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High Liquidity Saves the day

2005 exposes the strengths and weakness of Lebanon

by Nicolas Photiades

2005 has been a testing year for Lebanese banks. But it could have been a whole lot worse for the country’s most reliable economic sector were it not for the vision and caution of Lebanon’s central bank, Banque du Liban (BDL), which, seasoned by decades of political and security turmoil, was able to mitigate the various risks that resulted from the fallout from the assassination of former premier Rafik Hariri on February 14. The central bank was able to build up sufficient liquidity reserves to counter a run on deposits, particularly on Lebanese pound deposits, not seen since the heydays of the civil war in the mid-1980s.

Until then, the banking sector had enjoyed increasing liquidity, a substantial rise in deposits from both residents and non-residents, and a limited improvement in profitability as a result of greater product and geographical diversification. The banks were also stepping up their lending activities to reduce their reliance on Lebanese government Treasury Bills and other debt securities, which carry a very low rating of B- and B3 by Standard & Poor’s and Moody’s respectively, while regulatory capitalization levels were high. However, the operating environment was still difficult and limited the diversification and rise of profitability, while economic capital remained low due to the high sovereign risk.

The period that followed the Paris II donors’ conference in November 2002 was also characterized by lower interest rates, particularly on both Lebanese pound and US dollar deposits. However, Lebanese banks had long been plagued with a substantial maturity mismatch (deposit funding has always been short-term, while asset placements were long-term in nature), which leaves them vulnerable to a sudden rise in interest rates as a result of a drop in the general confidence level or threats of a Lebanese pound devaluation. The end of 2004 also saw the government fail to meet its obligations of economic reforms as established during the Paris II conference. This left the banks facing an uncertain future, forcing them to plan on a short-term basis and leaving them with little choice but to contemplate raising interest rates again.

Managing risks

Lebanese banks have always been careful to mitigate the risks associated with their balance sheets, such as the low sovereign ratings on government debt securities and the potentially explosive operating environment which limits the availability of good quality lending opportunities, by keeping a high level of liquidity, particularly in foreign currencies, namely in US dollars. Events prior to and following Hariri’s assassination have shown banks keeping liquidity reserves in foreign currencies that make up almost 50% of the foreign currency deposits at the central bank, while liquid assets in Lebanese pounds, including liquid Treasury Bills, have always more than 100% covered corresponding deposits in local currency. This prudent approach by the local banks of keeping high levels of liquidity has proven to be more than appropriate in the aftermath of Hariri’s death. The significant loss in public confidence as a result of the political turmoil that ensued, resulted in a run on Lebanese pound deposits, which were massively converted into foreign currency deposits. Some $2 billion or so of deposits were also withdrawn from the banking system altogether and taken out of the country. The dollarization rate of bank deposits moved from a roughly 65% in dollars to 35% in liras parity to one close to 80% to 20% in a matter of a few weeks. All this not only put a strain on the liquidity of the banks, but also on the BDL’s foreign currency reserves, which started to fall at an alarming pace. Were it not for the prudent approach towards liquidity and for clever mechanisms initiated by the BDL, which were only possible due to large liquidity reserves, significant crises on the local currency, which would most probably have ended in a disastrous devaluation scenario, would have been too hard to avoid.

By initiating a liquidity preservation mechanism whereby the banks would sell their three-year, Lebanese Pound Treasury Bills to the central bank in exchange for local currency liquidity, the BDL proved that it was a capable regulator, worthy of a place amongst the world’s best. The mechanism allowed the banks to increase their liquidity in Lebanese pounds, and to then buy US dollars and convert Lebanese pound deposits into US dollar ones, with the final obligation to place new US dollar funding into three-year, US dollar bonds issued by the government. With such an ability to respond to significant runs on liquidity, the central banking authorities and the banks were able to kill off the confidence crisis within a couple of months and stop the hemorrhaging.

BDL shows what it’s made of

2005 was a year that confirmed that support from the financial authorities would be forthcoming in cases of necessity. The BDL and its Banking Control Commission (BCC) were swift in finding solutions for a banking sector that was made extremely fragile by a very weak operating environment, stagnant profitability and undiversified funding sources.

Nevertheless, the banking sector remains to this day under significant pressure, despite successes in the early part of the year to meet confidence and liquidity crises. Indeed, the local banks are still characterized by poor asset quality, over-exposure to government risk, stagnant and undiversified profitability, and very low economic capital.

Elsewhere, exposure to sovereign debt has decreased since the Paris II donors’ conference in late 2002, but remains too high at slightly more than 20% for most of the local banks. This worrying concentration is unlikely to fade away in the near future, although it is now clear that the banks’ capacity to finance the government has reached its limits. The good news is that the current government is aware of the situation and is planning to enter a phase of sovereign debt restructuring, which should include a significant number of swaps. The banks are now more inclined to subscribe to these swaps, as a way of replacing their existing stock, and will be gradually looking to concentrate their funding allocation on assets that carry lower risk weightings and are less onerous on capital.

As for Basel …

The Basel II capital accord, which changes the perception on how regulatory capital is calculated, is due for implementation in Lebanon in 2008. Basel II forces banks to become more rigorous in terms of determining credit risk, as the latter determines risk weightings, which in turn determine the level of capital needed. Lebanese banks are mostly unprepared for Basel II, which requires a world-class capacity to evaluate credit and operational risk, and to amass a considerable amount of information. A recent attempt to calculate the capitalization ratio for Lebanese banks after applying Basel II requirements has shown a substantial drop in that rate to below 6% for a large number of banks, which is way below the regulatory minimum of 12% set up by the BCC. With a consolidated equity of US$3.8 billion at the end of August 2005 (a 4.65% increase from year end 2004), the banking sector will need to tap new and existing shareholders to increase their capital in line with Basel II.

The recent boom in the Gulf region combined with sovereignty in Lebanon and the desire of Gulf investors to invest here should make it easy for banks to strengthen their capital base. However, it will be important for all the banks to follow their capital increases with significant restructuring. Indeed, the priority will have to be the improvement of economic capital, which can only be achieved through a diversification of funding sources (for instance, banks will have to increasingly look to tap the regional and international capital markets), and of profits through geographical and product expansion and through the extensive development of risk management capabilities. The latter have until now been neglected by a large number of banks, which still confuse risk management with financial control. The final aim will be the generation of a healthy, diversified and recurring revenue base, which will diminish banks’ reliance on external capital and strengthen their capacity to grow organically.

2005 has been a crucial year for the entire Lebanese economy and banking sector, exposing the weaknesses of the latter and changes that need to take place. Now is the time for Lebanese banks to start looking more like international financial institutions ready to get involved in major regional financing transactions, rather than small and medium size companies, barely able to finance the growth of the national economy.

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Nicolas Photiades


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