Circular 165 and the Prisoner’s Dilemma

Circular 165 and the Prisoner’s Dilemma

(Illustration credit: Bigstock)

Between 2016 and 2019, Lebanese banks have benefited from the Banque du Liban (BDL) “financial engineering” scheme. The purpose was to attract “new” foreign currency inflows to the country, in order to improve the balance of payments. The principle was simple: In return for blocking “new” dollars at BDL, Lebanese banks would earn a very high return, which they would then share with participating clients.

Unfortunately, little new money was brought in, thanks to financial engineering. The dollars placed at BDL were mostly round-tripped. For instance, large depositors could easily transfer existing funds outside the country from one Lebanese bank and later return them to another Lebanese bank to earn excess return. Finally, to boost their earnings and enable them to pay higher interest rates to their depositors in general, banks ended up transferring their reserves from their foreign correspondents to BDL, at the risk of undermining their liquidity.

Banks are often criticized for having participated en masse in this bonanza. But the reality is that it would have been very difficult for most banks not to participate, because the competition would have robbed them of a large part of their deposits. The choice was difficult: accept to participate in financial engineering with the inherent high risks, or exit the market.

This situation recalls the famous “prisoner’s dilemma,” formalized by mathematician Albert Tucker, in which two criminal accomplices are offered the following "deal" when they are arrested: if one of the accomplices denounces the other and the latter does not confess, the former goes free and the latter is sentenced to five years’ imprisonment; if neither denounces the other, each is sentenced to one year’s imprisonment; if both denounce each other, each is sentenced to three years’ imprisonment.

As in the prisoner’'s dilemma, the individual interests of each player do not always lead to the optimum, and only a collective decision by the Lebanese banks could have stopped this financial engineering madness.

The Circular 165 affair is reminiscent in many ways of the financial engineering debacle. Some banks will surely find it beneficial to participate: mainly, those that do not have a foreign correspondent, whether this is because they cannot provide a sufficient volume of business, or because they do not meet the correspondents’ compliance requirements. Regardless of the reason, however, at worst this will force recalcitrant banks to agree to enter the game for competitive reasons, and at best to be contaminated by the potentially devastating effects of this circular on the reputation of the financial system.

Let’s start by explaining what Circular 165 is about. Since the end of 2019, transactions in “fresh” dollars flow automatically through correspondent banks in New York. These transactions are carefully scrutinized by the compliance departments of the correspondent banks, including (and especially) cash deposits. Circular 165 recreates a local clearing of fresh dollars within the BDL. This means that transfers and checks can now be issued and cleared between banks through BDL. The clearing account of each bank will therefore be funded by such checks and transfers received from other banks, and by cash deposited in BDL by the banks.

The stated purpose of this circular is to recapture the cash held by the Lebanese, which the World Bank estimates (perhaps optimistically) at ca. 10 billion dollars, and to recycle the cash dollars in the banking system. This goal is laudable but the risks are colossal for the system. There are four types of risks:

Money laundering: By authorizing banks to fund their clearing account with cash, the risk of recycling unwanted money into the system increases substantially, without warning to the other participants. Imagine a trafficker wanting to recycle 30 million dollars they have in their vault (these people do exist!). They find a non-compliant bank and deposit the cash into their account. The bank then deposits them at BDL, which has not provided for any system of verification of the origin of the funds. The money is now credited to the account of the trafficker, who can acquire any asset from a third party, whose fortune is legitimate and who will receive this sum in their account at another (but compliant) bank. BDL argues that the banks themselves, not they, are legally responsible for monitoring the origin of funds. However, it will be extremely difficult, if not impossible, for the receiving bank to reliably check the ultimate source of the funds coming from the sending bank. In addition, as many banks struggle to generate enough fresh dollars to pay their expenses, the temptation to make big commissions, especially on cash transactions, will be very strong.

A new class of dollars: The "fresh dollars" cleared in Lebanon are not of the same nature as the fresh dollars cleared abroad. For the “fresh, local-clearing” dollars (call them “half-fresh”) to be considered the same as the “truly fresh” dollars, they would have to be transferable abroad. However, until further notice, the BDL refuses to transfer the balances held in these clearing accounts to the banks’ foreign correspondents. BDL may be wary of the scrutiny of the foreign financial sector on such transfers. Therefore, this money is not “truly fresh” since it is not transferable; nor is it local dollars (“lollars”), since BDL will presumably allow banks to withdraw the funds in cash. Thus, banks participating in this 165 system will have either to create a third category of dollars in their chart of accounts, or agree to mix “truly fresh” with “half-fresh” dollars. This reminds us of how we penalized expatriates, who, before 2019, had transferred real dollars from abroad, by commingling them with the dollars sold short by BDL against Lebanese lira to resident individuals and companies at an overvalued exchange rate.

History repeating itself: The new, recycled money from 165 will be included in the BDL reserves. Given the recent history, it is legitimate to fear that BDL might dip again in those fresh reserves for its own designs. This could be either to support the Lebanese lira, or to transfer wealth away from depositors through Sayrafa, or to subsidize the state and cover some of its bills — all of which may prove popular in the short run (as the peg was).

The call of the dirty money: Entities that pass the compliance test, in particular companies, but also certain individuals, can deposit their legitimate cash dollars in the banks at any time, by providing the appropriate supporting documents. The banks, in turn, will send the cash received to their correspondents. However, those legitimate clients that did not already deposit their cash dollars in banks, due mostly and understandably, to the lack of trust in the system, will certainly not do it now under 165, and transform their cash dollars into “half-fresh” dollars! Circular 165 will only increase their mistrust. Above all, it is likely that only the dirty money will find its way to the banks through this circular.

Some international donors find the idea of reducing the cash economy by recycling the cash dollars into the banking system attractive. Superficially, it certainly is. But in our opinion, they may have missed some critical aspects and failed to consider all the above-described risks.

On the other hand, most Lebanese banks are opposed to this circular, even if they do not say so publicly. BDL replies that nothing obliges them to participate.

Back to the prisoner’s dilemma.

Michel Accad

CEO Bankmed

Jean Riachi

CEO I&C Bank

This opinion originally ran in French in L’Orient-Le Jour.

Between 2016 and 2019, Lebanese banks have benefited from the Banque du Liban (BDL) “financial engineering” scheme. The purpose was to attract “new” foreign currency inflows to the country, in order to improve the balance of payments. The principle was simple: In return for blocking “new” dollars at BDL, Lebanese banks would earn a very high return, which they would then share with...