In the foreseeable future, the cost of banking security is set to rise. A bewildering number of legal and regulatory initiatives are almost certain to drive costs higher for banks and their clients in virtually all jurisdictions, with special emphasis on the Middle East.

The prospects of unavoidable higher spending on banking security refer not to needs for safeguarding authorized access to an online account, nor the cost of protecting banking customers against the theft and abuse of their card information; the real booster of banking security costs originates from the fear of terrorism and will likely entail the banks being obliged to carry out much greater scrutiny of their customers’ transactions.

In regulatory initiatives relating to the issue of cutting off terrorism financing, the United States and Europe are currently upgrading their arsenals of demands on the finance industry. These initiatives include proposals by the US Financial Crimes Enforcement Network (FinCEN) to require broader licensing of prepaid card issuers and ongoing European debates on a new European Markets Infrastructure Regulation (EMIR) on trade in derivatives and commodities.

Then there is the extension of the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (USA PATRIOT Act), in which three tools of supervision were set to expire at the end of May. The US Congress’s extension of these enforcement powers was described as a done deal, with an agreement to keep debates to a minimum as Executive went to print.

The USA PATRIOT Act — passed in October 2001 in a vote carried out while America was still reeling in shock from the September 11 terrorist attacks — is not only one of the most contrived linguistic constructs of the epoch, it is also named with one of the most fitting terms from an American perspective: it wholly serves US interests to the potential detriment of others, including banks, as recent experience has shown.

For banks, however, probably the most consequential proposed revamp of regulations currently in the works is the discussion of updating the Financial Action Task Force (FATF) Special Recommendation VII (SR VII), which covers wire transfers. The FATF is the global community’s hammer to drive home anti-money laundering (AML) measures and to counter financing of terrorism (CFT).

If proposals to upgrade SR VII are adopted in 2012, banks could be required to not only perform checks on those sending wire transfers, as is the case today, but also demand and verify information, including address and birth date, on the beneficiary of a bank transfer under the AML/CFT standard for cross-border wire transfers.

As the FATF invited consultations, industry groups such as the International Banking Federation (IBFed, at its core a meta-association of G7 banking associations) sternly warned that such changes to requirements “are very likely to entail massive costs”. IBFed and a number of other stakeholders also expressed grave concerns over a probable explosion in the number of “false positives” — wrong AML/CFT flags.

The Association of Foreign Banks in Germany admonished, “our experience has not shown that screening transactions against sanctions lists containing mainly long Arabic-sounding names has led to successful tracing of terrorist financing transactions” [the emphasis is from the association’s own documentation].

From a vantage point in the Middle East, two elements in the current push for expanding controls are not surprising, but nonetheless deserve to be pointed out: (1) Although discussions on issues like the FATF regulations are nominally inclusive, the drivers of the initiatives are what once was called the first world; (2) in about 400 pages of comments on the FATF proposals, no banking association or federation from any Arab country was heard to voice a comment on banking requirements that could become  very costly and would be difficult to implement for banks in this region.

Indeed, only one individual bank with Arab identity submitted comments in response to the FATF consultations (which will go into a next round in July): BLOM Bank Jordan, which stated its position, and effectively represented the whole Arab world, in a two-page letter.

It’s not often that Executive speaks with Lebanon’s Beta Banks, but their unique operating conditions can give them varied insight into Lebanon’s banking future. This month we spoke with Tarek Khalife, chairman and general manager at Credit Bank, to get his perspective on these rough economic times.

• While lending activity may have increased in the first quarter of 2011, it grew at a slower pace than the last quarter of 2010, and loans to non-residents were much higher. How has the political stalemate impacted lending to residents?

The growth of loans seems to be subsiding and this is related to political uncertainty. People are pulling back on investments, pulling back on importing and on increasing their turnover. It is normal in this situation; it is a hesitation period. There is also a lack of performance on the banking sector side. Certain banks have grown significantly dependent on easy assets such as treasury bills. It takes time to develop a lending machine that can grow. There is a learning process that requires time, effort and experience. When it comes to non-resident lending, real estate is a main investment for non-residents and accounts for almost 85 percent of the whole banking sector.

• With the economy slowing, the deficit growing and no end in sight for the debt problem, how long can you keep lending to the government at rates of around 7 percent without incurring substantial risk and continuing to drag down your ratings?

The regulators seem to know exactly what to do. The regulator has done a wonderful job of stabilizing the currency exchange rate and continues to support and guide the sector toward a competitive and healthy benchmark in the region. The sector has had outstandingly healthy growth in the last two years of crises. Unfortunately the political turmoil that continues to plague the country has not allowed the state to benefit from all this extra liquidity that was attracted into the sector. The state could have financed its much-needed infrastructure projects and banks would have benefited from diversifying their investments into projects of privatization and infrastructure with good return. On that level, the state has come up short and on another level the uncertainty caused by a void in government has begun to stunt the growth of the sector.

• In the present climate, what do you think the next Eurobond issue will look like as we already see upward pressure on interest rates from political instability?

New bond issues by the state risk having a lower return for subscribing banks. However, the state has a stake in maintaining those subscribing banks’ interests; local banks have become partners in financing the state deficit and will continue to carry a good chunk of the internal debt. Although at this stage in the game most banks need the issue as much as the state needs the issue, political correctness dictates that the drop in rates would not be extreme. There is always oversubscription to all the issues that have been launched. I believe the state could manage to drop the rates dramatically but I think we will only see a modest drop.

• Popular opinion seems to be that Riad Salameh is the only man for the job of central bank governor; are there not others who are qualified enough?

If this is a hypothetical question, no one is indispensable. I think he has unmatched experience that very few people around could claim today. However, the overriding issue is that we have a specific situation in Lebanon—highly technical in fundamentals and highly complex in market perception—and the governor and his team have mastered it. The team at the Central Bank has experience managing crises that very few people in the world have. It goes against all international norms to have someone in such a position for such a long time, but again it would not be wise to change horses in the middle of a race. This is not the time to reengineer something that is working.

Akl el-Helou’s farm has grown beyond his wildest expectations. Just outside of Jbeil in Hosrayel, it is a far cry from how it looked in 1989 when it was ravaged by the Civil War. Helou did not have much to his name after he lost over $80,000 in equipment and contracts with Gulf countries but he had an idea: broccoli. He obtained a $34,609 loan from Kafalat, a government subsidized loan program, in 2005, and used it to rent additional land at high altitude, in Laqlouq, for summer production, as well as set up greenhouses. According to Helou, since obtaining the loan his profits have increased by 40 percent. But stories like Helou’s may be fewer this year as Kafalat lending has taken a southerly turn.

Today, Lebanon is mired in an ongoing political crisis; the situation is reflected in the country’s economy as well as in Kafalat. “It’s a wait-and-see attitude of some banks in respect to the political situation,” said Freddie Baz, chief financial officer at Bank Audi. 

This certainly seems to be the case, according to recent figures published by Kafalat.

Loans to small and medium-size enterprises (SMEs) under Kafalat’s guarantees fell to $41.9 million in the first quarter of 2011, down 9.5 percent from $46.3 million at the same point a year before. The total loan guarantees totaled 301 year-to-March in comparison with 392 during the same quarter in 2010. The average loan size, however, reached $139,183 compared to $118,173 in the first quarter of 2010. 

While Mount Lebanon received 44 percent of the guarantees, the South and Nabatieh follow with 21 percent. The North received 16.3 percent, the Bekaa 12.3 percent and Beirut 6.6 percent.

The industrial sector accounted for 40 percent of total guarantees, agriculture 37.2 percent, tourism 19.3 percent, specialized technologies 2.3 percent and handicrafts 1.3 percent. 

Kafalat loan guarantees had increased by 42 percent in 2010, said Khater Abi Habib, Kafalat’s chairman, in an interview with Executive in March 2011. “Economic and political conditions affect the market, and they affect us,” he said, but declined to offer an explanation for this year’s drop. With the current political stalemate and the economy slowing, SMEs’ situations are vulnerable.

“When it comes to investment, people are cautious,” said Walid Raphael, general manager of Banque Libano-Francaise, adding that investors require visibility in terms of economic and political development. According to Saad Azhari, chairman and general manager of BLOM Bank, people are not encouraged to start new businesses in an environment without growth. As many industry voices have noted, Lebanon’s economy is threatened by both internal and regional instability.

For new, innovative companies to emerge, strong and diversified funding must be available; with new public sector initiatives on hold until at least a new government is formed, this will only be done through the commitment of private funds. As May came to an end, the lack of risk appetite in the market likely had much to do with the lull in Kafalat lending, offering perhaps the most simplistic demonstration of how political stagnation can cripple a country’s productivity.

What is Kafalat?

Kafalat is a private financial company owned by the National Institute for the Guarantee of Deposits and by about 40 Lebanese banks. Kafalat loans receive a subsidized interest rate and are financed by the Lebanese Treasury and administered by the central bank. The program aims to support young entrepreneurs, helping SMEs to receive loans from commercial banks, by providing them with loan guarantees. The candidates are required to submit a feasibility study and business plan for their project, which has to fall within the industry, agriculture, tourism, crafts and technology sectors.

Out of the 14 private banks doing business in Syria, Lebanese banks comprise a third, with five helping to spearhead the establishment of this sector over the past decade. Those Lebanese banks operating next door are: Bank Audi Syria (BASY), Byblos Bank Syria (BBS), Bank of Syria and Overseas (BSO), Banque Bemo Saudi Fransi (BBSF), and Fransabank Syria (FSBS). Lebanese banks have been amongst the highest earners in the Syrian financial market, leading the sector in asset rankings since its inception. Since protests broke out in Syria, however, the double-digit year-on-year growth seen by the above banks has been curbed.

The initial reaction of the market was a withdrawal of assets by individuals and foreign businesses alike, to the extent that for a few days in early April there was a limit set on permitted withdrawals. Nonetheless, the financial market is stabilizing with the efforts of the Central Bank of Syria and some private sector businessmen connected to the regime, who have been compensating for the liquidity withdrawn from the market by foreign investors.

Chairman of the Union of Arab Banks, Adnan Yousif, said to the Syrian Arab News Agency  in mid-April that the monitory conditions in Syria, along with the banks, were faring well, noting that major withdrawals had halted. He added that the financial market was not affected by the past few weeks of protests and that banks had confirmed their assets had not been affected.

Yousif said, “We saw some withdrawals from banks in Syrian pounds, which were later changed to dollars, yet this was a small [amount] that does not exceed 8 percent [of total consolidated assets].” He added that an injection of liquidity into the market by the Central Bank of Syria had mitigated the drop in the Syrian pound, which began the year at 46.8 to the United States dollar and stood at 47.5 as of May 25. Nonetheless, first quarter figures make Youssef’s comments appear selectively optimistic, showing that the financial sector was indeed affected, exemplified by a drop in the assets of the leading private banks — all Lebanese.

BBSF, the leading bank by assets, witnessed assets shrink over the last quarter of 2010 by 7.7 percent, from $2.44 billion to $2.25 billion, while BASY, the second leading bank in asset rankings suffered the most, with an 8.5 percent drop, from nearly $2 billion to $1.82 billion.

BSO, the third bank in rankings, which had earned a number of countrywide and regional awards in 2010, suffered a milder drop of 4 percent, from $1.96 billion to $1.88 billion.

It is notable that BBS, contrary to other banks, exhibited a 4.5 percent increase in assets, from $0.91 billion to $0.95 billion; bank sources wishing to remain anonymous alleged this was due to the personal consequence of one of the Syrian investors who has a substantial share in the bank. 

Yet, this does not reflect the current day-to-day reality of the Lebanese banks, or private banks in general, operating in Syria. The protests gained momentum after March 25, only a week before these first quarter figures were released, so the full effect of the unrest was not reflected; second quarter results, however, will be much more telling of the damage done, and the direction of the Damascus Stock Exchange (DSE) is likely a good harbinger of what is to come.

The DSE weighted index suffered a 19 percent drop over the last three months, from 1721 to 1394 points, despite intervention and the halting of trade for several days. The shares of Lebanese banks suffered as well, with BBSF dropping 33.5 percent, BASY down 20 percent, BSO down 17 percent, and BBS dropping 14 percent, trading of its shares having been suspended from mid-March until early May. Conversely, FSBS shares increased by 83 percent, only because it was recently listed on the market, which automatically made it a viable investment in the eyes of the market, as nearly all newly enlisted bank shares are.

Damage to banks’ books will not be limited to direct business losses but will also stem from indirect effects rippling through the economy. The Organization for Economic Co-operation and Development downgraded Syria’s country risk rating from 6 to 7 in late March, making investors even more hesitant about the prospects of doing business in the country. Further, the tourism and travel economy in Syria, accounting for 12 percent of Syria’s GDP and employing 792,000 people, has also taken a major hit [see story page 50].

The Syrian regime is taking some steps to try to stabilize the financial market, from increasing interest rates, to allowing foreign currency accounts and decreasing the compulsory reserves private banks are required to keep in the Central Bank. In addition, the issuance of Law 29 in February allows companies to buy their own shares on the DSE.

But with no resolution to the protests in sight, the fragile economy of the country is bound to hit new lows. The newly found financial sector, a less than a decade old private banking sector and a two-year old stock market are bound to suffer. And with the Lebanese banks already well established and leading the market, there is no clear exit-strategy.

Assets

Share prices

Since the end of the civil war, Lebanon has developed a relationship between its economy and banking sector that resembles an old beat-up truck carrying a heavy load on a road to nowhere. The banks keep the truck (in this case the economy) running with the money they pump into the gas tank. In return, the driver (the government) agrees to take on a heavier load of debt as he drives the economy aimlessly toward a destination of which even he is not really sure. Whenever the truck slows down everyone gets worried that it has finally given out and the price of gas to keep it going will be too high for the driver to pay. When that happens the mechanic, in this case the central bank, comes along and makes an arrangement with the government and with the banks so that the fuel can be afforded. So far the arrangement has kept the truck running. But the further the truck travels, the more beaten-up it becomes, and the less it delivers to its owner, the people.

“The system is not creating jobs,” says Jad Chaaban, acting president of the Lebanese Economics Association (LEA) and assistant professor of economics at the American University of Beirut, in relating the banking sector’s contribution to GDP. “Its creating consumption but this is not sustainable because there are no jobs and the incomes to finance it. It’s just creating a debt cycle.”

An economy of consumers

At the end of the first quarter, Lebanon’s commercial banks held $30.9 billion in loans to the private sector and $28.2 billion in loans to the government, according to Banque du Liban, Lebanon’s central bank.

Since gross domestic product is comprised of several components, it can be calculated either by looking at expenditure (the sum of consumption, investment, government spending and net trade) or various income approaches. But because Lebanon’s lack of accurate or timely GDP statistics on many of the elements needed to compute output using the income approach is useless as a basis for analysis. The only way to make an assessment of how banks contribute to the economy is to consider how the money they pour into the country affects the elements of the national accounts — the numbers that come together to make up national output or GDP — using the expenditure approach.

Lebanon calculates national output by adding consumption, gross fixed capital and changes in inventory (in other words gross net investment), and exports, then subtracts imports from that figure. Looking at the last available national accounts from 2009, consumption accounts for $32.45 billion, equal to 92 percent of total GDP at nominal prices that year. Gross net investment, by comparison, totaled $11.98 billion, equivalent to just 34 percent of nominal GDP.

Effectively, that means Lebanon’s economy is heavily dependent on how much it can consume.

Consumption requires income, which comes primarily from wages, as well as remittances, which came in at $8.2 billion last year, according to the World Bank.

Official employment figures are scant and widely believed to be inaccurate; figures on wages are pretty much non-existent, but one does need a job to have a wage. In this regard the banks do not contribute as much as is popularly thought; the Association of Banks in Lebanon puts the number of employees in the banking sector at 27,268 in 2009, the latest figure available. Total wages and allowances during that year came to $732 million, or just 2 percent of nominal GDP during the year.  Indirectly, however the banks’ private sector loan portfolio supports different sectors that spur some consumption and investment.

“We play a major role. Lending for the economy is like blood for life,” says Freddie Baz, chief financial officer and group strategy director at Bank Audi.

The latest available figures from the central bank for how loans are split up in the financial sector date to the end of 2010 and were released in May; total loans to the private sector from the financial sector were $38.7 billion, up from $31.56 billion a year earlier. Of that figure, 77.68 percent of the total number of borrowers had taken out individual loans.

The LEA’s Chaaban explains that the predisposition toward consumption is a matter of a glass being “half full or empty” — Lebanon needs consumer spending to spur confidence but at the same time the banks have become “almost partners in setting up fiscal policy,” and have an interest in seeing consumption in the economy maintained. According to Baz and other bankers Executive has spoken with, loans go to the economy according to its structure. At present, the economy is not just heavily tilted toward consumption but also consumption of imports as well as goods and services produced by specific sectors.

“[Banks] play a major role. Lending for the economy is like blood for life”

You are what you fund

Economies are defined by their primary, secondary or tertiary activities. Primary activities are those that produce raw materials and basic foods whereas secondary materials use the former to produce finished products. These first two activities are commonly agreed to be characteristics of classical productive sectors. Tertiary activities are those associated with the services sector and in developed economies account for the overwhelming majority of jobs. 

According to the 2009 national account, the proportion of loans given to what economists label as “productive sectors” is scant at best. Agriculture and livestock made up 4.8 percent of output ($1.7 billion at nominal prices) that year, constituting a 6.9 percent real contraction, while industry made up only 6.4 percent of output ($2.6 billion at nominal prices), also falling 4.2 percent in real terms. The only secondary productive sector that saw an increase in output was construction, making up 13 percent of output ($4.7 billion at nominal prices) constituting a real expansion of value-added by 10 percent. 

Assuming that the economy is relatively similar a year later, the first discrepancy with regard to the allocation of loans to sectors according to their output is obviously the loans to the government to finance the public debt, which currently stands at more than 130 percent of GDP. Government expenditure constituted 9 percent of output in 2009 ($3.16 billion at nominal prices), an expansion of 8.5 percent on the year previous.

More is not spent on much-needed public services and infrastructure for several reasons, including the government’s inability to pass a budget for the past six years, the large fiscal burden for civil service employee salaries, and predominately because the government has to pay its interest on the public debt, which is majority-held by the same local banks that dole out the loans.

One also notices that loans to construction constitute 16 percent of total credits to the economy ($6.3 billion), which is roughly the same as output. If one considers all the elements of the real estate industry together (construction, real estate rents and housing loans) the figure rises to 35 percent of total loans ($13.6 billion). This, however, could be an oversimplification of the sectoral risk the real estate sector poses — especially given the recent decline in retail prices — because a housing loan is backed by a real asset, requires a significant down payment by the buyer and the amount of refinancing on retail property is ostensibly nothing compared to that seen in US when the housing crisis triggered the global financial crisis in 2008.

“The process of building is development but the process of selling is different,” says Marwan Iskandar, economist and chairman of Banque de Crédit National.

Even so, walk by any construction site in Lebanon and one will notice that the majority of workers are not Lebanese. Stroll into any real estate broker’s office, however, and the opposite is true. Since most construction workers are paid off the books and breakdown figures for real estate jobs are not published, it is difficult to gauge how many jobs are being created for locals and what the net income effect on the economy is for the sector that can go to construction.

The only indicator is the national accounts, which showed the output of the construction services sector to be some $398 million at nominal prices in 2009, below 10 percent of nominal construction output for that year. Ergo, the net effect on job creation, and thus local wages and the economy, is presumably much less than in a country that employs local labor in that sector.

Those who are quick to accuse the banking sector of not creating jobs often point to their contribution to the tertiary sector. “Does a large farm produce as much as two expert doctors?” responds Iskandar rhetorically to the idea. “Jobs, maybe more so. But if you are concerned about the national income you have to weigh these things. Is it really a good thing to employ many people who produce a little, or a few people who produce a lot and then allow you to invest because their savings go into facilitates? This is debatable.”

“You don’t decide if its sustainable and neither do I. History will always tell if it is sustainable or not”

Make up the breakdown

But even so, here the loan breakdown formula propounded by banks doesn’t make much sense: total contribution of market services and trade at nominal prices in 2009 was $20.6 billion constituting 59 percent of the total. If transport and communications are added to this figure it becomes $23.3 billion or 66 percent of the economy. Loans to “trade and services” at the end of 2010 came to almost $14 billion, or 36 percent of the total. Adding financial intermediation and “others” — which includes health, social work, defense, public administration and regional organizations — that figure increases to just 48 percent.

The difference between the bankers’ formula relating to loans and output can be explained by the loans that go to individuals. In total at the end of last year $9.1 billion went to individual loans (including housing loans at $4.5 billion) making up some 24 percent of the total. This allows for further consumption that is not predicated on actual labor and output. “The banks also give interest on deposits, mostly to consumers, which also inflates the GDP,” says Chaaban. 

How productive that money is for the economy also depends on how it is spent. “If you buy cars and homes then, yes, you are contributing. But if one takes out a personal loan just to have a good time then not really,” says Nassib Ghobril, head of economic research and analysis at Byblos Bank. 

What is certain, however, is that the loan portfolio of banks is heavily skewed toward consumption. This inherently creates a problem for output because when import prices rise — as is the case presently because of rising commodity prices — GDP suffers as people’s ability to consume decreases but their dues to the banks stay the same.

Moving away from such a model will require concerted public policy and regulation to steer the economy toward a model that can produce locally and shield the economy from external shocks.

“Today in Lebanon, increasing the job component of growth can only be possible by shifting our growth model from internal demand as a major driver to external demand,” says Baz. “If the Lebanese economy is a tertiary activities economy and a services industry economy, it is not up to us to make miracles and shift it overnight to a manufacturing economy… It’s like a tanker — when you want to change the direction it takes time.” 

How long it will take, if that is even the intention of Lebanon’s so-called economic policy makers, is as unclear as the still non-existent government’s policy of job creation. In the meantime, the banks will likely continue to contribute to the economy in the same way they have since the end of the civil war. As for the Lebanese, it also seems they will have to wait and see if the system is maintained or, perhaps at their own accord, it eventually crumbles.

“You don’t decide if its sustainable and neither do I,” says Baz. “History will always tell if it is sustainable or not.”