Well, better late than never. At least that’s the sentiment of some of Lebanon’s top bankers, eager as they are to satiate an increasingly ravenous global and local appetite for Islamic Banking (IB) services.
Indeed, as with so many aspects of Lebanon’s socio-economic maze, the country’s relatively late entry to the IB trend is puzzling, if nothing else.
We host many of the leading banks in the region, we are routinely ranked as the top country for Human Resources recruiting, and Gulf investors, typically the ones most interested in conservative investing, have long made Lebanon a second home of sorts – both financially and from a tourism perspective.
Moreover, according Jamil Jaroud, Deputy General Manager at Lebanon’s Arab Finance House, an estimated seven billion dollars in deposits is potentially available from Lebanese who want to invest their money here according to Sharia principles.
“This industry should be very crucial to the Lebanese economy,” said Jaroudi. “In other words, if there wasn’t something called Islamic Banking then we should have invented it to help bring capital and partnerships into the economy… After all, this is what most Lebanese companies need.”
Nevertheless, as it currently stands, the central bank (BDL) only recognizes one fully functional IB: Islamic Credit Libanais.
And while there are two other contenders, AFH and Al-Baraka bank, both of these institutions have yet to be licensed as IBs – although the bulk of their services already adhere to IB principles.
According to Pierre Kanaan, who is heading up BDL’s legal effort to expand Islamic Banking, the reason why Lebanon hasn’t fully joined the estimated $250 billion (and growing) global Islamic marketplace is mostly due to one factor: the law.
Although banks here can competitively conduct some IB transactions for their customers under the current Fiduciary law, IB’s prohibition against charging interest, among other Sharia principles, necessitates a wider use of contracts  – a fact that often moves IBs into a different and less competitive class of activity under the law.
One prominent example of this, cited by Jaroudi, is when AFH wants to do business with certain sectors of the economy that receive state subsidies, such as healthcare.
Although regular banks here can benefit from an interest rate subsidy, in effect, when lending to hospitals, AFH is not permitted to do so under the current law because such deals are structured without interest. Instead, the transaction gets considered as a merchant transfer: Equipment is purchased for the hospital by the IB who then benefits from the profit margin that it charges the hospital.
Of course, in the meantime, that margin is reduced by the state subsidy that the hospital is unable to obtain because of the nature of the deal.
An even greater barrier to Islamic Banking in Lebanon is double taxation.
Because a transaction may be regarded as a merchant transfer, both the IB and the ultimate buyer, the client, must pay the VAT.
Crunch the numbers in either of the cases and you’ll see why IB has been largely throttled in the domestic market.
As Jaroudi put it, ““why would anyone want to do business with us?”
To top it all off, the current banking law, even as it was modified last year to allow greater IB activity, does not allow a Lebanese bank to simply open an IB window.
Instead, the entire bank must be licensed as a separate entity, necessitating a separate Sharia audit committee, separate tax structure etc. – a costly procedure, in any case.
While BDL has issued a number of circulars over the past year and a half, allowing more attractive capital to deposit ratios, for example, there is only so much it can do without Parliamentary action.
Unfortunately, even as over a dozen banks are said to be preparing IB licenses (and at least three foreign banks already have approached BDL for branch licenses), there still has been no action to consider a number of draft laws that might put IB on an even competitive playing field with conventional banking.
The story of IBs seemingly meteoric rise dovetails, at least on its face, with that of the oil-driven region.
As it is usually told, three decades ago IB got off to a slow start in the Gulf, prompted by the needs of conservative investors who did not want to invest in certain prohibited activities and who wanted to respect Islam’s prohibition against interest rate taking.
Of course, that’s not an entirely faithful way to tell the story (pardon the pun).
As one seminal IB publication put it in 1997, “Although the western media frequently suggest [sic] that Islamic banking in its present form is a recent phenomenon, in fact, the basic practices and principles date back to the early part of the seventh century.”
Nonetheless, the sector did lie mostly dormant until the late 1990s, when the industry began to take off as a result of a confluence of factors: Pent up oil wealth, an increasing focus on adhering to Sharia principles and, most importantly, a new breed of educated Sharia experts who were deeply familiar with both Islam and modern banking structures.
“The industry is growing so fast because the scholars now are connected,” said Jaroudi.
“Not to undermine previous scholars… but the previous ones may not have known, and would have ruled a certain instrument was haram, perhaps because of a lack of knowledge. It was better for them to stay no than yes.
“The modern scholar goes and researches the fatwa, and says yes you can do this under this school of thought. This is what has pushed the industry forward in the past few years.”
And indeed, pushed forward would be something of an understatement.
Further buoyed by the post 9/11 environment that prompted regional money to stay put, the industry is now a $250 billion market (in terms of assets), having grown by an average of 15 % each year over the past decade, according to one leading Lebanese Bank who is currently surveying the marketplace.
There are now 265 IB institutions worldwide in 60 countries, though 2/3 of Islamic funds are from the Middle East.
Led by Malaysia and Bahrain, among others, total deposits now total $202 billion.
Islamic equity funds, of which there are now 125, have grown an average of 25 % each year for the last 7 years. Islamic Bonds too are estimated to be worth between $25-30 billion, a market that has nearly doubled over the past few years.
And finally, in a clear sign of its arrival on the banking scene, it is now anticipated that Islamic finance will be responsible of managing 40% to 50 % of total Muslim wealth (3 trillion USD) worldwide by the 2010-15 period.
Even the US Department of Treasury has gotten on board, recently appointing an IB Scholar in Residence who will spearhead the regulatory changes necessary to introduce IB to the American market.
“There are two important things when it comes to IB,” Jaroudi explained. “The contract must be structured according to Islamic principals and second, you should have the intention that you are adhering to sharia,” that your deal is ethical throughout.
As a result, “you become a partner in the operations more so than the conventional bank,” a fact that often raises the due diligence costs, not to mention certain risk factors.
“Any delay,” Jaroudi said, “in repaying an IB causes us to lose the opportunity cost of the money… With conventional banks, if you are late, you accumulate interest for the delay on top of the interest you owe.”
He added that AFH was able to get a ruling from the Sharia board that permits collecting penalties from clients who have delayed payment intentionally.
The amount, however, goes to charity, not the bank.
“It’s kind of like building a society. There is no remoteness between the money and the outcome of it.”
Despite the apparent difficulties, according to Kanaan, the BDL expects that between 12 to 15 banks will indeed apply for IB licenses shortly.
Although he was unable to predict how many of these applications would ultimately be successful, he noted that the BDL has wide authority to grant such licenses – after all, the law says that a potential licensee must yield a “public benefit” as well as meet any and all legal requirements.
“I am convinced that it will have a good impact to try to develop this sector, to make some exemptions in this area,” said Kanaan.
“But we have to deal with these issues [such as double taxation], which demand a law.”
Although he added that the prohibition against window operations would continue, Kanaan did say that at least a few more circulars regarding IB regulations would be issued in the coming months by the BDL.
Of course, if the IB sector in Lebanon, not to mention the world, is to develop, its Human resources must grow – and fast.
Recognizing this, Lebanon’s Ecole Superior des Affaires recently unveiled a new training program in Islamic Finance.
According to Ahmad Barghout, ESA’s administrative and financial manager,  “ESA is always looking for new things. We launched a feasibility study and found that we can contribute to this industry on the HR development level.
“HR is the key here,” he added. “Everything starts from the HR level.”
As a part of its effort, at the end of March ESA launched a foundation for research in Islamic finance that aims to provide business cases and applied research to the industry. Through its educational programs, ESA will also soon offer a module in Islamic finance as a part of its Masters in Finance, possibly as early as October 2005.
“We don’t need repetitive seminars with the same people,” Barghout said. “ And two days is not enough. We need practical applications… We need to understand the ways of thinking which are completely different from regular finance.”
By assembling a retinue of junior experts – approximately 8-10 people, ESA is positioning itself to become what Barghout said would be a “hub for Islamic finance on the HR level.
“Look, if you have the whole structure but not the human assets you will fail, that is certain.”

For at least the past four years, foreign banks have been leaving Lebanon in regular succession. The exodus began in 2001, when ING Baring sold its franchise to Byblos Bank, followed by ABN Amro also selling its Lebanese operation to Byblos Bank in 2002, while Credit Lyonnais sold its franchise to Credit Bank, a smaller domestic bank. More recently, during 2004, Crédit Agricole also left the country, selling its 51% stake to local individual investors.

It has also been six years since a foreign bank announced its intention to acquire a local bank, let alone set up a branch in Lebanon. In fact, most international banks have shied away from entering the Lebanese market, which has only four major Western banks, HSBC, BNP Paribas (BNPI), Standard Chartered and Citibank, all of whom have a decades-old historical presence and are committed to the country. This is the main reason why BNPI and HSBC are still operating, while Standard Chartered has a global emerging market franchise, and is keen to give itself more time to develop its presence. Citibank’s size in Lebanon is too small and doesn’t impact the consolidated balance sheet. The bank has however closed its branch on the highway and, no doubt looking to cultivate a better class of depositors, told all customers with less than $25,000 to close their accounts.

The fact of the matter is that most foreign banks have viewed Lebanon with caution. Those who were interested kept a cool head during the euphoric times of the mid-1990s, and opened only small offices. Others, such as ING Baring, predicted Lebanon would regain its position as the region’s banking center and were quick to open a fully-fledged branch, only to pull out altogether after five years. Those that remain such as BNPI, HSBC, Standard Chartered and Citibank are still considering the level by which they will increase their market share and compete heavily with the larger domestic banks, many of which have gone regional.

Some local partners of foreign banks argue that therein lies the dilemma. They say Lebanon cannot be viewed as a sole entity. Its natural disposition is that of a regional hub and local banks that have prospered have penetrated regional markets. The instinct therefore is to expand, while foreign banks may be reluctant to “interfere” with their other regional offices.

Risky business

The reason Lebanon makes foreign banks twitchy may lie in its country risk, as reflected by Standard & Poor’s rating of the Lebanese government, one that establishes a benchmark for the entire Lebanese economy, which has shown significant signs of weakness and volatility for virtually the last decade. Doubtful loans have been very high, both on the corporate and retail sides, averaging more than 20% of banks’ loan portfolios, while earning diversification and recurrence has been suffering. Furthermore, there are little fund placement or investment opportunities, and both local and foreign banks find it extremely difficult to place gathered deposits into risk-free or low-risk loans or securities. For this reason, foreign banks have been reserving significantly against Lebanese risk at head office level, and have found their Lebanese presence to be costly. Those banks that sold their Lebanese franchise did not do so to simply cash in on the value of the local franchise, but rather to be able to release reserves at Europe head office level.

Another major reason for the foreign flight is the imminent Basel II Capital Accord due to be implemented with all banks within the G10 countries (including the Netherlands and France). This accord forces banks to determine capital according to risk weightings on assets. The risk weightings are in turn determined by credit risk ratings, whether these are internally developed or provided by internationally recognized rating agencies, such as Moody’s, Standard & Poor’s and Fitch. Therefore, a B– rating, such as the one carried by the Lebanese government and just about every rated institution in Lebanon, would carry a minimum risk weighting of 150% for international banks with any exposure in Lebanon. For example, if a foreign bank with total assets of $75 billion had a presence in Lebanon amounting to say, $3 billion in terms of assets, it would then have to risk weigh this amount at 150% and set aside $360 million in terms of capital just in order to comply with the Bank for International Settlements (BIS) minimum regulatory capital requirements, which sets the lower limit of the BIS Capital Adequacy ratio at 8%. The international bank in question would much rather allocate the $3 billion in less risky markets in Europe, where ratings are higher and risk lower, and which do not cost as much in terms of capital.

Incentives to stay

A capital allocation such as that described above could have been worthwhile if yields in Lebanon were significant and the domestic market profitable, but yields have dropped substantially in the last few years, while economic, political and social risks have stayed, if not worsened. The government has done a relatively good job in reducing interest rates on the Lebanese pound, but has done little to accompany interest rate drops with appropriate reforms, financial restructuring and privatization.

Given the political power games at play and threats of international sanctions in recent years, even today’s hopes for a better government cannot ameliorate the situation, particularly considering the killing of former premier Rafik Hariri in February was a big blow to the country’s stability. Furthermore, the government also showed significant incompetence in handling the fallout.

The bottom line for foreign banks is that Lebanon represents too much volatility and risk. The low rating – coupled with the small size, lack of diversity and capital market developments – hamper any desire for a foreign financial institution to either venture into or remain in Lebanon.

The absence of a developed local capital market is also an obstacle to a greater foreign presence. International banks, which have a presence in most world markets, rely on market funding or the issue of debt and hybrid debt securities (e.g. preferred shares, subordinated debt, etc.) to fund their placements. In turn, their placements usually involve a high degree of sophistication, which sometimes necessitates the use of capital markets for their corporate clients. In Lebanon, foreign banks usually operate with a handicap with regard to deposit gathering, as their approach toward retail customers is less appreciated by the Lebanese public than is the case with Lebanese banks. A reliance on capital markets is therefore crucial in foreign banks developing activities in local markets.

Relationships

Further issues arise with local partners, whose presence is very beneficial during the initial years when the foreign bank needs to make itself known to local clients. But if and when the market and economy grow and develop significantly, requiring the local partner of the foreign bank to be up to the task financially in terms of capital injection, then the relationship can run into trouble. For a while, a local partner – whether an individual or an institution – might be able to inject sizeable capital, but today’s banks, particularly those in a high risk environment such as Lebanon, need to be capitalized to the tune of sums in the high eight and nine figures. In Lebanon, with the exception of a handful of billionaires, few bank partners can do this.

The absence of sophisticated banking regulations and the Lebanese government’s monetary policy are also a problem for foreign banks, who unlike local banks, can engage in activities that are useful when hedging against volatilities and risks in the local market – such as securitization and derivative products like swaps, options and futures. The central bank, quite rightly, forbids resident banks from engaging in such activities but foreign banks would be handicapped and hampered in their efforts to carry out what they believe are standard banking and asset/liabilities practices.

The government’s post-war policy of using the local banking system as the major funding tool for the state or as the reservoir of Treasury Bills and other government debt securities, was the final straw for foreign banks aiming at funding the Lebanese economy and not the state. They were (and still are) unwilling to play the game, mainly because of their own internal policies and guidelines that forbid a direct exposure to B– rated debt securities. The upshot is that they have been left handicapped in terms of profitability compared to their local competitors and have significantly limited their treasury capabilities.

Some positives

There are opportunities in the wake of the foreign exodus. It has in theory opened the way for local banks to develop their own capabilities as well as tailor-finance tools that fit the domestic environment, such as lending to corporate departments – still underdeveloped in Lebanese banking – and bespoke retail products. However, it is hoped that local banks and the national regulator would also sit up and take notice and work to make the Lebanese financial system more attractive and efficient. It is also hoped that local officials will recognize that the country’s risk is too high to attract foreign and Western investors, and that they need to take action sooner than later.

The downside is that local banks are no longer exposed to international standards, which increases the chances of them getting deeply ingrained in old habits. There would also be fewer opportunities for local companies and individuals to benefit from more sophisticated financial engineering and more diversified banking products such as those provided by international banks. But the most important and immediate negative consequence is that of image. The departure of such blue-chip names looks bad and will not help Lebanon’s quest to attract Western investors.

The politics of it all

The issue of bringing back foreign investors rests entirely in the hands of the Lebanese government, which has to resume economic reforms, eradicate bureaucracy, and provide incentives for foreign investors (mainly on the fiscal side). The government could also attract Lebanese expatriate bankers by providing them with a direct tax incentive, in a similar vein to what other emerging market countries have been doing for the last decade. It is also crucial to provide foreign investors with comfort as regards to the political environment, and develop a wise and stable political and social policy. One can only hope that the current decision makers realize what is happening and mobilize to rectify the situation.

For an industry that is battling a higher cost of doing business and, during the past quarter witnessed its first contraction of deposits after something like 50 quarters of perpetual increases, the mood at leading banking institutions is exuberant. And for more than one reason.

The first is confidence, both economic and general. Many bankers saw their confidence get not one but single but a multiple shot in the arm in the past quarter. The nation’s ability to navigate the sudden storm-swept political waters and avoid being torn apart by internal strife and violence, clearly imprinted itself into the minds of many bankers as a general confidence booster.

Secondly, banks saw good rise out of their own ranks. The fast action and effective leadership of the central bank in averting the danger of capital flight and handling the pressure on the currency has been suitably acknowledged. But banks also played an effective part in calming depositors, managing a sudden surge in dollarization of accounts and steering customer funds back towards the Lebanese pound.

This resilience in the nation’s economic stance made the president of the Association of Banks in Lebanon, Joseph Torbey, exclaim assertively in a meeting with Executive, “We are not a third-world country! We are a country with a real economy and a real growth and the real power of the country is its people.“ [for the full interview, go to page xxx]

Assured by Lebanon’s and their own successes in defeating the dangers of political and economic turmoil, and now betting confidently on a graceful transition to a new political governance paradigm, bankers today publicly profess optimism. When asked by Executive about their evaluation of the situation in the middle of the second quarter, sector leaders voiced positive expectations for the economy at large, with some projecting growth for 2005 just slightly below last year’s level or even referring to a GDP potential of breaking the $30 billion if Lebanon only fulfilled its promise. For all lines of banking activities they predicted new upswings either in the medium or, especially for retail banking, in the short term.

Expressions of such optimism were also aided by sector numbers, which had been good for 2004 and at the end of the day also came out much better for the first quarter of 2005 than it had been widely feared in February and March. The 12 out of 14 Alpha Group banks with deposits over $1 billion for which figures were communicated, achieved growth in assets, deposits and loans of 16.27%, 14.95%, and 12.68 %, respectively, in the Alpha group’s consolidated balance sheet. Profit cushions were comfortable for many large banks as the group’s consolidated net profits rose by 11.75%. BLOM Bank was again the leader in profits even as the gap with some in the leading group narrowed. Three banks recorded moderate profit contractions, while one, SGBL, saw a large one. BLC, previously resident in negative profit territory, led the sector in profit improvements with 181% growth.

As banks tallied their first quarter results and finalized their audited annual reports over the past weeks, they confirmed that the first quarter contraction in customer deposits in wake of the Hariri assassination, was slight at about 2%. For some, even from January 1 till March 31, deposit growth was achievable as demonstrated by mid-sized Bank Al-Mawarid, which achieved 3.78 % growth in deposits and 3.71% growth in loans for the period.  

In signaling readiness to respond immediately to an improvement in the economic climate, Lebanese Canadian Bank went ahead with opening five new branches it had bought from Bank Al Madina, while Lebanese Canadian and BEMO and are in the process of erecting new headquarters downtown. BEMO, only last month, concluded an agreement over the purchase of a plot near Starco where the group plans to establish 6,500 square meters of built-up headquarters space. 

Another, and newer, message from Lebanese banking is that of regional successes. Where local banks began two years ago to justify their need for expansion into other Middle Eastern and North African countries with the over-ampleness of their own size in relation to the domestic economy, they speak this year in glowing terms of their initial experiences in operating those new subsidiaries and present a plenty of further projects.

Byblos Bank, which was at the forefront of going regional by establishing Byblos Bank Africa in Sudan in 2003, is full of praise over its progress there and its new expansion accomplishment in Algeria, where it recently acquired a bank with six branches. With teams already having been dispatched from Lebanon to Algeria, Byblos’ second regional venture is already operational and only awaiting final administrative approval in both countries to complete the acquired bank’s transition into Byblos Bank Algeria.

The third regional joint venture banking project of Byblos, the establishment of an operation in Syria, is also well underway with a head office already having been bought and launch of the institution planned for this year, hopefully before September. According to Byblos’ general manager, Semaan Bassil, Algeria (which is also being eyed-up by Lebanese Canadian) is attractive due to its proximity to Europe, strategic importance in oil and gas, large projects and numerous development needs in the banking sector, while in Syria, the bank is looking not only at corporate clientele but also at building a network and consumer franchise there.

At the Audi Saradar Group, where there is a history of strong European subsidiaries, the rollout of the first regional operation in Jordan has been a tremendous story, claims strategist Freddy Baz. Based on a license for a 10-branch network, the Lebanese group had six out of ten branches up and running at the end of 2004, three months after assuming operations. “We reached a level of assets of JD 120 million at yearend, which corresponds approximately to $160 million,” Baz told Executive. “This is a very good performance when you compare it with existing banks having several branches and six, seven years of operations. We are at 60% of their performance after 14 weeks. This is related to vision, strategy, well-defined business plans, and more importantly, your people.” The group foresees completion of the branch network in Jordan within a matter of weeks as well as launching operations in Syria before the end of the summer. The start of the joint venture was delayed because of a decision to double the new bank’s capital from $30 million to $60 million, in order to meet the requirements of what Baz described as “a very aggressive business plan for Syria”.

As Audi Saradar’s ambitions extend even further than these two new ventures and the group regards the Levant, North Africa and the Gulf area all as within its reach for regional activities, the public should not be surprised to see another Audi Saradar startup coming along, perhaps in form of a new niche operator in corporate finance in the Gulf or through acquisition or founding of an institution in Egypt where the group’s market interest is documented.

Also gearing up towards their opening in Syria is Bank of Beirut, which is collaborating with Emirates Bank and Qatar National Bank in their joint venture for the Syrian market. BoB is also preparing to co-list its shares on the Dubai Stock Exchange within the coming three months.

No single banker talking to Executive last month about plans for the Syrian market left any doubt that money talks equally sweet from both sides of the border and Syrian customers had no squabbles or reservations in letting Lebanese banks serve them.

Already in Damascus is BEMO Bank, where a high reputation with the Syrian business community runs in the blood. The bank’s aspirations are for the Syrian operation to eventually outpace the asset size of the parent bank in Lebanon. “In Syria we achieved $400 million after one year, for most of which we had only one branch,” said BEMO general manager Samih Saadeh.

Among the two private sector banks already open in the neighboring country, the joint venture Bank BEMO Saudi Faransi (BSF) is currently leader by number of assets, deposits, and loans, according to Saadeh, and growing to four branches this summer. Interestingly, the focus at BSF is on retail banking growth while BEMO’s home strategy is to develop its niche as boutique private and corporate player. Covering both angles, the group aims for a substantial role as banking conglomerate between Lebanon and Syria.

The Syrian market’s need for advanced and indeed basic financial services should provide Lebanese banks participating in joint ventures there with no shortage of opportunities to break growth records over a good number of years, as long as the flows of economic freedom and overall reform in the allied country do improve and not subside. Their market expertise and managerial leadership as drivers of joint banking ventures in the Syrian economy may even allow stronger Lebanese banks in the longer run to get around the restrictions on their roles created by the legal framework that dictates Syrian majority in the capital of private sector banks.

While the regionalization of their business is buttressing the market positions and risk diversification of Lebanese banks, it does not provide them with answers to all their challenges. Many still have to work on ameliorating their asset quality and interest rate risk, loan portfolios and policies, management and service structures. Although appearing perhaps somewhat less attractive today under the inescapable size limitations of the market, domestic mergers and acquisitions in further consolidation of the sector can be expected to become again more important with progressive implementation of Basel II requirements over the next five years.

Furthermore, within the limitations of the economic environment and the prospects for gradual improvements over a not short period before full recovery of fiscal and macroeconomic health, innovative contributions of banks to the financing of growth and productivity in Lebanon have a lot of calling. In an example for a new project, Byblos Bank is currently working on establishing a joint venture financial firm with the European Investment Bank (EIB) and probably another foreign partner. An EIB expert had been hosted at Byblos Bank for the past six month in a mission to analyze the feasibility of an equity fund for investing in companies in Lebanon and the region, and the project is ready for start-up within 2005.

To be capitalized initially at $30 million, with 50% participation by Byblos Bank, the investment fund firm aims to enter the equity of promising companies that also export. Managed out of Beirut with a Lebanese team and also based as offshore entity in Cyprus for reasons of giving the Europeans and foreign partners a blocking vote, the fund will be designed to cover not only Lebanon but also be active in other countries of the Eastern Mediterranean, such as Syria, Egypt, Algeria and Palestine.