Lebanese banks are the life raft of the national economy. While this raft is astoundingly large in comparison to the real economy, with banking sector assets surpassing the real economy by a factor of four, the existential role and solidity of banking make it the focus of attention in national economic and policy debates. Many reports and studies, and an exponential number of rumors, have increasingly questioned if and how the Lebanese banking sector can keep functioning so well. Executive sat down with Freddie Baz, chief strategist and member of the board of Lebanon’s largest bank, Bank Audi, to see how the economy looks from the top of the banking industry.
E Do I understand correctly that you believe the perspectives presented in many of the alarming economic reports that have been circulated in Lebanon in recent months have somehow been tainted—flavored, for example, by ulterior motives or even by ignorance?
The background of our discussion today is the plethora of economic reports in the media in the past two years that were filled with warnings, some of which had zero substance. People do not know how to look at things in relative terms. The Lebanese economy is facing major macro-imbalances. Nobody is disputing this. But for those imbalances to translate into a hard landing for the economy, there has to be a causality between the problem and the hard landing. We have seen reports alleging the [imminent breakdown] of the Lebanese economy. However, while these reports [offer a] more or less fair diagnosis of the situation, things start to diverge when some ignorant economist [starts] saying that we are heading [toward an] imminent hard landing. Some others, who know that there are strong implicit buffers in existence, are even more alarmist in their tone of analysis, because it might be in their interest to see the collapse of the economy happen.
E What is your view? Is Lebanon’s economy in danger of imminent meltdown?
No. What does it mean to have more pain? One does not kill [a] patient in order to [cure] him. What I am telling you is that I technically agree with most diagnoses regarding the problems of the Lebanese economy. Where I diverge from the analysts that are honest and not technically ignorant, is in saying no—those problems, in the case of Lebanon, will not necessarily translate into the same hard landing we observed elsewhere. This is because we have a financial dimension in Lebanon that is far above the economic dimension, with four times the GDP in bank assets.
Despite all you read and hear, we are still having gross financial inflows. In the first eight months of 2018, inflows amounted to $10.5 billion. We pay a small premium on those USD denominated funds, obviously, but as long as the magnitude of inflows is far above the absorption capacity of the economy, a part of them ends up in the accounts of the central bank for the purpose of getting [banks] a higher yield on liquidity. We already pay a premium, and so we want to reduce negative carry.
Thus, when you look at Lebanon’s history, the last several years have seen BDL [Banque du Liban, Lebanon’s central bank] foreign assets as [a] percentage of the local currency money supply in ranges above 70 and 80 percent—81.9 percent today. This [percentage ratio] is where you have evidence for the risk of a collapse in the local currency. I am talking about 18 years during which the central bank’s foreign assets have represented 80 percent of the money supply in local currency; this is a technical buffer.
I am not saying that there is resilience despite all those distorted risk profiles and debt ratios [in Lebanon], but what we are trying to explain is that there are technical buffers that [stand against] the conceptual translation of macroeconomic imbalances into a correction of the currency. This auto-correction mechanism of markets to restore equilibrium does not work in Lebanon or would take much more time [to unfold].
E The World Bank’s latest Lebanon Economic Report, published this October, said “global market conditions have become a more important determinant of Lebanese Eurobonds’ risk/return profile,” and seemed to suggest that Lebanon’s financial sector today is more strongly correlated with factors that influence other emerging markets. Is that a point of concern?
There is no such correlation. Otherwise the correction [of the currency] would have happened years ago. [In the 2000s] we went through two years when debt to GDP was at 186 percent. When you look at peer groups in the global economy, the foreign reserves at the central bank [in these countries] represent, on average, 35 percent of the money supply in local currency. We are at 80 percent, so you see how this is about technical buffers.
[However, viewing Lebanon] on a standalone base, I am not at all happy about [the country’s] risk profile, and I believe that it needs to be adjusted very quickly. I know that we can sustain [such a risk profile] because of the specificities that I mentioned just before, but our capacity to sustain such risks has, over the years, created a huge laxity among our decision makers.
E Are political Lebanon and economic Lebanon like two different planets?
First of all, I don’t believe that we have decision makers in [either realm]. This is unfortunate. If we take the current situation, the talent that we have is not represented in either field. If we talk about the commitments of CEDRE, for $11 billion, out of which $800-$900 million are to be grants, which translates into an average cost of these commitments for borrowing at market rates that is very acceptable to Lebanon. Especially since those funds, as per the [Capital Investment Plan] presented by the government, would cover major infrastructural bottlenecks as priority, which, once adjusted, cannot but improve the overall efficiency and competitiveness of the Lebanese private sector. [But] look how this issue is dealt with politically and economically. Still, I do not believe that it is a situation of harakiri.
E Do you then fully believe that the banking sector is healthy and the monetary sector remains buffered in 2018 while the real economy is not doing well? Where, then, would the problem of our political economy figure into this picture?
If I want to be a bit more nuanced, I will say that the banks still enjoy a good standing but that one cannot say that banks are doing well. You cannot do well in a depressed and weak environment. But again, we have good standing, which is measured by the large size of the banking sector in comparison to the size of the economy. If the banking sector were smaller in size, any setback in the economy would translate into a more material [impact]. [Notwithstanding] the fact that [banks] have lent too much to the domestic private sector.
E How high is the ratio of lending to the private sector today? The Lebanese Economic Monitor (LEM) mentioned that BDL-subsidized lending via banks created strong credit flows to the private sector between 2012 and mid-2018, saying that “by June 2018, the stock of outstanding credit to the resident private sector reached 99 percent of GDP,” and 130 percent to the resident and non-resident private sector.
[The ratio] is 105 percent loans to GDP all in all, for the resident and non-resident private sector. But still, a ratio of 100 percent of loans to the private sector is too high. However, let’s talk about the situation in US dollars, because this is the real firepower of Lebanese banks. I believe, based on tables I prepared two or three weeks ago, that we have lent $40 billion.
At the end of August 2018, domestic deposits of Lebanese banks stood at $119 billion. Banks have provided loans to the private sector of $40 billion and have outstanding Eurobonds of $16.5 billion. This means that we have lent to the public and private sectors in Lebanon $56.5 billion out of $119 billion, which in turn means that we have $71 billion of operating surplus, which is placed with the central bank and with correspondent banks abroad. This is a huge amount. I am amazed when people point to our decreased deposit growth rate and ask what if banks are no longer capable of financing [the public and private sectors]—but our operating surplus today represents 1.26 times GDP. When people look at liquidity in terms of flows, we have decreasing trends in deposit growth, but this is on the background of an operating surplus of $71 billion.
E Turning to the regional landscape and specifically to the exposure of two large banks, Bank Audi and BankMed, to the risk in the Turkish lira, the LEM said in October: “Any significant erosion of the capital base for the Lebanese banking groups” behind Turkish banks Odeabank, in the case of Bank Audi, and Turkland Bank, under BankMed, “will likely require intervention by the Lebanese central bank”—referring to the need for recapitalization by BDL. What is your response?
These are basic conceptual analyses. All banks have recovery resolution plans as per [Banking Control Commission] regulations. The central bank has intervened to provide liquidity, not to provide capital, because the main risk is liquidity, not capital. In response to this remark [on the possibility of capital adequacy issues at Turkish units of Lebanese banks], at the end of September, Odea had the highest [capital adequacy] ratio in the whole Turkish banking sector.
We did a stress test [using Basel III methodologies] that showed that we can sustain an exchange rate of 12.5 Turkish lira to one US dollar for our [Capital Equity Tier One (CET 1)] to fall below the 7.5 percent minimum requirement in Turkey. Even at the consolidated level, since the article that you are referring to said that the groups could be impacted because of Turkey, our stress tests show that in order to fall below minimum 10 percent CET 1, the Turkish lira should be above 10 TRY to one USD. This [LEM comment on the Turkish exposure of Lebanese banks] is a conceptual theoretical report made by analysts sitting in a room somewhere and having very little interaction with what is happening on the ground. How can you make such a statement without picking up the phone and talking to someone at BankMed and Bank Audi to get info? Say what you want, but at least get information, listen, and educate yourself.
E They did not call you?
E So in summary, how do you see the Lebanese banking sector’s development in 2018 as compared with the rest of the economy?
It is not about trends. It is about performance. This is different. I do not see any major weakness, but I see that we can do more and achieve more, in terms of turnover and results of operations for the banking sector.
E How about Bank Audi?
We have released our results, and there is some paradox in achieving such important results. I mean, when you achieve a 20 percent year-on-year [increase in net profit after tax before accounting for results of discontinued operations in the 2017 income statement] for the first nine months in your main markets, under the current operating conditions in these markets, people say: “What is this?” But when you go into details, you see that we launched, almost two years ago across the group, a performance management strategy. Turkey was the trigger [for implementing this].
This strategy aims at derisking, deleveraging, and rebalancing our balance sheets in our main markets from foreign currency exposures to local currency. This has translated into an important overall decrease in our risk-weighted assets and has been triggering the improvement in our capital adequacy ratios, but not to the detriment of our bottom lines. In our rebalancing, we let go of opportunistic big tickets from depositors, which were highly priced and not stable. We are trying to replace them with more granular customers, and we also did not renew many of our maturing loans to non-core or non-prime relationships in terms of providing the group with ancillary business. This has translated into reducing our size in Turkey—the size of Odea—from close to $11 billion to approximately $6 billion. Out of these $5 billion [in the reduction of assets in Odeabank], probably 60 percent is due to exchange rate depreciation, but there [is] $2-3 billion of real derisking and deleveraging. We also have rebalanced our loan portfolio toward local currency lending instead of foreign currency lending.
E Only in Turkey or also in Lebanon?
This was in Turkey, Egypt, and Lebanon, but the bulk was in Turkey; this has allowed us to sustain almost the same level of daily net interest income in Turkey, despite the fact that the size of the business has shrunk. Thus the first reason behind those important results is improved topline net interest income. Our consolidated spread in the first nine months of 2018 improved by almost 40 basis points (bps) with respect to the corresponding period of last year. This has been generated by improved spreads in Lebanon, Turkey, and Egypt. It is not coming just from one geography.
The second point to note in relation to the performance management strategy is the cost efficiency measures which have been implemented. We have shown 20 percent increase in profits. When you look at our operating expenses in the consolidated nine-month 2018 results, they decreased [year-on-year] by $80 million, out of which probably 25 [million] are due to depreciation of the Turkish lira, because of the resulting shrinking in the counter value of the cost base. The remaining [reduction in operating expenses] is real cost savings in Turkey of $30 million and from Egypt and Lebanon, too.
We also have improved NIM [net interest margin] from $780 million to $907 million, so we have $127 million of additional topline, and we have $80 million of reduced cost. Our profits increased by $68 [million] because we had $80 million of additional taxes with respect to new taxation of banks, mainly in Lebanon, comprised by the tax on deposits and the increased income tax. The remaining was $40-50 million in additional provisions—this is real recurring [income] driven by the performance management where people [in the bank] are focusing much more on sustaining the quality of existing loans instead of granting new loans on a daily basis and revising yields on loans with respect to operating environments in each market. We are trying to reduce the cost of deposits not by decreasing [deposit interest rates], but by letting go of opportunistic big tickets—this translates into savings [for the bank], while we are also increasing the more granular base of small depositors.
E Did the cost of deposits in Lebanon go up significantly after the extension of high interests for long maturity deposits?
By end August, we had $120 billion of domestic deposits in Lebanon [in the banking sector]. Bank Audi is always lower, although we launched 15 percent [interest] programs for deposits of five years. We did maybe $500 million or $600 million [of such long-term deposit contracts with high interest rates] and probably other banks did the same, whereas you have the equivalent of $54 billion in local currency deposits. So if there was $1 billion [out of these $54 billion], this is a small margin [of the total deposit portfolio in the sector].
Look at three-month LIBOR. The average cost over one year increased by 60 bps whereby the benchmark rate increased by 1 percent year-on-year, from 1.32 percent to 2.32 percent. This means we are paying less spread with respect to the benchmark, despite the fact that the costs [in the form of interest on deposits] are increasing, and stand at 4.2 percent today. I would not be surprised if they reach 4.5 by December. But can you imagine that if you make a big ticket deposit, say $5 million over three months, in whatever large global bank today, they will give you 2.6 or 2.7 percent?
My main message is that Lebanese banks—assuming [for this exercise] that they would be a single bank—today are capable, despite all that we are witnessing in the country, to sustain a deposit base of $120 billion at 4.2 percent. This represents less than a 2 percent premium over what leading global banks are paying [as deposit interests]. This speaks for itself.