The banking sector remained the backbone of the Lebanese economy in 2009. Bank assets are equivalent to 334 percent of gross domestic product and deposits are equivalent to 274 percent of GDP, among the highest such ratios in the world. The sector displayed its resilience to global financial shocks and domestic political instability, and proved it can finance the private sector while supporting the public sector’s needs at a time when governments around the world have been forced to bail out their banking systems. But, with the rapidly changing global and regional financial landscape, the sector is likely to face new challenges in 2010.
A spotlight on risk management
The credit crisis has revealed glaring gaps in risk management, as banks around the world learn that underestimating liquidity creates severe systemic risk. Commercial banks in Lebanon have a fiduciary responsibility to conserve capital, safeguard deposits and minimize depositors’ risk. In the current climate, most Lebanese banks have focused on increasing liquidity, minimizing risks and increasing quality assets. In the past, risk management at many commercial banks consisted primarily of reassuring large depositors that their money was safe during the political instability and security shockwaves that have characterized the Lebanese economy. Indeed, the structure of bank deposits is concentrated, as between 70 and 80 percent of deposits are held by 20 to 30 percent of depositors. Thus, reassuring large depositors that their money remained safe was the main risk management approach of banks. However, with the regional expansion of banks in recent years, there has been an evident focus on developing advanced risk management systems. This trend has accelerated since the global crisis erupted.
The crisis has clearly reflected the fact that the size of financial institutions is not the most relevant criteria for gauging security, as some of the largest global commercial and investment banks aggressively expanded their balance sheets at the expense of proper risk management, with disastrous results. The larger Lebanese banks are likely to focus increasingly on risk management, internal auditing and corporate governance and transparency, rather than on the aggressive expansion of the balance sheet. Those who still favor size over more fundamental issues are likely to be more affected by regional developments due to their increased exposure and aggressive risk taking.
Regional expansion, under caution
Lebanese banks have embarked in recent years on a cross-border expansion strategy to take advantage of new markets and to diversify their assets and revenue base. Lebanese banks are currently present in more than 20 markets through about 70 branches, affiliates and sister companies, not only in the Middle East and North Africa, but also in sub-Saharan Africa, Eastern Europe and Central Asia.
The global crisis led banks to take a wait-and-see approach by consolidating their positions and assessing their exposure in the markets where they are already present. But with global and regional conditions stabilizing, and Lebanese banks emerging largely unscathed from the crisis, they continue to lend abroad. Most of them will follow a more cautious approach, while they resume their operational expansion in existing markets. However, regional expansion inevitably has its risks, as one Lebanese bank tested positive to exposure to the Saudi Arabian Saad and Algosaibi conglomerates that defaulted earlier this year. Also, the recent announcement by Dubai World that it is requesting a debt standstill on its obligations and that it will restructure its liabilities, in addition to pre-existing crises like the defaulting investment firms in Kuwait, reflect existing regional risks and are a reminder to Lebanese banks about the need to remain cautious. Furthermore, the slowdown in regional economic growth increases the risk of non-performing loans. Still, Lebanese banks have the liquidity, experience and skills to decide when and where to expand in 2010.
Deposit growth remains a double-edged sword
Early concerns about the impact of the global financial crisis on deposit inflows to the Lebanese banking sector turned out to be unfounded. Indeed, while the growth of deposits slowed down and displayed some volatility in the fourth quarter of 2008, there were no material deposit outflows from the system. The first nine months of 2009 saw unprecedented capital inflows to the sector, with private sector deposits growing by a monthly average of $1.5 billion in the first three quarters of the year and averaging a more impressive $1.8 billion in the third quarter of 2009. Indeed, private sector deposits have grown by 17.2 percent from the end of 2008 and by 21.6 percent year-on-year, with non-resident deposits rising by 40 percent year-on-year. The massive inflows are attributed to the resilience of the sector in the face of the crisis, but also to the interest rate differentials on dollars and Lebanese lira deposits at local banks compared to global rates. Furthermore, the relative political stability in the country since June 2008 encouraged depositors to convert their funds into Lebanese lira to take advantage of higher interest rates, leading to a marked decline in the dollarization rate of deposits from 77 percent at end-2007 to 66 percent at end-September of this year, a still elevated rate. Despite the slight reduction in deposit rates earlier this year, interest rates on deposits in Lebanon are unlikely to decline substantially until the structural imbalances represented by the high fiscal deficit and public debt are addressed, and until long term political stability is sustained. As such, banks are likely to continue to attract deposits, but since part of these deposits is speculative in nature, they will face the challenges of the high cost of funds as well as volatility and the risk of outflows from a potential revaluation of risks for the region as a whole.
What goes up…
Banks have been faced with a high level of liquidity in both the national currency and in foreign currencies, with not enough outlets to place this liquidity since the start of the crisis. The certificates of deposits issued by the Banque du Liban (BDL) to absorb local currency excess liquidity and its measures to encourage lending in Lebanese lira have helped somewhat. But the sector’s cautious lending approach, fewer lending outlets abroad, record-low interest rates in global money markets, the decline in demand from the non-resident sector and the high cost of funds are likely to combine and affect the banks’ profits this year. To be sure, banks will continue to be profitable in 2009, but the growth rate of their profits will be slower than the 25 percent rise posted last year. Moreover, the profitability ratios are likely to stagnate, as the sector’s average return on assets reached 1 percent as of July 2009 relative to 1.1 percent in 2008, while the average return on equity was 13.9 percent in July on an annualized basis relative to 14 percent in 2008.
An optimistic outlook
The ratings on the long and short term foreign currency debt obligations of Lebanese commercial banks have long been constrained by the sovereign ceiling. Indeed, international rating agencies have argued that the banks’ exposure to the sovereign continues to keep their ratings at the sovereign level, even though rated banks are well managed, profitable, liquid and well capitalized. But recent trends and a closer analysis of the banks’ sovereign exposure warrant a different conclusion. The consolidated balance sheet of commercial banks shows that the banking sector’s exposure to foreign currency denominated sovereign bonds was at $11.7 billion at end-September, which accounts for less than 11 percent of the sector’s total assets. Further, the sector’s total exposure to the public debt in Lebanese lira and foreign currencies accounts for less than 25 percent of the sector’s assets, which is slightly lower than the banks’ lending to the private sector that represents 25.4 percent of the asset base. Rating agencies consider the banks’ reserve requirements at the central bank as part of the sovereign exposure. However, BDL places these reserve requirements in the global money markets, similar to what the banks do themselves to the 15 percent liquidity requirement on their foreign currency deposits. More importantly, the BDL has not utilized these reserves to maintain the stability of the currency and its reserves have reached the equivalent of 100 percent of GDP. So it is not clear why rating agencies continue to consider reserve requirements as part of the sovereign exposure. The share of foreign currency sovereign bonds to the sector’s assets is likely to decline further, depositors have proved to be resilient to domestic political shocks and external financial shocks, and the banks’ share of revenues from foreign operations is increasing as a share of total income. As such, it may be time for rating agencies to reconsider their ratings of Lebanese banks to a level above the sovereign, even though it is way too premature for any Lebanese bank to claim regional status.
Nassib Ghobril is chief economist and head of economic research & analysis at the Byblos Bank Group. He recently received the World Lebanese League’s award for “Best Economist in Lebanon & the Diaspora for 2009”
