Lebanese banks have increased their capital significantly over the last decade, as consolidated equity moved from less than $500 million in the early 1990s to slightly more than $6 billion today due to external capital increases, capital injections from existing shareholders and, above all, organic growth. Indeed, the significant profitability of Lebanese banks during the mid to late 1990s facilitated the increase in capital through internal injections of revenues. The allocation of assets to extremely high-yielding government securities – and corporate and retail lending at prohibitive rates – boosted profitability and allowed banks to increase capital without necessarily relying on external investors. This relatively easy profitability was achieved with a majority of banks not having to bother to set up efficient diversification strategies, as the government’s policy of continuously issuing debt securities meant that banks had their strategy practically decided for them.
Paris II cuts off government largesse
The radical decrease in interest rates in the aftermath of the Paris II donors’ conference led bank profitability to decline, forcing banks to establish their own financial and operational strategies without having to behave reactively and rely on the government’s monetary policy. The radical reduction in government bond and Treasury bill issues also meant that banks had to start thinking about serious asset and revenue diversification strategies to produce a recurrent income stream and reduce the reliance on interest income (more than 50% of which stems from government debt securities). At the same time, a substantial growth in deposits and a rising level of problem loans (as the operating environment became increasingly difficult) required even more capital, which decreasing profitability could no longer provide.
The announcement of the Basel II capital regulations in 2000 accelerated the need for capital. Banks had to start focusing on efficient risk management, on dealing with risk weights, which under Basel II are determined by credit ratings (internal or external), and on developing a diversified and recurring earning stream. A few banks reacted with the development of a capital financing strategy, which mainly consisted of issuing hybrid capital instruments such as preferred shares.
A preferred share is a capital security which carries a “dividend” or a fixed interest rate. It has a long maturity and is classified as equity and not as debt. Lebanese banks have used preferred shares extensively in the last few years and have even transformed the dividend into a fixed interest payment for its subscribers. Banks such as Byblos Bank, Lebanese Canadian, Bank Audi, BLOM Bank, Crédit Libanais and more recently BLF and BEMO have carried out more than one issue of preferred shares, with very generous interest payments. Byblos’ first preferred share issue carried an interest of 12%, while more recent issues by a variety of banks carried rates of around 8%. The reason for these high interest payments is that, in case of liquidation, a preferred shareholder is paid after depositors and senior debt holders, but before shareholders. In the international capital markets, a preferred share normally carries a rating two or three notches below the rating of the senior debt of the issuer.
The preferred shares issued by Lebanese banks succeeded because these issues contained several essential characteristics:
* They provide new value to the bank.
* They are permanent or at least have a very long maturity.
* They have contingent payment terms (i.e. payment can be stopped without precipitating default or regulatory intervention).
* They are ranked behind all creditors in liquidation.
Beyond preferred share offerings
The problem today is that banks cannot afford to issue preferred shares frequently and in large amounts. Preferred shares are expensive and can eat up a significant portion of revenues, which still need to be diversified and increased. What banks need now is to open up their capital and invite in new shareholders, whether they be financial or strategic. However, the decision of many Lebanese banks to increase their capital via the international capital markets at almost the same time is a cause for concern. Markets don’t like it when many issues from the same sector and the same country come out all at once, and Lebanese banks still need to coordinate a more effective timetable. This partly entails an extensive roadshow agenda, as most international investors who are targeted for these issues are unfamiliar with banking in Lebanon and need to be convinced of long-term strategies. In a market where size counts, the smaller banks will have to be on top of their game if they want to emulate BLOM’s successful $276 million capital gain through Global Depository Receipts issuance this February.