Investing in a venture capital (VC) fund is a bit like betting on a horse. The gambler can choose a horse carefully, looking at the animal’s past performance and even evaluating the jockey, but once the race starts and the money’s laid down, all the gambler can do is sit back, watch the race and hope for a big payday. Risk is high, but promise of a windfall is higher. Georges Hajj does not look like a gambler. Nor does he talk like one.

Hajj is the head of the CEO’s office at Banque Libano-Française (BLF) and speaks to Executive about the bank’s VC bets under central bank circular 331. He says BLF invested $8 million each into Berytech’s Fund II, Middle East Venture Partners’ Impact Fund, and Leap Ventures’ first fund, commonly referred to as the “Leap fund” (although the company doesn’t mention a name for the fund on its website). He says the bank also put a total of $4 million into the Cedar Mundi fund (a joint-venture between Kuwait’s International Financial Advisors KPSC and Spain’s Mundi Ventures SL) the Division I fund managed by B and Y Venture Partners and the Azure fund, the latter two of which do not seem to have yet publically launched. In industry parlance, BLF is a limited partner (LP) in each fund in which they’ve invested. The managers of each fund are its general partners (GPs). Outside of Lebanon, the horse betting analogy is apt. Limited partners have no influence on how general partners make investments. They put up the vast majority of a fund’s capital and then sit back to watch the race (which can last 10 years or more), hoping their investments come back in multiples. In Lebanon though, that’s not exactly the case.

[pullquote]Unlike most other markets, bank representatives sit on the boards of the funds into which they’ve invested[/pullquote]

A dozen or so commercial banks are taking advantage of circular 331 (which guarantees 75 percent of their investments into VC funds and startup companies) and are currently LPs in one or more of the local VCs. (As no database tracking 331 money exists, specificity is difficult.) Unlike in most other markets, bank representatives sit on the boards of the funds into which they’ve invested. Hajj explains that, because some funds have many banks as LPs (Berytech boasted 19 when it launched Fund II), not every LP has a seat, but all of the funds managing 331 money have bankers on their boards. He doesn’t specify how many boards BLF sits on, but does note it offers the bank at least a voice in decision making (a no-no in other markets, see PE law article). “We, as BLF, believe that being part of the board of directors is good for us to follow [up] on all these investments,” he says, noting that while a fund’s investment committee takes final, independent investment decisions, the board approves and can influence a fund’s general investment strategy. Not exactly as passive as our gambler. Nor, Hajj says, does the bank hope for a big profit. Asked what return BLF is anticipating, Hajj explains that a return of the initial investment makes it a successful venture for the bank. Though he points out that should the investment prove profitable, gains are split 50-50 with the central bank, not 25-75 the way the risk is divided. 

Off to the races

While Executive did not interview every bank making use of 331, BLF’s approach seems to be industry standard. Indeed, only three of the country’s banks are either known in the market to be direct investors or have publicly announced such equity participations. (Again, the lack of a database means these figures are based on Executive’s open source research and interviews, meaning there may be a direct bank investment or two we missed). Of those three, Executive was only able to arrange an interview with Al-Mawarid Bank, which got the 331 party started back in June 2014 by making the first compliant investment into Presella, an “online e-ticketing platform,” according to its website. Since then, Mawarid has made eight more direct investments (the value of which the bank did not disclose). Seven of them basically fell into the bank’s lap, explains Marwan Kheireddine, the bank’s chairman. In addition to being active in directly deploying 331 money, Mawarid has its fingers in a few more pies. Banque du Liban (BDL), Lebanon’s central bank, is giving 100 percent guarantees to Mawarid investments into the UK-Lebanon Tech Hub (UKLTH) – the result of a partnership between the central bank and the UK Government – as well as Bootcamp (which describes itself as the place “where ideas become startups”). Kheireddine explains that seven of the young ventures Bootcamp has worked with could not find the small ticket investments they were seeking, so Mawarid stepped in. (The bank provided a list of the companies it invested in but not the exact ticket sizes.)

These Bootcamp opportunities, however, may not be around for very long. Two new funds – Division I from B and Y Ventures, which Executive covered in April – and the Phoenician Fund I, managed by Phoenician Funds, will be focusing on seed investments. Phoenicia, however, will generally only invest in companies dealing with financial technology (FinTech), health care and e-government, explains Jad Salame, one of the fund’s five GPs. He notes the managers are open to opportunistic investments larger than seed and in other sectors. In addition to the two soon-to-launch funds, Kafalat is running an equity investment program (iSME) that is funded via a World Bank loan to the Lebanese government. Part of the program includes giving $15,000 grants (with no equity participation) to entrepreneurs directly as well as startups, explains Bassel Aoun, the project manager. Aoun says that since iSME began disbursing grants in Q3 2015, 46 were given as of May 24. While iSME’s website is not up to date (less than 30 grantees are listed), many grant recipients have also passed through Bootcamp, the UKLTH or Speed@BDD, an accelerator run out of the Beirut Digital District.

Outside looking in

[pullquote]Three of the country’s banks are either known in the market to be direct investors or have publicly announced such equity participations[/pullquote]

Raed Khoury, chairman and general manager of Cedrus Invest Bank, is taking a conservative approach to making use of 331 money. He says the bank generally would prefer doing a direct investment as opposed to investing in a fund, but notes he has not had the time to find the right opportunity. Khoury admits that lack of centralized data on new companies being created and deals being signed makes the task of finding a good investment more difficult, but he has no fear of missing out. Instead of rushing to enter promising companies as soon as possible (with the associated risk), he says he’d rather let the ecosystem develop more before jumping in. “I’d rather go at a later stage with a higher valuation and more visibility,” he explains. 

This article was amended on October 27, 2016. Executive misspelled the name of Phoenician Fund I and manager Phoenician Funds. We regret the error. 

Lebanon is being blessed with another proposed law, and several serious voices are intonating praise of the type of a minor doxology to the deities of capital. The new private equity draft law is designed to boost the – currently lacking – ability of fund operators to incorporate commercial entities that are best suited as establishments offering private equity and venture capital avenues. These establishments have hitherto been forced to function with difficulty because they had to rely on holding companies or other conventional formats instead of incorporation as firms with a general partner/limited partner structure.

Mohamed Alem, managing partner of the law firm Alem & Associates in Beirut, explains to Executive how and why his firm has approached the project of drafting the law. “Lebanon is not known to have an infrastructure on the legal level that encourages the creation of Lebanon-based private equity funds,” he says. “The purpose [of introducing the law] is to allow room in Lebanese legislation to permit the structuring of private equity funds, which are typically funds structures, obviously companies, in which you have a general partner and limited partners.”

According to Alem, Lebanon’s dated Code of Commerce, or legal framework for corporations and businesses offering the well-known société anonyme Libanais (sal) or société à responsabilité limitée (sarl) company forms, is not optimally suited to the tasks of giving investors enough minority shareholder protection, the fund managers the flexibility to make decisions, and provide the whole corporate structure with what he describes as “tax transparency”. This is an extremely important issue to address, he says, as for companies using the private equity funds structure “there should be no penalization from a tax point of view.”   

Whereas the common formats of incorporation such as sal and sarl according to the central bank  both limit shareholder liability to their capital contribution, they also give shareholders duties and rights that allow them to influence corporate decisions on the board level. Converse to that, the European continental format of the société en commandite simple (known as SECS or SCS in francophone countries and as KG in German speaking ones) distinguishes two classes of participants in the company, which according to Alem corresponds to the general partner/limited partner structure commonly used by private equity companies.

In private equity (PE) parlance, the general partner (GP) of a fund is the decision maker regarding the investments and manager of day-to-day operations. The limited partners (LPs), on the other hand, supply the fund with its ammunition – the cash needed for investments – and have certain expectations, namely to make a healthy return on their money.

The law is being commissioned by the Office of the President of the Council of Ministers – the prime minister’s bureau. The main driver behind the initiative is Lebanon for Entrepreneurs (LFE), a nonprofit organization that was established in 2013 and that, in the words of its managing director Abdallah Jabbour, supports legal reform and other measures that would be beneficial to the business community, with special emphasis on entrepreneurs and members of the Lebanese diaspora. “We started with 16 laws on our list in 2014, three of which we were able to pass successfully. We have been drafting several laws in conjunction with the prime minister’s office and advocating for adoption of some laws that have been sitting in various drawers,” Jabbour says.

The Lebanese private equity draft law will benefit the country’s economic community and more specifically, the group of financial actors that spend their time with the structuring and operations of private equity and venture capital funds. This funds industry is a highly skilled and specialized profession, with a handful of practitioners who contribute to wealth creation – firstly their own.

Confidence in confidence

What makes this a macro-economically interesting discussion is the disproportionately large growth of entrepreneurial companies that are taken forward by PE and VC funds. This is also the argument of Firas Safieddine, executive board member of the Capital Markets Authority. “As regulator we believe that the private equity law is a requirement to complete the ecosystem as regards to equity and capital markets,” he tells Executive.

Under this mandate, the CMA became a stakeholder in reviewing and assessing the draft law, which according to Safieddine was “beautifully written” but would need a further round of drafting and review. He expects that the law, once it is passed, would deliver a component to make the Lebanese scene more inviting for investors.

[pullquote]Firas Safeddine, executive board member of the Capital Markets Authority, expects that the law, once it is passed, would deliver a component to make the Lebanese scene more inviting for investors.[/pullquote]

He also admits that it is an “ambitious undertaking” to attract investment funds to base their operation in Lebanon, but chooses to see the cup as having room. “Optimistically, the private equity law is a major step forward in terms of creating more confidence in the market,” he says.

Building the ecosystem from a legal point of view will not only require the PE law but “many laws that need to be addressed and attended to,” he says, naming the bankruptcy law as an example for other needed legislations.

Since Lebanon does not have a setup where such funds could be incorporated, the law would close this gap, and the CMA would further contribute to building trust and developing capital markets. “We will be proving very soon that the CMA is a major source of confidence,” he states.

Safieddine’s belief extends beyond the PE law into a trust of being able to remedy a more fundamental disequilibrium: as general agreement goes, banking dwarves the financial markets, and he emphasizes that capital markets are so tiny in Lebanon that they are “negligible”. That needs to change and he points to the case of the United States’ post-recession recovery after 2008/9 as an indicator that equity-based economies recover more quickly from economic weaknesses. “We are heading towards shifting our economy from a debt-based banking reliant economy towards capital markets, an equity-based economy.”

Whereas Safieddine claims to have read studies that show how equity markets and growth of GDP are correlated one-to-one, the story according to other studies is more complicated and it is an open question if debt or equity are suitable as magic keys for economic growth. Post the Great Recession, academic opinions and empirical indications are against one-key solutions and more tending towards combinations, meaning that the financial secrets to best-possible growth scenarios will likely be different for different countries and economies.

The Bank for International Settlements (BIS) indicated as much in a research paper two years ago, finding wide diversity. “First, financial structure differs considerably between countries. The relative importance of banking ranges from less than 20% in the United States to over 60% in Austria, Hungary and New Zealand. Second, financial structure is not static. Market-based intermediation has gained ground over the past two decades,” it said in a paper published in March 2014.

Noting that market-based financial intermediation tends to increase as per-capita GDP rises, the BIS paper found that some industries in emerging markets tend to benefit from capital markets while others – like small firms and sectors with tangible and transferable capital (such as agriculture), as well as those where output is easier to pledge as collateral (such as construction), are more amenable to bank debt finance.

[pullquote]Recessions in countries with bank-oriented systems are three times more severe than in those with a market-oriented financial structure[/pullquote]

“The results of this paper confirm the widely accepted view that both banks and markets are very important for economic growth,” it said. “We also find that banks provide services which differ from those offered by financial markets and that such services prove to be particularly beneficial for less developed countries […] Finally, our evidence suggests that banks and markets differ considerably in their moderating effects on business cycle fluctuations. Banks are more likely to supply loans during a ‘normal’ downturn, thus smoothing the impact of the recession. But their shock-absorbing capacity is impaired when the downturn is associated with a financial crisis. In this case, recessions in countries with bank-oriented systems are three times more severe than in those with a market-oriented financial structure.”

A few hurdles yet to clear

Given the near two decade-long dormancy of the Beirut Stock Exchange in combination with the dominant role of bank debt in the domestic market, plus the inertia in the political and legislative class, it seems moot to debate whether the Lebanese migration toward capital markets will be a “shift” with rapidity, as the CMA’s Safieddine contends, or slow and gradual, or even more hesitant and not actually tangible, as some economists suspect. But the drafting of the PE law has already been remarkable, says Alem. Besides helping local companies, which previously had no choice but to take on debt, to tap into capital markets, the law in future “can attract foreign private equity managers to base themselves in Lebanon because of the modern legal framework,” he says.

The draft law for private equity was accomplished by a team at Alem & Associates that comprised two partners and two associates. By researching existing laws in Luxembourg and France and by adapting the draft from suitable European codes – a job that required about 240 hours of legal research and writing and was supported by three PE companies as sponsors which LFE could mobilize – the team developed a draft law that is at the forefront of such legislation for the entire Middle East and writs forth the pioneering business legislation in the same tradition by which Lebanon introduced the offshore corporate structure in 1983, Alem says.

LFE’s Jabbour agrees, emphasizing there is “no modern law for private equity funds in any country of the Middle East. If our law passes, it will be the most modern one in the region.” According to him, adopting such a law comes with positive implications not only for tech-oriented funds and investors in the knowledge economy but also for real estate funds and any area where separation of investors and managers of funds is desirable.

He acknowledges the pitfalls of acceptance by Parliament, such as the fact that no law of any sort is passed when the assembly does not gather. But once that barrier is removed, the private equity draft law stands a good chance of being adopted, he says. “Usually, passing a law faces little opposition when it does not affect the vested interests of politicians or groups,” he reasons. A combination of proper advocacy (he doesn’t like to use the word ‘lobbying’) and the absence of vested interests will help the draft pass into law at one (not yet determined) point, he hopes.

“We need a law that is flexible, that follows global standards and makes any investor feel comfortable,” he emphasizes.

In May 2016, rumors circulated that the largest banking group in Lebanon, Audi, had engaged in an exercise of tinkering with the possibility of relocating its corporate holding to a foreign jurisdiction. More tangibly, the bank released its results for the first quarter in 2016, showing lower assets and deposits when compared with the end of 2015 but a 10 percent year-on-year gain in profits. Executive sat down with Freddie Baz, the group’s chief strategist, to inquire about the group’s numbers, strategies and exercises in planning.

E  One reason why we felt the necessity to sit down with you at this time was to seek ultimate clarification of the rumors that Audi Group was considering a move of its holding.

I am not going to expand on this point. Everything needed as clarification was stated in our press release [see page 64]. It was very clear.

E   Looking at the results, there was a noticeable downturn in numbers at the end of the first quarter in 2016 when compared with the end of 2015. Can you explain?

A big chunk, albeit not all of [this drop] was due to currency movements, because we have a material presence in Turkey and Egypt. Sometimes there is some [foreign exchange] impact when we translate [all figures] into the national currency, which is the Lebanese pound, because the parent [company] is in Lebanon, but we express it in US dollar because of the currency peg.

E   But the Turkish lira did not drop much in the first quarter, or are we mistaken?

No, it was almost stagnant. What shows is that we have adopted a wait-and-see attitude in Turkey not only in Q1 but even in Q4 of 2015. We decelerated a bit. The prospects are still good. Turkey is an atypical case whereby the fundamentals are good, as seen by the improvement of the real sectors last year. They achieved 4 percent real growth, which is a very good performance as it represents more than two times the average GDP growth of emerging markets last year, excluding India and China. The very good performance does not only relate to growth. If you look at the debt profile, the fiscal balance to GDP is at a mere 1.5 or 2 percent – and the total debt to GDP [ratio] is within the Maastricht criteria (for EU economies). The concerns are only about the current account – which have also improved significantly, going down by almost 50 percent. So when you look at fundamentals, the country is doing well, but Turkey has a paradox. Its major weakness is [that they possess] zero oil and gas, so they have to import all their energy needs and [at the same time} it is an exports-driven economy. Thus they need to import the major inputs in exports, which is the most important driver of GDP growth. So there is some kind of dependence on the oil bill. This is a weakness which makes Turkey vulnerable from time to time, especially when the international environment is not supportive, such as the current one, which has been pervading for the last two years.

E   What pressures or non-supportive elements are you referring to?

The tapering and the Fed[eral Reserve’s] policy towards emerging markets which have led to many investments to exit emerging markets and return mainly to US markets. Turkey is very vulnerable. This, as I often say, is a weakness that is coming from a strength. Because it is an industrial country and Turkey’s exports are a major GDP growth driver, they need to import energy and are suffering from a structural current account deficit, which needs to be covered by short-term portfolio investments or longer-term foreign direct investments. If the international markets are not supportive, [Turkish economic players] can suffer some pressures on the real exchange rate, which happens from time to time – but they are wise enough to have implemented all kinds of hedge accounting.

[pullquote]The economic performance wasn’t achieved randomly. The GDP growth of 4 percent [in 2015] was supportedby more accommodating Fed policies.[/pullquote]

E   Does the Turkish scenario contain other specific challenges?

There are many pluses and minuses which are translating into a real sector which is performing well within the context of a currency which is drifting, in my opinion, with no fundamental reasons. I have to mention also the second vulnerability besides the capital account in an efficient market which translates into capital inflows and outflows and ultimately the exchange rate. But Turkey is also a very politicized country that is undergoing major structural political changes under [President Recep Tayyip] Erdogan as he wants to change from a parliamentary system to a presidential one. This is generating some domestic political tensions which are impacting the psychological dimension of the exchange rate. It is true that the exchange rate was at 1.70 (Turkish lira per USD) when we did our investment but the fair value at that time was [better than] the market rate. After the change in the international environment and the slight deterioration in the domestic political environment, the market rate closed the gap to the fair value and went beyond that. Today most knowledgeable market analysts put the fair value of the Turkish lira at 2.4 while the [exchange rate] is at 2.9. This means there is a markup of close to 20 percent because of the political volatility and that is too much.

E   How much of the political volatility and markup of the exchange rate vis-à-vis the fair value is in your opinion domestic and how much is related to international issues?

In my opinion it is today almost 100 percent domestic. The economic performance wasn’t achieved randomly. The GDP growth of 4 percent [in 2015] was supported by more accommodating Fed policies and the oil prices were at a level which was supportive for Turkey to significantly reduce its current account deficit, and, more importantly, the improvement in the eurozone, which remains one of the most important trade partners for Turkey, has all together supported the economic performances. What remains is the domestic political scene where there were two very sensitive points at the beginning of the year that were creating [political] volatility. One of [the challenges] was mostly solved through the nomination of the [relatively independent, experienced and well-liked] central bank governor. Also the renewal of positions of all the members of the monetary policy committee was carried out with people [who were accepted by the markets] and provided comfort and confidence to the market. What remains now is the regime change [and the questions related to the ambition of Mr. Erdogan].

E   Aren’t there also international issues, such as the row with Germany over a satirist’s words?

That is all part of the game. But in my opinion, 20 percent markup is excessive. One has to go to Istanbul and see the situation on the ground. People love to talk politics but at the end of the day there is a socioeconomic issue which is so large and so dense that there is some power of inertia in Turkey. I am telling you this because in the full year 2015, the [banking] sector achieved growth rates of major aggregates in two-digit territory, on US dollar adjusted basis.

E   So how did Odeabank perform in this context?

We have outperformed the industry by adding four to five bips market share in assets, loans and deposits. That means that our growth rate was higher than the average. These are five basis points, but it is a $700 million market. But in Q4 [of 2015] we said [to go slower] and we kept [that approach] in Q1 [2016].

[pullquote]You shouldn’t relate deposits to profits. You should relate deposits to spreads, which is the top line, not the bottom line.[/pullquote]

E   But as you said, the currency fluctuations cannot explain all the drops in your aggregates of Audi Group.

This brings us back to the first argument that we have been in consolidation mode in Turkey versus our traditional growth mode. In Egypt, we did grow but this was impacted by the heavy depreciation of the currency, and Lebanon did not achieve any significant performance. The end result was those slightly decreasing figures but it is not meaningful [to review performances] on a quarter to quarter basis. We have a budget to add $3 to 4 billion in the full year 2016 and we are confident that we will achieve it. Having said that, however, we have been able to increase our profits by ten percent.

E   Is it then naïve to think that growth in profits is correlated to growth in deposits?

You shouldn’t relate deposits to profits. You should relate deposits to spreads, which is the top line, not the bottom line. If you want to buy market share, it is at the detriment of your spread. It will ultimately impact your bottom line but it starts by looking at the top line. Our spreads have been improving and we haven’t been competing to get deposits. This explains to a certain extent this consolidation mode versus the growth mode, but is as strategic as growing your deposits base. We are very happy about our overall performance; it is true that we haven’t shown in Q1 important increases on the major aggregates on the group level, but when you look at the key performance metrics of the group, they all improved in terms of spreads, non-interest income generation and decreasing cost to income; and also you need to know that the 10 percent increase in consolidated profits do translate into similar trends in the positions of individual entities. The breakdown of consolidated profits over major development pillars – Lebanon, Turkey, Egypt, and private banking and other entities – shows a balanced contribution to the increase from all those pillars.

Although 2015 was a trying year for the Lebanese economy and tested many economic players beyond what they experienced in the already challenging year of 2014, the results of Lebanese banks were remarkably stable. It is notable that the consolidated market shares of alpha and beta banks maintained high concentration on the domestic side. Their domestic assets increased by 13.2 trillion Lebanese lira, accounting for over 95 percent of the growth in total assets.

The same is true for domestic deposits, which edged up 5.1 percent to over $151 billion, with the highest growth in percentage terms in lira-denominated deposits at 7.1 percent, down only 30 basis points when compared with 2014. Growth rates in foreign deposits, due to foreign currency developments, were down a multiple versus 2014, namely at 1.7 percent from 22.8 percent in 2014. This was reflected in the aggregate figures where the share of domestic deposits of overall alpha and beta deposits moved up by 50 basis points, in opposition of trends seen in previous years.

Lebanese banks in the two main size segments by deposits, the alpha banks with more than $2 billion and the beta banks with $500 million to $2 billion, account for over 95 percent of the sector. Bankdata, the consulting and analysis company covering the Lebanese financial sector, has consolidated the results of alpha and beta banks (14 alpha and 12 beta) for the past two years, illuminating their performance in a new and sharper light.

Overseas operations of alpha banks were stronger than those of beta banks as only two beta banks are active in markets outside of Lebanon. But the consolidated results reveal that alpha and beta groups together reached stable portions of approximately 82 percent of assets and deposits, 72 percent of loans and 82 percent of their profits in the domestic Lebanese market.

The profit growth rate of alpha and beta banks in 2015 was 7.5 percent, down 2.4 percentage points from the 9.9 percent growth achieved the year before. However, the growth rates of profits remained strong when compared with all other aggregates; growth in assets, deposits and loans were halved from the growth rates seen in 2014.

Beta banks, whose overall contribution to the consolidated aggregates revolves around 8 percent, saw an increase in their operating expenses that amounted to twice the increase in their operating income.

Of the total workforce of alpha and beta banks, 24,000 or about 70 percent, are active in the domestic market, compared with 10,000 employed overseas. Domestic recruitment was increased versus 2014. The concentration of bank branches is still in a wide range of less than 20 branches per 100,000 residents in outlying provinces to more than 80 branches per 100,000 persons in the Greater Beirut conurbation.

The overall bankerization rate of the Lebanese population is estimated by Bankdata to have reached above 70 percent. In terms of the outlook for network developments, we believe that there are still unused potentials for domestic rollouts, especially using advanced, diversified and innovative methods.

In review of the ratios reported by alpha and beta banks, liquidity is maintained at a high level in both the Lebanese currency and foreign currencies, mainly US dollar. Total net primary liquidity over deposits stood at 31.03 percent at end 2015, compared with 32.38 percent at end 2014. Portfolio securities over deposits increased to 40.97 percent. Collective provisions over net loans and operating expenses over average assets remained in the same ranges as 2014, registering 1.11 percent and 1.41 percent respectively.

Yield ratios on earning assets increased 7 basis points from 5.68 percent in 2014 to 5.75 percent in 2015, reflecting in stable interest margins of 1.97 percent and spreads of 1.89 percent. Asset utilization rates and net operating margins moved in narrow ranges, registering 2.83 percent and 35.08 percent respectively. The closely observed ratio for return on average assets (ROAA) remained unchanged at 0.99 percent while the return on average equity saw a marginal weakening from 11.35 percent in 2014 to 11.19 percent in 2015.

Bankdata notes that the stability of performance ratios and asset quality ratios is remarkable, given the overall market conditions and disruptive developments seen in 2015, and provide proof that Lebanese banks are resilient, run by bankers who are experts at what they do.

The introduction to this interview has been updated in response to the June 12 bombing of the Blom Bank headquarter branch in the Verdun district of Beirut. The original introduction began by noting the ire of Hezbollah party leaders in their reaction to the central bank’s early May decision (circular 137) ordering local banks to comply with a United States law aiming to isolate Hezbollah from the global financial system. The ire conveyed was that of political rhetoric and its acknowledgement is in no way an accusation of complicity at any level for the June 12 bombing. The views expressed in the interview, conducted in late May, also made no accusations of wrongdoing of any sort by Hezbollah in regards to American allegations or, to be clear, the recent targeting of Blom Bank. To better understand the nuances of compliance regulations at the technical level, Executive asked Chahdan Jebeyli, chair of the compliance committee at the Association of Lebanese Banks (ABL), who also doubles as head of compliance at Bank Audi, of the implications to banking of the US law, of institutional investments in compliance infrastructures and on the importance of maintaining partnerships with correspondent banks – those banks that facilitate a local bank’s transactions in the former’s jurisdiction.

E   Lebanon as we know it cannot exist without the banks, and the banks effectively cannot operate without connections to correspondent banks worldwide. In this sense, do you see compliance with the US law as a choice or as a must?

We, as Audi and we as banks, have committed to following international standards. We are living in a dollarized economy – the bulk of our transactions are in US dollars and cleared through the United States. When a transaction crosses a border and [is transacted in] the US, we become subject to their laws. This is the reality because the dollar is a key currency and because transactions in the world are in US dollars and they touch US correspondent banks. So because we are keen to maintain a position as a sophisticated and fair player in the global financial market, we respect the applicable laws. The key applicable laws, because of these reasons, are US laws – we are not talking about politics, this is a business and legal reality.

E   When you speak with other compliance executives at committee meetings of the ABL, is there concern in applying circular 137 or concern that there’s an impending disaster on the way akin to the forced closure of the Lebanese Canadian Bank in 2011?

Yes there are some questions and requests for clarification of some aspects of the implementation and because of the importance of the law and its implications, yes there is an increased focus on the subject – not at the level of the compliance officer but at the level of the banks’ management. This is a very important piece of legislation in the US with an important impact on us and on our customers and we care to preserve our image with the rest of the world and we care about protecting our customers without compromising our obligation to comply with the laws [and] do it in a way that is systematic with our local rules.

E   You word it as increased focus but does that mean executives in the banking community are worried?

No, I’m not losing sleep over this. I’m paying attention to the issue, of course. It is an important subject because we’re in the business of managing risk and when you have an item with such importance and implication for the bank and to the clients of the bank, of course we give it more attention than other things. I’m not trying to minimize the [issue] but I’m saying it is important to the US, it’s important to us, and it’s important to our clients.

E   The rules that the US Treasury Department published to implement its law say it is looking at major transactions and that the Americans are not targeting Lebanon’s economy or the banking sector. But at the same time when the Treasury sanctions an individual or entity they do not provide the evidence justifying their action. You don’t necessarily know why the Americans say this entity is bad but that one isn’t.

To me, I think we don’t need to know the why. I follow the law, the official process. I read the Simpson designation which said they had reason to believe that Lebanese Canadian Bank was a primary money laundering concern. To me, I would differentiate between the fact (and I don’t know exactly the facts) and the lesson you learn out of stuff like this. In the Lebanese Canadian Bank case they raised two issues: one being management complicity – and of course I’m not saying there was management complicity – but in terms of what I need to pay attention to as a prudent banker; and then they spoke of insufficient controls.

And you always ask yourself whether you have sufficient control, and I think our response to all of this is to continue to strengthen our compliance program, that we continue to give assurances to ourselves – our boards, our management, to our shareholders, our employees – that we are managing our compliance program efficiently and prudently so we can continue to maintain partnership with our correspondent bank. Not only do I need to pay attention to my standards but to comply with the standards of the correspondent bank. That means a successful continuation of correspondent banking relationships, which in turn means that we’ll continue to exist and prosper and continue to support our clients in their dealings with the world.

E   KYC (know your client) due diligence might be especially important to the correspondent banks in New York. Have those institutions reached out or been in contact for reassurance that Lebanon has the compliance structure in place and that all applicable rules and legislation are implemented?

They are dealing with our client, who they don’t know, and they rely on us to make sure that the transaction passing through their channel is in compliance with our rules and with their own. That’s why our central bank issued circular 126 [in 2012] which says that we need to respect the foreign laws of the countries where we do business or have transactions. And actually circular 137 refers to [circular 126]. So it means that if I’m doing business with a European client, I have to clear with a European bank paying attention to European laws. If I’m doing a business transaction in dollars, because those clear through the US, they touch the US and become, consequently, subject to US laws and I have to comply with and observe those laws.

E   In terms of opportunity cost, the individuals or entities that may come into contact with, may be linked to or may be directly connected to Hezbollah, might be blocked from accessing whatever banking service, product or financing. In aggregate, can this segment of the economy be quantified to say that this amount of business cannot be facilitated by our banks because the risk is too great?

I don’t have a view on the quantity [or] on quantification of income. All I can tell you is that we apply the law to the extent that is needed for the purpose of meeting our commitment to ourselves, our shareholders, our regulators, and to the global community.

E   Central bank rules and the anti-money laundering legislation passed by the parliament, as well as the latest circular, have added additional layers of compliance reporting requirements. Do you see the cost of compliance becoming prohibitive for Lebanese banks?

If it is a cost that is required by legislation and it’s a cost that you need to invest in for the purpose of continuing business successfully, or if you want to invest in systems for the purpose of improving your control environment, you must do this. With the investment in compliance, in human resources or otherwise, we’ll continue to make money. The challenge, however, is not to make money but to make durable income – income that you make and keep and don’t pay back as a matter of penalties or litigation. It is a cost and a necessary investment that we need to engage, and have, for the purpose of our continuity.

E   For Bank Audi, as Lebanon’s largest bank, these kind of costs can be absorbed. But are there concerns, maybe from a smaller bank, that might say ‘listen we can’t do it on our own, the investment threshold is simply too high’?

Yes, it’s manageable [for Bank Audi]. But providing compliance services is just not doable. This is a commitment of the management of each bank, and also there are regulations that prohibit banks from outsourcing main functions. There are discussions on the increasing costs of compliance, not just in Lebanon but across the world. Of course it is a bigger challenge for smaller banks than for bigger banks but it seems that the situation is still manageable. You cannot really compromise on [compliance] requirements for the purpose of saving money because you may end up paying a more expensive price. Compliance failure, if it is serious enough, could affect the franchise – it depends on the situation. That’s why this is essential spending, this is money well spent.

E   Can you point out how much investment this has required?

There has been an important cost increase but we never question if we should or should not spend. We spend as much as we need for the purpose of continuing to preserve our standing as a compliant banking industry. In compliance there are two risks. There is the risk of making a mistake and there is the other risk in missing legitimate opportunities because of being too conservative or because of insufficient knowledge. I don’t have exact numbers to give you, but is [investment in compliance] significant? I think so, and necessary.

Executive sat with the governor of Banque du Liban (BDL), Lebanon’s central bank, Riad Salameh, for updates on the banking sector, the results of the central bank’s monetary policy, the stimulus of the knowledge economy – known as Circular 331 – and the response to latest foreign initiatives, namely compliance with the United States’ Hezbollah International Financing Prevention Act.

All indicators, Salameh says, point to a continuation of slow economic growth in the country. One challenge to the economy is the low demand of consumption and credit, weakness offset by the central bank’s stimulus plans and incentives that directly contributed to growth rates in the targeted sectors. He tells Executive that the central bank will issue two new circulars to complement its May 2016 decision compelling local banks to comply with a US law meant to isolate Hezbollah from the global financial system. The Special Investigations Commission (SIC) will issue a circular requiring banks to detail justifications for the closure of any account. The Banking Control Commission (BCC), meanwhile, will also issue a circular concerning debtor’s accounts [i.e. those with a negative balance]. The balance of any forcibly closed account – whether positive or negative – must be addressed.

E   In all your statements you point out that Lebanon’s banking industry is still very healthy. What are the major developments, if there are any, relating to the growth of the sector and what would be the policies in order to amend or improve these ratios?

The growth of deposits is an important indicator as the Lebanese economy relies on remittances to fund the private and public sector. The central bank monitors closely this development and we can, in our assessment, look at the underlying base. That underlying base has been constantly increasing and therefore the percentage of increase is not really meaningful, it’s the amount that is being added to the liquidity of the country that is more important. Obviously, the remittances were affected by the low oil prices in 2015, and by the decline in commodities in general, as most of the remittances come from either the oil producing countries or from Africa. The increases last year were around $8 billion, which is lower than the previous year but enough to fund the public and private sector, especially since we saw a decline in the demand for credit from the private sector. For 2016 we expect the same amount and so far it is progressing in that sense. The country is liquid and today banks have excess liquidity. The issue is that we don’t have demand on credit, meaning enough to offset this liquidity.

E   But commercial banks’ lending opportunities to the private sector seem subdued. Why is that in your opinion?

The credit policies of the banks, and you see it from advertising, is still in force with the same energy. But today you have to recognize there is less demand for consumption and for investment.

E   Several circulars have been particularly impactful to the economy: the limit on borrowing by necessitating consumers to downpay 25 percent (from 2015), and those circulars seeking to inspire economic growth in areas ranging from renewable energies to creative industries and the arts, not to mention the stimulus package. How are these developing in 2016?

The general guideline and the target of the central bank is to increase local demand. We are in an environment where there is a slowdown in all the countries around us, and the reliance on external input to the economy has decreased. This is due to the political and security conditions in the area but also, again, due to lower liquidity because of lower oil prices. The incentives we are putting in place, we believe, are yielding results because today 67 percent of the growth rates of the country are directly linked to these incentives. Therefore, as long as we can increase the local demand without creating inflation or threatening the stability of the currency, the central bank will pursue these policies.

[pullquote]We have shown that the monetary initiatives, although non-conventional, have had results.[/pullquote]

On consumer debt, preemptively, we wanted to have more equity involved when there is a consumer debt and that is to protect from excesses or bubbles. Today, [households are] dedicating almost 44 percent of income to servicing their debt and we believe that we are close to a ceiling after which there will be social problems in that debt. The consumer debt in general represents 20 percent of the total portfolio of credit in the banks, and it is important to also be prudent so that we don’t have, in the future, failures in that sector that could affect the sustainability of our banking sector.

E   In the absence of fiscal policy in Lebanon and knowing that medium to long term monetary policy takes time to have effect, to what extent does the central bank have a margin of maneuvering in impacting the Lebanese economy with its monetary policy?

We have shown that the monetary initiatives, although non-conventional, have had results. Financial inclusion has developed and also the number of accounts dealing with banks exceeds today [one million accounts]. Credit has been spread to the community and you have today whole sectors relying on these credits that we initiated. Since 2008 most of the world’s central banks have been trying to stimulate their economies through monetary policy and they undertook non-conventional initiatives. The [European Central Bank] is buying all types of papers just to inject liquidity, even corporate papers. The [United States’ Federal Reserve Bank] has done it before, and they even bought companies. The Bank of Japan is buying shares. Of course adequate fiscal policy is helpful for the economy but the role of the central bank as of today is to try to avoid collapsing into a crisis.

E   Is it correct that the transformation of the Beirut Stock Exchange into a joint stock company is imminent, and does the central bank have a specific view of measures that are in support of developing capital markets in Lebanon, such as the drafting of a Private Equity Funds law?

The government under the recommendation of the minister of finance has asked the [Capital Markets Authority (CMA)] to prepare the first step changing it into a joint stock operation, which we are in the process of finalizing and then it will be up to the government to see how they’re going to do that privatization.

The CMA, on another course, had prepared an electronic platform for trading and it is intended that that platform be operated by the private sector. The advantage is that this platform will be accessible worldwide [so that] all the Lebanese diaspora can invest in the Lebanese markets. Both markets, the stock exchange and the electronic platform, will be monitored as per the law by the CMA which will guarantee transparency and good governance. The final package is not yet clear but ideally what we will try to do is a joint privatization for both entities in a way that the stock exchange in Lebanon will be under one umbrella and not have two exchanges competing.

[pullquote]The central bank by law does not interfere in business decisions or business activities. We provided an engineering approach that is a legal one to create funding for this sector[/pullquote]

E   Critics of circular 331 say that the equity guarantee initiative should only be used for investments in very high-risk seed investing into idea-stage startups. Some say fund managers cannot identify promising entrepreneurs in this category and are therefore not using the guarantee as intended. Also, some argue too much 331 money is being spent in London, here specifically talking about the UK Lebanon Tech Hub. What is your response to criticism directed at 331?

The central bank by law does not interfere in business decisions or business activities. We provided an engineering approach that is a legal one to create funding for this sector. The markets will decide how they invest. But what we have seen so far is that the banks have already committed and invested around $300 million in various funds and companies. The accelerators are needed in order to make this a success and that’s why we give a guarantee. Whether the companies will sell into London or the US is not an issue for us as long as the company that is profiting from the funding engineered by [the central bank] is a Lebanese company. If they are not taking funds from 331, we cannot oblige people to be in any place. We’re trying to create jobs, this is the only aim we have, by creating a new sector that would enrich all Lebanon, so one should not ask the central bank to go and organize that sector – it’s not our role.

E   Stepping back to the beginning of May just after circular 137 was published, there were reports in the media that some banks had closed the accounts of several Hezbollah MPs as well as affiliated organizations. Your mid-May statement clarified that banks will need to justify why an account was closed. Are reports accurate then that a new circular will complement 137, and, if so, what will the clarifications be?

The central board [of the central bank] dictates the policies that the banks have to follow based on [its] prerogative as determined by law. The board cannot ask to look at names because of the bank secrecy law, so the SIC will complement that circular by asking the banks prior to closing accounts to submit a file to the SIC – which has the right to look at names and cannot be opposed by banking secrecy. That file has to be documented by the activity in the account and the [know your client (KYC), due diligence] of the account. The SIC will look into that matter – there is a timespan of 30 days. If there is no answer [from the SIC], the bank will act on its own responsibility.

The BCC will also issue a circular on how to treat the debtor’s account that could be closed. If there is a dispute, the higher banking court will take the final decision – its decisions cannot be challenged. The aim is first, as we stated, to implement [the US] law locally. Two, is to be fair and don’t commit, without study and justification, financial exclusions.

Of course there are protests about [complying with the US law], but our concern is to protect the interests of Lebanon and to keep the integrity of our dealings with external banks.