housing bubble burst in 1990.

To this day, significant amounts of non-performing loans are held on the books of zombie banks from that era, adding to the deflationary trap from which Japan has struggled to recover.

A man walks past the Bank of Japan (BoJ) headquarters complex in central Tokyo on March 19, 2024.

The eurozone also repeated the same mistake following the 2008 global financial crisis. Its zombie banks, burdened with toxic loan obligations, continued lending to troubled customers, relying on liquidity from the European Central Bank to stave off further losses.

In this way, creditworthy companies missed out on financing they could have repaid, choking off sustainable economic growth in a major misallocation of capital that kept failing lenders alive at the expense of healthy competitors.

That delayed the bloc's economic recovery, and the zombie lenders went on to fail anyway when their customers failed to meet obligations. And European banks are still grappling with a $1tn bad debt burden.

In contrast, the United States approached the 2008 mortgage crisis drawing from its experience with the 1987 savings and loan crisis. It implemented rigorous stress tests and compelled zombie banks to rebuild and bolster their capital and divest from old toxic assets.

It also adopted quantitative easing policies to keep liquid assets flowing in the financial system. Nonetheless, these measures only served to delay the inevitable, and, in the end, banks had to write off bad loans.

Corruption factor

Most studies and research on zombie banks have primarily focused on developed countries. But the International Monetary Fund's February paper also examined zombie banks in developing economies, where they came from, and why.

It found it impractical to define zombie banks solely by hidden losses. Instead, it identified them when negative net worth appeared in their financial statements or when they faced serious capital shortages, requiring measures like recapitalisation, restructuring, nationalisation, privatisation, mergers, acquisitions, or liquidation.

Corrective action is expected for such banks within one year from the declaration of loss in their financial statements. However, this deadline was extended to two years for 77% of the banks surveyed across the Asia-Pacific, Europe, Africa, and Americas regions.

Corruption was a significant contributing factor to the rise in zombie banks. Some came from countries known for high levels of it, where lending to institutions linked to people in power with little or no intention of making repayments can be commonplace.

Corruption is a significant contributing factor to the rise in zombie banks.

Zombie banks can also linger in countries with limited financial infrastructure, including the number of branches, where riskier loans can be extended more frequently, especially in rural areas.

In areas like this. where capital is short, banks that are obviously in distress can also be an established route for scarce incoming funds from abroad, adding to the incentive to keep them going.

General financial crises stoked by wider problems with debt, currency, or banking instruments can also create zombie banks. If the financial sector is cleaned up as part of IMF crisis assistance, there can be a window of opportunity to prevent this. That has happened in cases including Nepal, Pakistan, and Moldova.

The Lebanese exception

The IMF research paper did not focus on Lebanon's financial sector collapse but sought to differentiate the crisis there from those elsewhere, which also created zombie banks. Lebanon's problems are the world's most severe banking crisis since the mid-19th century.

The World Bank's Lebanon Economic Monitor considers it to be the first crisis in contemporary history caused by a central bank violating national law and international regulatory norms.

Lebanon's central bank ran what amounted to a Ponzi scheme to attract the bulk of its dollar deposits via an irregularly fixed exchange rate, which in turn attracted capital for a corrupt public sector.

Read more: How a central bank's failings led to Lebanon's financial collapse

The collapse was prompted by the unchecked control of political elites over the banking sector, aligned with the Central Bank's policies, which were managed without oversight or regulation, according to a criminal report prepared by the consulting firm Alvarez & Marsal, at the request of the IMF, on the bank's operations between 2015 and 2020.

Lebanon now ranks 149th among the 180 nations in the Corruption Perceptions Index published by Transparency International.

The Lebanese crisis led to a significant depletion of banks' capital, dropping from approximately $20bn to about $1bn. This decline was primarily attributed to the devaluation of the Lebanese pound by approximately 90%.

A money exchange vendor displays Lebanese pound banknotes at a shop in Beirut, Lebanon, March 10, 2023.

Additionally, a gap of about $70bn emerged in their financial records due to the central bank's failure to reimburse their investments.

Consequently, the central bank imposed restrictions on depositors' dollar withdrawals, implementing a harsh reduction in the value of their accounts,  exceeding 80%. These measures aimed to mitigate some of the losses incurred by the wider banking sector and the central bank.

In August 2020, the central bank mandated every regular bank to devise a plan for gradual compliance with all legal statutes and regulations, particularly those concerning liquidity and solvency.

These plans were supposed to be submitted to its Central Council for approval by the first quarter of 2021.

The directive threatened to refer non-compliant banks to the Supreme Banking Authority, headed by the Central Bank's governor, for imposition of appropriate administrative penalties, including potential legal action, to enforce the provisions governing cessation of payments.

But enforcement never came. Last month, Prime Minister Najib Mikati's cabinet intervened with a draft law to restructure the banks in Lebanon.

This caused confusion over how the authorities would deal with zombie banks. There was a sense that decision-making was, in effect, on hold.

Lebanon's prolonged crisis is entering its fifth year without any visible progress toward resolution. It threatens the country's relationship with the international financial system.

This perpetuates zombie banks' presence, impacting the cash economy and illicit practices, including money laundering.

Lebanon's problems are the world's most severe banking crisis since the mid-19th century.

The danger is especially acute in clearing so-called "fresh" dollar payments, which are conducted through accounts with the central bank itself rather than with other banks. There has been concern that such funds are, in effect, facilitating finance for Hezbollah and Hamas.

This risk was mentioned to Lebanese authorities during a recent visit from a United States delegation. Jesse Baker, the deputy assistant secretary of the Treasury for Asia and the Middle East in the Office of Terrorist Financing and Financial Crimes, pointed it out as significant.

Read more: What did a US probe into money laundering in Lebanon find?

Meanwhile, industry figures in the country point to a simple solution.  Salim Sfeir, president of the Association of Banks in Lebanon, said:  "The zombie banks don't require any reforms; the return of their funds by the central bank would suffice to resolve all matters."

The IMF report branded Lebanon's central bank as a zombie itself. It highlighted the use of "unconventional" accounting practices to compile financial statements, which are released in an opaque manner.

They falsely depict the bank as profitable, with the Ministry of Finance purportedly receiving $40mn annually. However, since 2015, the reality has been a deficit totalling $50.7bn.

By the close of 2020, discrepancies in financial reporting and manipulative operations, such as attracting foreign currencies through certificates of deposit and other means, had concealed the deficit within the "other assets" category.

There was an expectation to offset this deficit with future profits. It even included issuing additional banknotes.

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