Beirut’s banking sector healthy but challenges lie ahead

Basil II looms and diversification beckons to financial services in Lebanon

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The Lebanese banking sector has survived and thrived through not one but two major shocks in two years: the assassination of Rafik Hariri in 2005 and the Israeli-Hizbullah war in the summer of 2006. A younger or less experienced banking sector would have collapsed under shocks like these, but the shrewdness of Lebanese bankers and banking regulators, the implicit and sometimes explicit support of friendly Arab neighbors and the extraordinary recurrence and solidity of Lebanese deposits and remittances from a very wealthy and influential Lebanese diaspora once again allowed the banking sector to remain solid.

This impressive resilience and the continuous financial performance and growth in assets, despite the setbacks, was reflected in Riad Salameh being named best central bank governor in the world for 2006 by the renowned Euromoney magazine. This is not the first time a Lebanese has been honored this way: In 1990, Mr. Edmond Naim also got the nod for his work in preserving the banking sector during 17 years of civil strife.

Balance sheets maintained

The balance sheet of Lebanese banks had been structured in more or less in the same way for the last 15 years, albeit in different proportions. At the end of August 2006, treasury bills (government debt securities) accounted for 27.2% of total assets of LL108,603 billion (or $72.04 billion), compared to 25.13% at the end of December 2005. The trend of Lebanese government treasury bills holdings has been decreasing for the last few years, particularly after the Paris II donors’ conference, when the government, through the BDL, underwent a series of monetary reforms. These mainly consisted of increasing liquidity levels on the banks’ balance sheet, reducing interest rates on both US dollar and Lebanese pound deposits, and, last but not least, reducing the exposure on the state, which remains to this day poorly rated by the international rating agencies (B- and B3 by Standard & Poor’s and Moody’s, respectively. These groups are the world’s largest and most respected rating agencies, particularly by international capital markets).

The exposure to the Lebanese sovereign bonds has shown its weaknesses in the aftermath of the Israeli war on Lebanon in 2006, as T-bill values went down as a result of a lack of liquidity on these securities in the secondary market and reduced investor confidence. This decrease in the value of T-bills has affected the banks’ liquidity, in the sense that they could only be disposed of at a loss, and hence would have brought less cash to the banks were they to have been liquidated. Although values are beginning to rise, banks are now aware that T-bill holdings have to be reduced over time. The disposal of T-bills by banks can only be carried out gradually, with individual investors (e.g. expatriates, non-residents) and foreign institutional investors replacing the banks. It should be clear by now that the capacity of Lebanese banks to fund the state through the subscription of T-bills is fast reaching its limits, with most banks, particularly the larger ones, growing unwilling to buy government securities within the scope of swap deals (exchanging current government securities with newly issued ones, holding a longer maturity).

Lebanese banks have retained their very strong capacity to gather deposit funding throughout 2006, and are unlikely to feel any weakness on that front in the foreseeable future. Customer deposits accounted for 81.15% of total assets at the end of August 2006, compared to 82.64% at the end of 2005, and amounted to LL88,128 billion ($58.46 billion). The rising levels of customer deposits with Lebanese banks reflect the high standards of banking penetration and financial intermediation, with banking assets to GDP amounting to around 350%. The banks’ solid and recurrent deposit base improves financial flexibility (or the ability to raise funding) significantly, and even reduces the risk of maturity mismatching between assets and liabilities. Although deposits are short-term in nature, they are highly recurrent and have funded longer-term maturity assets for more than a decade.

Deposits staying put

Customer deposits have traditionally been denominated in foreign currency (mainly the dollar), given that confidence in the Lebanese pound has never been substantial. However, the Lebanese pound has shown a strong resilience to the successive crises of 2005 and 2006, while the monetary authority has proven its strong commitment to maintaining the local currency at its post 1975-1991 civil war value. The injection of $1.5 billion in the form of deposits at the BDL by the Saudi and Kuwaiti governments at the height of the war this summer is a further reflection of the desire by regional powers’ desire to support Lebanon in maintaining a stable value for its local currency. The dollarization rate of customer deposits during the 2006 crisis was less significant than in the aftermath of the Hariri assassination, reaching 75% compared to more than 80% in 2005. The dollarization rate had dropped to 73% by the end of December 2005, and therefore did not increase substantially even as Israeli warplanes were thrashing Lebanon’s infrastructure. There was insignificant fleeing of deposits during the summer of 2006 (believed to be less than 4% of total sector deposits), with those deposits leaving the country transferred out to foreign branches or subsidiaries of local banks in any case. A major proportion of transferred-out deposits are now believed to have returned to their original accounts in Lebanon.

Asset quality was slightly affected by the summer 2006 war, with loan losses believed to have reached around $80 million for the entire sector, which at the end of August 2006 had total consolidated loans of around LL28,052 billion ($18.61 billion). Loans to the private sector accounted for 25.8% of total assets, and are not expected to change significantly, as banks remain cautious in a very difficult operating environment. Retail lending, on the other hand, is showing signs of tremendous potential, with most banks developing an expertise in products such as credit cards, car loans, housing loans and personal loans. Retail loans usually carry lower risk weightings and should be less onerous on bank capital come 2008, when Basel II capital regulations start to be implemented in Lebanon.

Interested in profits

On the earning side, Lebanese banks have continued to rely on interest income for their profitability. As at the end of 2005, net interest income accounted for slightly less than 70% (around 67%) for the entire consolidated banking sector. Although this figure appears high, it has been decreasing since 2002 when the proportion of net interest income to total operating income accounted for close to 80% (77%). Banks have been trying to diversify their earning base by increasing non-interest income and decreasing the proportion of interest income derived from treasury bills. Non-interest income has essentially been emanating from treasury and capital markets activities, with the Audi-Saradar group being the most active in that field. Interest income has been slightly diversified in favor of interest income from inter-bank deposits and retail loans. However, the main hope for earnings diversification comes principally from the geographical expansion of a number of banks, particularly the larger ones, into regional “captive” markets. By setting up branches or joint ventures in markets such as the GCC or parts of North Africa, including countries such as the Sudan, Lebanese banks have laid the foundations for future earnings to be equivalent or even outweigh domestic earnings. Geographical expansion is the key to solving the problem of operating in a small and troubled domestic environment, and would diversify income and funding.

At the end of August 2006, the consolidated shareholders’ equity of Lebanese banks amounted to LL8,412 billion ($5.58 billion), or 7.75% of total assets and almost 30% of total loans to the private sector. The sector’s equity to assets ratio at the end of 2005 stood at 6.04%, which is significantly lower than the figure at the end of the summer 2006 crisis. Banks have been increasing their capital either externally, by issuing shares to new investors (a lot of them coming from the GCC region) and issuing products such as preferred shares, or internally, through the re-injection of profits into equity. The effort to increase capital is due to the forthcoming Basel II capital regulations, which the BDL intends to start implementing in Lebanon in 2008. From 2008 until 2011, Lebanese banks will have to follow the standardized approach of Basel II, which virtually means risk weighing all assets, including T-bills at 100%, risk weighing non-performing loans at 150% and applying a 15% charge on the three year average operating income to account for operating risk. Market risk is also to be accounted for, as part of Basel II regulations.

Dangerous times ahead

Although some banks have enough fire power to raise capital relatively easily and meet Basel II standards, a number of smaller banks are likely to struggle to meet the new regulations, given their weak capacity to fund themselves in terms of capital. However, with the current dangerous and unstable political environment, the entire banking sector, including the big guns, runs a serious risk of seeing its profitability—and hence its internal/organic capital raising capacity—dwindle, as well as seeing the last and most determined investors turn their shrugging shoulders on them. Let us hope Lebanese politicians recognize the potentially explosive economic situation and start acting accordingly.