With praise from international media raining in for his steadiness at Lebanon’s financial helm, Executive sat down with Central Bank Governor Riad Salameh to discuss the current and future state of Lebanese Banks.

E  As a foil to the rest of the world, Lebanese banks have actually struggled to find profitable uses for their excess liquidity, especially in local currency. Do you believe that the banks have enough tools to keep this liquidity from becoming a burden?

Well, as you know, the amounts that came to the banking sector after the collapse of Lehman [Brothers], and between September 2008 and July 2009, were very large amounts compared to the size of deposits already existing in the banking sector. Plus they were mostly converted into Lebanese pounds. It is normal that the banking sector can’t find immediate use for such amounts when they total around $16 billion. The credit market in Lebanon usually increases by $2 billion to $3 billion a year.

So the central bank issued 5-year certificates of deposit (CDs) in Lebanese pounds in order to mop up some of that liquidity, and the

Ministry of Finance also issued more treasury bills in Lebanese pounds than needed, in order to keep discipline, prevent bubbles, speculation and inflation. And this money will be gradually used again in the economy in Lebanon.

Therefore, we have to face the positive aspect of not having been touched by the crisis and embrace the confidence in our system, and we thought that it was an opportunity for Lebanon to receive and keep all these funds, as there will be a need for them in the future, whether to finance the public sector or the private sector.

E  Why did the central bank stop issuing five-year CDs?

We have issued circulars to enhance credit in Lebanese pounds and we have given incentives to lend for housing without placing price ceilings, so you can now see the banks competing to lend money at rates that are around 5 percent for medium-term [loans].

We have also given incentives for the financing of new projects, not only those covered by the previous circulars, which means that any project besides industry, tourism, agriculture, or technology that is launched between now and June 2010, and we’re going to extend it until June 2011, will be able to be funded with low rates of interest. We have also launched student loans and  environmental loans using those same incentives.

Given this package, we thought that we had to leave some liquidity in the hands of the banks in order to motivate them to lend according to these circulars. As we look forward, we can have good growth in 2010 if the credit activity is maintained and intelligently directed. So, the markets started to find a certain equilibrium despite the fact that we stopped these CDs.

We still had conversions from dollars to Lebanese pounds. We still had a balance of payments that showed a positive balance of $6 billion by the end of October, which is a record for any year in Lebanon for the first 10 months. Therefore, we thought that we can now afford now some gradual decrease in rates.

Nonetheless, if we see that our management of the liquidity in the market requires us to reenter by selling CDs, we will do that, and we have announced that we might come back with 7-year and 10-year maturities.

The idea is to acquaint the market with longer maturities in Lebanese pound denominated papers, and that the government later on can also issue bonds for 7-year and 10-year maturities in Lebanese pounds.

By extending the maturities on debt we will have less pressure on the refinancing of that debt on a yearly basis, and that will help maintain a more acceptable structure of interest rates.

E  As interest rates decline, do you expect the dollarization of deposits to remain around 66 percent?

We think the market is keeping that ratio. This is one of the equilibriums that we are starting to see. And today we have approximately $27 billion in liquid foreign currency on our balance sheet at the central bank, which is also a historical high. This means that out of the capital inflows coming to the country, 66 percent remain in dollars, while the rest are converted to Lebanese pounds. We find that it’s up to the market to define the equilibrium, but I believe we have seen the markets at this level for the past three or four months.

E  Both the prime minister and the finance minister have stated that they are keen to implement Paris III initiatives that include raising taxes on interest earned in local banks from 5 to 7 percent. Do you think this will actually happen in this government’s term?

The tax on the interest on deposits is not, I think, a priority for the time being, especially in that this tax was envisaged before the international crisis. And even though it is presented as a law to be voted, there is an understanding that this cannot be implemented before we have stability in the banking sector worldwide and in the region.

The tax approach is also not the priority, as I understand, because the priority is going to be given to more growth in the economy and to fix activities that are creating large deficits for the government, like Electricite du Liban.

Anyway, the government is presently discussing the economic program that they want to present to the Parliament or at least a declaration on that, and we will wait to see what will be approved. But I know that growth is the priority and for that, everything is going to be done to facilitate growth.

E  You’ve been successful in swapping the short-term debt for long-term debt with more maturity. How do you see Lebanon coming out of its debt situation?

Our priorities really are to reduce the yearly deficit because the present stock of debt that is in the market is perfectly sustainable, due to the high liquidity that we have and also to the increased confidence in the financials of the country. As you can see, the credit default swap that is quoted internationally for Lebanon for the past five years has declined to reach 2.3 percent, at certain times it was at 7 and even at 10 percent. So there is demand on the Lebanese paper, and interest rates in the secondary market have substantially decreased.

The future expectations of inflation are going to diminish the real value of that debt, which is stated today at around $48 billion. And the present value or the real value of that debt will look less important in the next four or five years, as the purchasing power of currency is going to be depleted worldwide. So what the market requires are signals showing that the deficit is declining, and for that purpose we hope that the originators of this big deficit be addressed in the reform program of the government. The most important sector to reform is the energy sector in general and electricity in particular.

We have to wait for the government declaration in order to see if the program of privatization is going to be implemented fully or partially and in what ways.

E  In light of the likelihood of the dollar decreasing in value, is the central bank changing the ratio of its foreign currency reserves?

No. We have the same ratios because we intervene in US dollars, so by departing too much from our structure of reserve in the dollar, we will incur risks on the Forex markets, dollar vis-à-vis euro or sterling or yen, which is not good for a central bank.

We cannot be speculators on the exchange markets, but we have created a model that preserves the real values of our reserves and don’t forget; the central bank, on its balance sheet, has a large stock of gold that represents around 30 percent of that balance sheet today. So the country is well hedged against any future development in terms of inflation internationally or a weaker dollar if this trend continues.

E  Is the devaluation of the dollar going to help us get to a higher balance of payments now that our exports are going to be more attractive?

You know, the dollar is decreasing in value against all of the currencies and most economic activity, whether in terms of production or services, is dollarized. This gives a competitive advantage to the country. And we have seen that in the correlation between the growth in the economy in Lebanon and the decline in value of the dollar. Of course we are talking about the economy in general. We are not talking about savings and the purchasing power of savings but this is an issue that concerns the people, the owners of capital, not the central bank. At the central bank, we have a diversified portfolio in terms of currency. We have a large stock of gold. But our transactions will remain related to the US dollar as long as the markets are dealing in that currency. If the markets change to another currency, then we will change as well.

E  To what extent are banks in Lebanon compliant with Basel II?

They are fully compliant to the criteria of Basel II; the solvency ratio in the country is around 12 percent. As you know, most banks worldwide are struggling to get to 8 percent, which is the norm. And this 12 percent is by applying all the criteria of Basel II. We are also working on the governance issue and on the risk and transparency issues along with the banks. We issued circulars in that regard and we have created, at the central bank, a unit for good governance that is going to work in the field to make sure that good governance is implemented, and we will start by a strict analysis of the composition of the board of directors and their prerogatives in the bank’s management.

The group is within the central bank so effectively it will give its recommendation to the governor. The governor will present it to the central board and there will be a decision that has enforcing powers. This is a follow-up activity, nonetheless there is also the banking control commission that is empowered and has the teams that are in the field working to see how our circulars are being implemented in the banking sector.

E  The sentiment at the Union of Arab Banks conference in November was that Basel II is insufficient to prevent a crisis like we are seeing right now from happening again. Do you agree with that?

The crisis happened after Basel II had been approved, so Basel II is not enough to prevent a crisis. Here, we added to Basel II the liquidity factor that did not exist before. So in Lebanon, the banks have to constitute a liquidity of 30 percent on their balance sheets, 15 percent as a reserve requirement with the central bank and 15 percent on their own books. The fact that we have low leverage and high liquidity has helped the sector refrain from going into adventurous credit, and Basel II is more on the capital side than on the liquidity side. So it has to be developed more. Anyway, Basel II is just guidance because the major countries did not even implement it, like the United States or India. There is no better protection for a bank than its management because they know what is really happening in the bank, and for a banking sector, the local central bank should be aware and prudent, to moderate leveraging in the sector.

The banking sector remained the backbone of the Lebanese economy in 2009. Bank assets are equivalent to 334 percent of gross domestic product and deposits are equivalent to 274 percent of GDP, among the highest such ratios in the world. The sector displayed its resilience to global financial shocks and domestic political instability, and proved it can finance the private sector while supporting the public sector’s needs at a time when governments around the world have been forced to bail out their banking systems. But, with the rapidly changing global and regional financial landscape, the sector is likely to face new challenges in 2010.

A spotlight on risk management

The credit crisis has revealed glaring gaps in risk management, as banks around the world learn that underestimating liquidity creates severe systemic risk. Commercial banks in Lebanon have a fiduciary responsibility to conserve capital, safeguard deposits and minimize depositors’ risk. In the current climate, most Lebanese banks have focused on increasing liquidity, minimizing risks and increasing quality assets. In the past, risk management at many commercial banks consisted primarily of reassuring large depositors that their money was safe during the political instability and security shockwaves that have characterized the Lebanese economy. Indeed, the structure of bank deposits is concentrated, as between 70 and 80 percent of deposits are held by 20 to 30 percent of depositors. Thus, reassuring large depositors that their money remained safe was the main risk management approach of banks. However, with the regional expansion of banks in recent years, there has been an evident focus on developing advanced risk management systems. This trend has accelerated since the global crisis erupted.

The crisis has clearly reflected the fact that the size of financial institutions is not the most relevant criteria for gauging security, as some of the largest global commercial and investment banks aggressively expanded their balance sheets at the expense of proper risk management, with disastrous results. The larger Lebanese banks are likely to focus increasingly on risk management, internal auditing and corporate governance and transparency, rather than on the aggressive expansion of the balance sheet.  Those who still favor size over more fundamental issues are likely to be more affected by regional developments due to their increased exposure and aggressive risk taking.

Regional expansion, under caution

Lebanese banks have embarked in recent years on a cross-border expansion strategy to take advantage of new markets and to diversify their assets and revenue base. Lebanese banks are currently present in more than 20 markets through about 70 branches, affiliates and sister companies, not only in the Middle East and North Africa, but also in sub-Saharan Africa, Eastern Europe and Central Asia.

The global crisis led banks to take a wait-and-see approach by consolidating their positions and assessing their exposure in the markets where they are already present. But with global and regional conditions stabilizing, and Lebanese banks emerging largely unscathed from the crisis, they continue to lend abroad. Most of them will follow a more cautious approach, while they resume their operational expansion in existing markets. However, regional expansion inevitably has its risks, as one Lebanese bank tested positive to exposure to the Saudi Arabian Saad and Algosaibi conglomerates that defaulted earlier this year. Also, the recent announcement by Dubai World that it is requesting a debt standstill on its obligations and that it will restructure its liabilities, in addition to pre-existing crises like the defaulting investment firms in Kuwait, reflect existing regional risks and are a reminder to Lebanese banks about the need to remain cautious. Furthermore, the slowdown in regional economic growth increases the risk of non-performing loans. Still, Lebanese banks have the liquidity, experience and skills to decide when and where to expand in 2010.

Deposit growth remains a double-edged sword

Early concerns about the impact of the global financial crisis on deposit inflows to the Lebanese banking sector turned out to be unfounded. Indeed, while the growth of deposits slowed down and displayed some volatility in the fourth quarter of 2008, there were no material deposit outflows from the system. The first nine months of 2009 saw unprecedented capital inflows to the sector, with private sector deposits growing by a monthly average of $1.5 billion in the first three quarters of the year and averaging a more impressive $1.8 billion in the third quarter of 2009. Indeed, private sector deposits have grown by 17.2 percent from the end of 2008 and by 21.6 percent year-on-year, with non-resident deposits rising by 40 percent year-on-year. The massive inflows are attributed to the resilience of the sector in the face of the crisis, but also to the interest rate differentials on dollars and Lebanese lira deposits at local banks compared to global rates. Furthermore, the relative political stability in the country since June 2008 encouraged depositors to convert their funds into Lebanese lira to take advantage of higher interest rates, leading to a marked decline in the dollarization rate of deposits from 77 percent at end-2007 to 66 percent at end-September of this year, a still elevated rate. Despite the slight reduction in deposit rates earlier this year, interest rates on deposits in Lebanon are unlikely to decline substantially until the structural imbalances represented by the high fiscal deficit and public debt are addressed, and until long term political stability is sustained. As such, banks are likely to continue to attract deposits, but since part of these deposits is speculative in nature, they will face the challenges of the high cost of funds as well as volatility and the risk of outflows from a potential revaluation of risks for the region as a whole. 

What goes up…

Banks have been faced with a high level of liquidity in both the national currency and in foreign currencies, with not enough outlets to place this liquidity since the start of the crisis. The certificates of deposits issued by the Banque du Liban (BDL) to absorb local currency excess liquidity and its measures to encourage lending in Lebanese lira have helped somewhat. But the sector’s cautious lending approach, fewer lending outlets abroad, record-low interest rates in global money markets, the decline in demand from the non-resident sector and the high cost of funds are likely to combine and affect the banks’ profits this year. To be sure, banks will continue to be profitable in 2009, but the growth rate of their profits will be slower than the 25 percent rise posted last year. Moreover, the profitability ratios are likely to stagnate, as the sector’s average return on assets reached 1 percent as of July 2009 relative to 1.1 percent in 2008, while the average return on equity was 13.9 percent in July on an annualized basis relative to 14 percent in 2008.

An optimistic outlook

The ratings on the long and short term foreign currency debt obligations of Lebanese commercial banks have long been constrained by the sovereign ceiling. Indeed, international rating agencies have argued that the banks’ exposure to the sovereign continues to keep their ratings at the sovereign level, even though rated banks are well managed, profitable, liquid and well capitalized. But recent trends and a closer analysis of the banks’ sovereign exposure warrant a different conclusion. The consolidated balance sheet of commercial banks shows that the banking sector’s exposure to foreign currency denominated sovereign bonds was at $11.7 billion at end-September, which accounts for less than 11 percent of the sector’s total assets. Further, the sector’s total exposure to the public debt in Lebanese lira and foreign currencies accounts for less than 25 percent of the sector’s assets, which is slightly lower than the banks’ lending to the private sector that represents 25.4 percent of the asset base. Rating agencies consider the banks’ reserve requirements at the central bank as part of the sovereign exposure. However, BDL places these reserve requirements in the global money markets, similar to what the banks do themselves to the 15 percent liquidity requirement on their foreign currency deposits. More importantly, the BDL has not utilized these reserves to maintain the stability of the currency and its reserves have reached the equivalent of 100 percent of GDP. So it is not clear why rating agencies continue to consider reserve requirements as part of the sovereign exposure. The share of foreign currency sovereign bonds to the sector’s assets is likely to decline further, depositors have proved to be resilient to domestic political shocks and external financial shocks, and the banks’ share of revenues from foreign operations is increasing as a share of total income. As such, it may be time for rating agencies to reconsider their ratings of Lebanese banks to a level above the sovereign, even though it is way too premature for any Lebanese bank to claim regional status.   

Nassib Ghobril is chief economist and head of economic research & analysis at the Byblos Bank Group. He recently received the World Lebanese League’s award for “Best Economist in Lebanon & the Diaspora for 2009”

Makram Sader Secretary general, The Association of Banks in Lebanon

We have good trends in terms of increases in our deposit base, in terms of increases in our credit portfolio, in terms of liquidity ratios and even in terms of profits. We hope these trends will continue in 2009. My opinion is that they will continue. It seems logical that these positive trends will continue during 2010 because with the current political stability in the country, due to the newly established government, we hope the level of activity will increase, and maybe we will even see the initiating of some big public projects. Any new activity, either public or private, usually translates into increased activity within the banking industry. I hope that we will have a higher volume of credit. It will be very good for us to continue this year’s poitive trend of a yearly 20 percent increase in deposits.

Marwan Barakat Head of research, Bank Audi

While a large number of governments around the globe have intervened recently to support their banking systems — either in the form of liquidity facilities, emergency lending programs, capital injections or acquisition of toxic asset portfolios, or maybe a combination of all such support initiatives — the Lebanese banking system has been, on the contrary, supporting the State of Lebanon prior to, and in the aftermath of, the eruption of the global financial turmoil. As a matter of fact, the Lebanese banking system has almost doubled in size during the past five years, over a period characterized by erratic political and security developments. Its capacity to finance the government’s borrowing needs has been recently fostered by an outstanding resilience to the external crisis environment, with funding growing at an unprecedented pace within the context of massive capital inflows towards Lebanon’s financial system, encouraged by the domestic regulatory framework and the conservative practices of Lebanese banks themselves.

Within such an environment, I do not personally believe that the Lebanese banking sector will be looking to the new national unity government to support Lebanese banks in 2010, but rather to ensure a sound environment for its own public finances as a step on the road to a fiscal soft landing. It is always important to recall that the observed Lebanese banking resilience to crises is not equivalent to permanent financial immunity in a country that is still suffering from significant structural imbalances. To reinforce the Lebanese resilience to crises, drastic structural reforms need to take place by the Lebanese state in an attempt to ensure a soft-landing scenario for its own public finance conditions that remain shaky and are where the main vulnerability lies. It is then that we can comfortably say that Lebanon and its financial sector could be a unique model of immunity serving as a viable example to a large number of countries in the region, in the emerging countries’ arena and across the globe at large.

Francois-Pascal de Maricourt Chief executive officer, HSBC Lebanon

When you are working in an environment like Lebanon, where you have crises from time to time and where the local banks have proven to be resilient, your first priority is to ensure that you have enough liquidity. A bank doesn’t close because it has made a loss; a bank closes because it is short of liquidity. The top priority for a banker, and this is true across the world, is to ensure that your balance sheet is structured well enough so that you will not have a liquidity crisis. And this is even more prevalent since the beginning of the financial crisis. We saw some major institutions that had to be saved at the very last minute by some governments because they were short of cash. If I were the CEO of a [Lebanese] bank, clearly my priority would be to ensure that it has sufficient liquidity so that in the event of a crisis, it can meet all its commitments. When it comes to profitability, the profitability of local banks is relatively acceptable. Some of them are now able to get a return on liquidity in the region of 20 percent plus, which is quite good, and the profitability is something that you access over the length of a cycle. You can’t just look at the profitability in one year and say, this bank is profitable or not, as there are years when you make more investments than other years, and you have to remember that local banks are investing quite heavily in some markets.

Walid Raphael Deputy general manager, Banque Libano-Francaise

Here [in Lebanon] the system is extremely resilient, given the strong banking sector that has shown its ability to endure over 15 years of war, the assassination of Prime Minister Hariri — which was an earthquake in Lebanon — and the war in 2006. When the crisis came at the end of 2008, the banking system had already been tried several times and the banks’ confidence was extremely strong, so that what we have seen is contrary to what is going on outside of Lebanon. We have seen an inflow of money coming at the end of last year. This in fact has continued this year. The question that some analysts were asking last year was “Will we have the same level of remittances?” and in fact the remittances were not affected. We are expecting to have $7 billion in remittances this year, which is very close to the number we saw last year.

The reason behind this year’s success in banking and the mood of Lebanese bankers can be summed up in one word: confidence.

“If depositors lose confidence in their bank, they will lose confidence in all the banks in the country,” said Chairman of the Banking Control Commission Walid Alamuddin in a speech to the Union of Arab Banks at their yearly conference in Beirut in November.

Not only have depositors shown up in record numbers this year, but due to a seemingly irresistible interest rate spread, they have also converted their deposits into local currency at unprecedented rates — creating a challenge for bankers used to a highly dollarized balance sheet.

Overall deposits into Lebanese banks increased 21 percent in the first nine months of 2009 compared to the same period of 2008, totaling $92.2 billion, according to the Association of Banks in Lebanon (ABL). Lebanese lira (LL) deposits saw a 55.6 percent year-on-year increase by end-September.     

High deposit conversions have been heralded as proof that nationwide faith has been restored in the LL, as dollarization of deposits dropped to a nine-year low of 65.9 percent at the end of the third quarter, according to Bank Audi.         

“It is important because the Lebanese [lira] is regaining its role as a stock of value as a deposit currency,” said Marwan Barakat, head of research at Bank Audi.

But only time will tell whether these overwhelming conversions were truly a vote of confidence in the local currency from Lebanese depositors, or simply the product of a large spread between deposit rates in LL and United States dollars (USD).

At the start of the year, the average interest rate on LL deposits was 7.22 percent, while USD deposit rates averaged 3.31 percent. Dollar deposit interest rates have dropped steadily since the end of 2007, losing 153 basis points in 22 months. Lira deposit rates, however, did not follow this trend as strictly, losing just 46 basis points over that same period. This has created an interest rate spread of 378 basis points at end-September 2009: a significant increase from the 361 point spread between the two currencies in the same month in 2008.

The LL deposit rate has been dropping ever so slowly from 7.22 in January to 6.94 at the end of September, most likely because of market pressure and recommendations from the International Monetary Fund and the ABL, the latter of which actually recommended in October that a ceiling of 7 percent be placed on LL deposit rates. But the spread between LL and USD rates is still enticing, and it remains to be seen whether the Lebanese predilection for extremely gradual change will end up costing its banks.

IMF interest U-turn

Walid Raphael, deputy general manager at Banque Libano-Francaise (BLF), said that the slow drop in the LL deposit interest rate is likely due to interbank competition and an unwillingness to put profitability before growing customer bases.

“[It is] maybe because they are fighting for market share,” he said. “We might see a change and a stronger reduction in interest rates on deposits in Lebanese [lira] by next year. But you have to keep a spread between the dollar and LL to maintain the attractiveness of the LL.”

The IMF’s November 2009 recommendation is particularly noteworthy here, as it is a shift from their earlier position. Since there is a need for high liquidity in local currency, due to Lebanon’s high public debt, the IMF had said in an April 2009 public information notice that, “Given heightened near-term risks, directors agreed that there is little scope for lowering interest rates over the coming months.” 

Perhaps in light of the overwhelming deposit conversions and surprise excess of liquidity in local currency, the IMF changed its position in its November country report, stating, “In the near term, interest rates should be allowed to decline further, but at a gradual pace.”

Where the lira is lagging

The USD remains the preferred standard of deferred payment. Dollarization of loans has been holding strong at 85 percent for almost a decade, which presents a problem when the funding side of the balance sheet switches to local currency.

Private sector loans grew 11.4 percent by the end of the third quarter, growing by $2.8 billion, down from $4.4 billion in growth for the same period of 2008, notwithstanding this year’s high liquidity and corresponding flexibility. However, despite the steady dollarization rate of loans in Lebanon, LL lending accounted for 29 percent of the loan growth in 2009, compared to 12.3 percent lending in LL in 2008.

Most of this can be attributed to the central bank’s actions in July and September, lifting reserve requirements on 60 percent of lending categories in order to incentivize local currency lending and absorb some of the banks’ excess liquidity.

Before the release of these circulars, banks were required to keep 15 percent of their local currency in the central bank at zero percent interest, making lending in LL even more expensive. The change lifted this requirement to the tune of approximately 60 percent. This allowed banks to lower LL lending rates to around 5 percent interest; enough to offer some attractive new products in home loans, car loans, education loans, some industry-related loans and green initiative loans. The measures were almost immediately touted as successful, but lending continues to be relatively low.

The September 2009 spread of USD to LL average lending rates was the smallest it has been since December 2007, at 198 basis points, with the LL rate at 9.22 percent and the USD rate at 7.24 percent.

The central bank circulars allowed certain loans to drop to around 5 percent interest, which is where most of the LL lending has taken place. But, despite the uptick in local currency lending, BLF’s Raphael still believes that more needs to be done, including searching for new markets.

“The problem with Lebanese banks is that the size of their assests is three to four times the size of the economy,” he said. “So the banks are very liquid and we need to find good opportunities to lend. This is why we are growing out of Lebanon. This is why we are trying to find new markets.”

Alpha banks’ rankings as of end-September 2009 (in $millions)

Narrowing options and dwindling returns

Treasury bills and certificates of deposit remain the primary methods of putting local currency liquidity to use; 85 to 90 percent of Lebanese liquidity is absorbed using these tools.

But the weighted average yield on LL treasury bills has been decreasing fairly steadily since the start of 2009. T-bills carried a 9.01 weighted average interest in January, which decreased by 22 basis points to 8.70 in September 2009.

Yet, despite these declining interest rates, monthly issuance for September 2009 reached its highest in nearly two years, with 2,289 bills issued over the month, marking a 58.6 percent increase on the same month of 2008.

This hike in the popularity of T-bills is no doubt due to the disappearing options to earn on local currency liquidity. Until July 2009, the central bank was offering 5-year certificates of deposit, which capped at a yield of 9.25. But, after issuing an equivalent $6 billion in certificates of deposit, this option was dropped by the central bank when the circulars lowering reserve requirements came out, in order to encourage lending.

“This should push banks to reduce interest rates on deposits, which was happening a bit, but not as much as it should,” said Raphael. “So right now banks are still paying high interest.”

Nowhere to go but down

The coming year for Lebanon will be all about the balancing act.

“We are not a charity organization, but we are not opportunistic. We are somewhere in between,” said Freddy Baz, chief financial officer and strategy director at Bank Audi.

In 2010, as international interest rates are predicted to stay low, industry experts say that Lebanon should follow suit. And Lebanese banks are set to lower interest rates even more: a move that may affect their precious liquidity.

“If these low levels of interest rates continue to prevail in 2010, our bankers will lower the domestic structure of interest rates to avoid losing money,” said Makram Sader, secretary general of the ABL. “Our bankers are managing the interest rate structure to maintain some spread between the domestic rates and the international rates. But we are seeing a gradual decrease in the interest rate and I expect, if the international rates stabilize where they are now, to see a lower differential.”

But again, Sader warned that this change would be gradual: “It is much more complex to manage a decrease of interest rates than it is to manage an increase.”

With the brunt of the financial crisis bested by the end of 2008, all Lebanon had to fear was the aftershocks of everyone else’s financial earthquake.

Lebanese bankers dodged the bullet of the sub-prime fallout and, under strict regulation from the Central Bank of Lebanon, avoided the structured products and derivatives that melted balance sheets all over the globe. But, in January of 2009, the worry was that lowered wages and layoffs in the Gulf and Europe would hurt the remittances and capital inflows on which Lebanon’s banks depend.

“When we started the year, the whole world was speaking about the effect of the collapse of different investment banks and the collapse of the markets that happened at the end of 2008, and the effect they would have on the negative growth that was happening in the world,” said Saad Azhari, general manager of BLOM Bank. “In Lebanon there was talk about how many Lebanese were going to be coming back to Lebanon, how the remittances were going to be less compared to years before. The fears did not materialize.”

Capital inflows have been healthy and deposits surprisingly robust for the first nine months of 2009. Cash flowed into Lebanon seemingly unabated this year, despite the fears of bankers and economists. According to Bank Audi, capital inflows reached $14.38 billion for the first nine months of the year; a 25.9 percent year-on-year increase.

This saw total bank assets climb to $109.9 billion at the end of September, a 16.6 percent increase over the same period last year, according to the Association of Banks in Lebanon (ABL).

Many see this trend as a vote of confidence in Lebanese banking.

“The money that came was from Lebanese,” said Azhari. “Those Lebanese used to believe that if they put part of their money in the Gulf or in Europe or elsewhere, it was security for them…because Lebanon was unstable. Now those Lebanese saw that…Lebanese banks are very stable and resilient. [The banks] gained their confidence and they moved their money or they opened new accounts to put their money here.”

On top of capital inflows, the balance of payments’ surplus reached a record high of $4.84 billion for the first nine months, already higher than the full year 2008; a feat that Makram Sader, secretary general of the ABL said is not only due to the restrictive policies of the central bank.

“It is not only that we are under strict prudential rules on behalf the central bank and the banking control commission,” he said. “Lebanese banks have been conservative in nature, they are known for their conservatism and this is why they tend to maintain high liquidity. They don’t engage in excessive leverage. They are all…deposit-rich banks, where the ratio of deposits to total liabilities is 82 percent, which is one of the highest ratios in the world.”

Still on planet earth

Even with the remarkable performance of Lebanese banks this year and despite statements to the contrary from the industry’s top experts, the banks have seen minor effects from the crisis.

“Where it hit us was more at the level of operating conditions, than at the level of business growth,” said Freddie Baz, chief financial officer and strategy director at Bank Audi. “Because we are operating in a dollarized economy and we have significant foreign currency deposits, we had to keep at all times, by all means, an ample liquidity in foreign currency. This is a major business parameter.”

Lebanese banks also felt the devaluation of the dollar acutely at the beginning of 2009 and took action to counter its effects.

“We were hit by the drastic decrease in the dollar’s reference rates, which reached close to zero,” said Baz. “So we got an important hit on the yield of our primary liquidity in foreign currency. For the whole industry, I think we suffered a little bit less than $1 billion of forgone income this year, due to the drastic decrease in the London Interbank Offered Rate (LIBOR), which affected the yield on the primary liquidity of United States dollars deposited with corresponding foreign banks abroad.”

The banks faced this problem with cost-cutting measures, “which made us look similar to banks operating in the environments under stress, at a time when the Lebanese environment was doing well,” said Baz.

The dollar rallied somewhat, and the cost-cutting measures were successful enough to put the banks back on track for the rest of 2009. 

As a further effect of the crisis, Lebanese banks naturally saw a decrease in return ratios, with a 0.61 percent year-on-year decrease in returns on equity and a 0.07 percent decrease in returns on average assets, fitting with the global trend of narrowing returns due to the crisis.

Banks’ deposits and credits in LL billions

Treasury bill yields

Any growth is good growth

The detractors of shrinking returns and expensive liquidity led to only modest growth in profits for 2009, explained Walid Raphael, deputy general manager of Banque Libano-Francaise (BLF). 

“What is happening is that it’s much more difficult to grow the profits of a bank, and the reason behind it is the fact that we have attracted this liquidity; it costs a lot of money but it’s not easy to use it,” he explained. “Every dollar in profit that came into the balance sheet was nearly a loss because [it was replaced] by [interest paid on] deposits. The spread is a loss. This is why it was very difficult to maintain the same growth in profitability this year.”

Profits for Alpha banks were up by 9.2 percent for the first nine months of the year, reporting aggregate profits of $912.8 million: a definite decrease from the 44.6 percent growth reported in the first nine months of 2008.

Lebanon’s top five banks saw varying levels of profit growth this year ranging from 3.5 percent growth to 21.3 percent growth in net profits. Byblos Bank was the leader for the first nine months of 2009 with 21.34 percent growth in net profits, totaling $95.95 million. Bank Audi, the leader in the amount of net profit, saw a 17.8 percent growth, bringing the bank’s net profits to $212.75 million. BLOM Bank posted net profits of $205 million, a 3.5 percent year-on-year growth. BankMed reported 8.6 percent growth in profits amounting to $76.5 million, and Fransabank saw 12.5 percent growth for $74.8 million.

“In effect, the mere fact that Alpha banks attained positive growth in profitability in such turbulent financial times is yet another indicator that Lebanese banks have insulated themselves from the negative repercussions of the crisis,” said Bank Audi’s Lebanon Weekly monitor.

But the moderate growth in profits, despite healthy deposits, has raised questions as to the priorities of Lebanon’s bankers.

“I think banks have been focusing too much on growing their balance sheets and less on profitability. If they decided to look more at their profitability, they have the means to increase their spreads and make more money,” said Raphael.

According to Baz, this trend is the will of a socially conscious sector.

“We are bottom-line driven, but ultimately we are not driven only by profitability to the detriment of the intermediation function we have to ensure in our market, in order to promote economic growth that will improve standard of living and welfare,” he said.

Still, BLF’s Raphael believes that the instinct to encourage deposits and maintain liquidity ratios may be walked back due to international market pressure.

“I think the markets will push us to do something about it,” said Raphael. “If in the second half of 2010 you start seeing an increase of rates by the [US Federal Reserve], we will start making more money on our liquidity.”

With lessening returns and expensive deposits, non-interest income — meaning commission fees and capital markets income — is becoming an increasingly important contributor to bank profits.

This year, banks saw a 21.9 percent increase in non-interest income and just 6.4 percent growth in interest income, according to Bank Audi. The increase in non-interest income is the result of both an overall increase in banking activity and the physical growth of the banks.

At the end of September, Lebanese banks had a total of 873 branches, 40 of which opened in 2009. Employment in the banking sector increased by 8.8 percent since 2008. At end-September, Lebanon’s banks employed 19,842 people.

A new era

Despite the success of 2009, some of the industries’ leaders hesitate to make predictions for 2010.

“Making predictions in Lebanon is a nearly impossible task,” said Raphael. But this year, many bankers have felt the shift in both the consistency and international prowess of the Lebanese banking industry.

Though no one expects the landslide growth in capital inflows of 2009 to come around twice, there is confidence in the diaspora that remittances will be maintained next year, especially with the increasing likelihood of a recovery of Gulf economies.

An active expatriate community, regional expansion and solid assets, as well as international recognition for impressively weathering the global financial storm, have seen talks begin regarding a new global position for Lebanon’s banks.

“Lebanon is at the eve today to become what it never was: a real financial center,” said Baz. “[Even] in the early 1970s, when [Lebanon] used to be considered the Switzerland of the Middle East, it was only an important banking center. Lebanon was never a regional banking center.”

He further predicted that Lebanon could become a true “banking platform with an important capacity to attract foreign money and to redeploy this money into foreign uses. Beirut probably is getting today as close as it ever has to this definition of a real financial platform, a real financial center.”

As shown by the sly smiles on the faces of Lebanon’s top bankers at the Union of Arab Banks’ annual conference in Beirut in November, despite the worries of its Arab brothers, Lebanon is poised to wield it’s regained international reputation for prudence and reliability, and enter a new era for Lebanese Banks.