BACKGROUND

Although the challenges faced are similar, the Fed and BDL’s differing histories and structures account in large part for their different responses.

First, the Fed was the federal government’s answer to a series of recurrent bank panics: its establishment was part of a natural response to a growing U.S. economy that required closer monitoring and better organized monetary growth. Unlike the Fed, the establishment of the Lebanese Central Bank by the 1963 Code of Money and Credit was not a result of financial evolution, but rather a political necessity as the Lebanese state established itself. 

Second, the monetary philosophies of BDL Governor Riad Salameh and the Fed’s Ben Bernanke differ. In a recent speech at the London School of Economics, Bernanke noted that the Fed would keep interest rates low and buy up mortgage backed securities in addition to conducting other open market activities. Salameh’s policy has always been more conservative, focused on maintaining exchange rate stability as a nominal anchor to protect the Lebanese Pound from deterioration.

Third, it can be argued that the Lebanese are more tolerant, if not more accustomed, to weathering destabilizing national events, while the recent financial crisis has not had its equal on American soil since the Great Depression, more than 70 years ago.

ANALYSIS

Agency Theory is one way to examine whether the U.S. and Lebanese crises are subject to the same economic driving forces. If they are, then despite institutional differences, there are lessons from the Lebanese crisis which may apply to the present financial crisis.  Agency Theory analyzes the behavior of economic units based on notions of adverse selection and moral hazard. In a financial context, from a bank’s perspective, adverse selection makes banks reluctant to issue loans, as many of the loan applicants could have very bad credit risk profiles. And moral hazard makes banks think twice before issuing loans, as many loan recipient candidates might use the funds for purposes other than those listed in the loan agreement.

In the U.S., adverse selection risks have increased, as firms with bad credit profiles are more motivated to take out loans because they have less to lose in case of bankruptcy. Moral hazard risks have increased with the relaxed flow of bailout packages and economic stimulus programs.

During the Lebanese crisis, customers did not know if their banks would survive the war – a problem of adverse selection for customers. Normally, this uncertainty would cause customers to claim their deposits, possibly creating a run on banks. The war-induced uncertainty also created a case of adverse selection of currency, which motivated individuals to convert their Lebanese Pound holdings into more stable hard currencies - mainly the U.S. dollar. All corporate credit lines were stopped because of the moral hazard fear that companies would use their credit lines to fund non-essential business activities or take the money and flee the country. Adverse selection and moral hazard problems persisted post-war, as disbursing agents struggled to decide who should receive reconstruction cash.

The same threats to financial stability present during the U.S. financial crisis were present in Lebanon during the July 2006 war: a run on banks, prospects of currency devaluation, and decrease in corporate funding. The most salient similarity is the series of asymmetric information problems tied to disbursing reconstruction aid packages.

Does this point to the need for decreasing the Fed’s power and giving the U.S. financial system more autonomy, as is the case in Lebanon, so that it may naturally steer clear of crises?

Narrowing the role of the Fed would force the financial sector to develop effective crisis mitigation strategies, as the comfort of having the Fed save the day under the pretext of “Too Big to Fail” would no longer exist.  Under the current Lebanese financial structure, banks are disciplined by the fear of insolvency. In the U.S., the Fed’s narrowed role might be a product of laws now under debate in the U.S. Congress. The kind of regulatory legal framework that might result from the debates underway on Capitol Hill, if it were to narrow the Fed’s role, might lead banks towards more effective self-regulation, while U.S. banks’ insolvency fears would ensure the banks become more disciplined adherents to principles of self-regulation. And by so doing, they will have adopted a system that might weather future crises like Lebanon’s weathered its own in 2006.

 Joulan AbdulKhalek is a graduate student studying International Political Economy at the London School of Economics and Political Science. He has obtained his Bachelor’s degree in Economics with a minor in Engineering Management from the American University of Beirut (AUB). He is a previous intern of Daimler Financial Services Strategy Department and has participated in numerous conferences advocating socioeconomic reform in the Middle East.

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