Efficiency not mediocrity

Makram Sader gives a wrap up of growth in the sector and a strategy in 2004

In the first nine months of 2003, four main developments were observed: the unexpected rate of growth in bank’s deposits or in monetary aggregate M3, the sector’s participation in easing the state’s debt burden; the reduction of interest rates; the creation of a mechanism to review and settle non-performing loans.

(I) Growth of M3

We were surprised by the extent of the commercial banks’ balance sheet growth, mainly in the deposit base growth. This is reflected by the growth of the monetary aggregate (M3: amount of money in circulation plus deposits at banks), which increased by 14% from September 2002 to September 2003. Usually, M3 grows by real and nominal growth, credit to the private economy plus credit to the public economy and by the changes in net foreign assets (balance of payments) if the balance is positive. M3 decreases if there is flight of money from Lebanon to abroad.

The 14% increase of M3 far outpaced the growth of the economy overall, which reached only 2%. The growth of M3 under normal circumstances should not be larger than the growth of the economy plus a value slightly exceeding inflation. Inflation in Lebanon is around 4%. When added to the 2% real growth, it means that a 7% increase in M3 is justifiable by nominal growth of GDP. But what about the remaining 7%? A notable factor in the development of money supply in 2003 was the inflow of capital to Lebanon. Many sources contributed to this inflow, including:

• $2.4 billion entered the country under commitments from Paris II.

• $1.2 billion was contributed in deposits from non-residents. • $400 million came from the repatriation of foreign deposits.

• $1.0 Billion or more from other capital accounts (i.e. real estate investments etc.).

(II) The Public Debt Service burden

The banking sector’s engagement was instrumental in the facilitation of the drop in public sector debt service through the Paris II mechanism, which acted directly through the acquisition by the banking sector of zero-percent T-Bills contributing to reduce the debt service by $383 million per year. The sector will be indirectly contributing to another LL400 billion in debt service reduction through the subscription to new issues of T-Bills to replace those maturing in 2004.

The interest rate reduction from 14% to 8% is considered “unusual business” and the IMF doubted the banking sector’s ability to decrease the public debt and reduce interest rates.

While the banking community delivered what we promised, the government did not. Primary expenditures – i.e., public expenditures without the debt service – increased instead of decreasing, allowing the fiscal deficit to reach 38% to 39% while the initial budgeted figure was 27%.

(III) The decrease in interest rates

Claims that falls in the interest rate decreases affected only deposits and not lending rates, is wrong. In truth, while the income of banks from deposits with the central bank decreased, double shifting mutation in rates and volumes caused a decrease in the profitability of the banking industry’s credit portfolio.

If we take into consideration not only changes in interest rate but also changes in the structure of invested funds, we can clearly see that the returns on bank placements decreased during the period from September 2002 to September 2003 at a rate wider than the decrease of the cost of the bank’s deposits. This shrunk the margins by 14% for the mentioned period. As the portion in total assets that consists of loans to the private sector decreased, the share of the sovereign risk (central bank and treasury) increased just as dramatically as the public sector lending rates decreased, doubly affecting the profits of banks.

It is thus more accurate to say that the drop in interest rates did not equally reflect on lending to the private sector, which became 12% cheaper, while the sovereign borrower benefited from an interest rate reduction averaging 21%.

(IV) A framework to settle problematic bank loans

After one year of negotiation, a framework to settle non-performing loans (NPLs) on banks’ books was achieved in cooperation with the central bank. This framework applies to both (1) the relation between the banks and its clients and (2) the relation between the banks and the supervisory authorities.

1. In the dealings between banks and clients (debtors), three main pillars govern the relations:

a. Unrealized interest rates are partly written off by applying reduced interest rates on the initial debt stock.

b. The debt stock is reduced by way of acquiring the real estate that served as collateral. Banks acquire these properties at good evaluation agreed upon with the Banking Control Commission. c. The remaining debt balance is rescheduled over a long-term period of five to 10 years, reduced interest rates agreed upon between client and bank.

2) The relation between the bank and supervisory authority is managed through a three-tiered scheme: a. Defining of the accounting methodology in provisions on settled and unsettled problem loans. b. Allowing a long period, up to 20 years, of provisioning of real estate, which banks have acquired from debtors under their loan-rescheduling scheme. c. Granting banks the possibility to rediscount, totally or partially, the securitized debt of the clients with BDL if the bank needs liquid assets to clear its balance sheets. In its entirety, this instrumentation provided for rescheduling of non-performing loans, if well and adequately used by bankers, will support the process of revitalizing the economy and resume new activities through restructuring the corporate sector.

What strategy for the coming years?

Looking towards the future, it is prudent to go beyond analyzing the main developments of 2003, as mentioned above, and review the larger situation of the banking industry and its strategic needs.

For this task, it is helpful to take stock of the numbers as they stand after a decade of strong banking growth. The most telling figure in this context is the ratio between total assets/liabilities held by banks and Lebanon’s GDP. This ratio stands today at 315% by the end of September 2003. It is the highest worldwide among “normal” countries.

How much of these liabilities are invested domestically is key to understanding the Lebanese economy from a banking perspective. Most of these resources are invested locally, therefore, the economy is enduring the cost of these bank’s liabilities. By the end of September 2003, 16% of bank assets were invested abroad, and the remaining 84% in the country (domestic placements). Of these domestic placements, 26% were in the private sector, 54% with the sovereign (23% at the central bank and 31% at the Lebanese treasury) and 4% in fixed and unclassified assets.

In simple terms, the banking sector has outgrown the Lebanese economy and domestic economic growth. It grew eight to 10 times in the last 10 years – while the Lebanese economy did not grow as fast.

Even if interest rates – i.e., the price – decrease further, the quantity of credits and loans to the economy (public and private) will still constitute a heavy weight and therefore a heavy cost on the economy. Capital funds have become very big also compared to domestic needs. Our international capital adequacy ratio exceeds 18% while Basel I Committee has set it at 8%.

Why does the Lebanese banking industry have to turn over a new leaf? The current model of banking growth was sustainable until today because of two factors: 1. The Lebanese community and some Arab funds repatriated part of its wealth to Lebanon, enabling our deposit base to widen without any relation with domestic economic growth. 2. The state, central bank and treasury became our main client (54% of our assets in September 2003) and both of them accepted to extend to a maximum their foreign currency debt. This policy helped a lot by providing fresh blood to this dollarized model in one hand and by providing the banking industry with good placement opportunity in another hand.

This pattern of attracting more funds from abroad can only continue if we keep interest rates at high levels, which are unsustainable by our domestic economy. This is a paradox situation.

When public and private sectors have difficulties to service their debt it is a clear signal that this model is no longer sustainable and should be revisited sooner better than later. This leaves us with the need to export our services abroad as only way to remedy the situation. Two recent signs confirm that the banking industry became too big for the Lebanese economy. The 0% coupon T-Bills to the public sector and the framework to settle the NPLs applying reduced interest rates.

If we want the banking sector to continue to grow and if we want the banking industry to continue to realize profits and good return on equities and assets (ROE, ROA), it has become necessary to diversify our placements to other countries and markets.

That means we have to export our banking services to countries like Syria, Iraq, Armenia, Algeria, Sudan, Libya, and other countries where the banking industry is not developed. We also need to enhance and strengthen our financing services to Lebanese communities abroad, and to look seriously for cross-border mergers and acquisitions with active Arab banking industries.

In summary, international and regional expansion is the only strategy to guarantee sound and further growth of the Lebanese banking industry, entailing three options for development that will not place an undue burden on the national economy of having to carry the weight of the enormous deposits base:

1. Expand into neighboring countries and optimize physical presence there.

2. Supply services in foreign markets, especially to the Lebanese expatriate business community.

3. Penetrate new markets through cross border and regional mergers and acquisitions.

Fortunately, based on the sector’s many strong points, and because over the past ten years we undertook a multi-dimensional restructuring and reorganization of our industry from within the prospects for exporting Lebanese banking services are good.

This reorganization has been characterized by achievements in following areas:

1. We refurbished and improved our human resources. This is a main factor needed to compete regionally and internationally.

2. We introduced very adequate management systems and technologies, including good manuals of policies and procedures.

3. We are complying with international standards in many important areas. Lebanese banks fulfill the current Basle requirements for capital adequacy ratio and the standards set for lending to related parties and lending to a single large borrower. We are also up to global standards in accounting and auditing, and rules on disclosure, transparency and combating money laundering etc. Lebanon has good supervision authorities that operate according to BIS principles of supervision.

4. We acquired during the last 15 years a lot of know-how in dealing with the dollarization of economies and in operating under very aggressive and risky environments.

Lebanon’s banking industry appears to be very well positioned regionally because it fully achieved these improvements and it is very well equipped to more important cross–border activity.

A further avenue for banking sector growth in Lebanon should be mentioned here. This would be to finance industrial activities, which are destined fully for export. To implement this strategy could require collaboration with international organizations to promote our exports. But even more essential for mobilization of Lebanon’s export capacities is a very good vision on behalf of the regulator. This is the role of the government. It should elaborate a new approach, new vision, and new model to induce the growth of our economy.

Fulfilling this role would imply many steps and taking strong measures, examples for which would be interventions with the Arab countries as well as the EU in support of Lebanese exports. It is up to the state as regulatory force in the economy to work towards better conditions for production by providing incentives, decreasing costs and preparing a reliable framework and consistent operating conditions. At the current stage, and in all these matters, one question must be asked: Where is the state? We have a heavy state with limited efficiency and productivity. We urgently need in Lebanon to redefine the role of the state in the economy, to rediscover where is the adequate dosage to be set between the state and the market. This hydride economic model of ultra-liberalism and ultra interventionism in the same time is no more appropriate for our country. We need a much more equilibrated liberal socio-economic model. We need a smaller and more efficient public sector and a state with a real vision for the future. The reason for this culture of NPLs is our non-performing and mediocre state.

The banking community and the banking authority are a necessary part of the problems and solutions of the economy. Whenever we have had a good program we have always been able to deliver our part of it.

Dr. Makram Sader is the secretary general of the Association of Banks in Lebanon