Reflecting the position of banking in the economy, the Association of Banks in Lebanon (ABL) is the country’s most potent group in representing private sector economic interests and influencing future direction. ABL president, Dr. Joseph Torbey, sat with Executive to discuss the current state of the nation’s economic affairs and its prospects.

How do you assess the situation in the first quarter of 2005 from the viewpoint of the Association of Banks in Lebanon?

Lebanon faced a very dramatic turmoil during the first quarter of this year. This political destabilization had some impact on the banking situation, the economic situation, and also the spirit. The country without [assassinated former Prime Minister Rafik] Hariri is different to the country with Hariri. But in my opinion, the country really recovered. This is also expressed by the behavior of the banking sector and the confidence of depositors. It is important to know that the banking sector is not only a domestic one; it is now a regional one with also international ramifications. Thus the assassination of Mr. Hariri was really a big event and caused two problems.

What problems were these?

The first was the threat to see a flight of deposits from the country. The second threat was lack of confidence in the Lebanese Pound due to the macroeconomic situation, especially the public debt and budget deficit.

The flight of deposits from the banking sector was a threat but it really didn’t happen at all. The second threat of massive conversion of deposits in Lebanese pound into deposits in foreign currency was a real threat and the central bank, in cooperation with the banking sector, acted in a very creative way to face this challenge. Together we were able to convert 10 percent of the deposit base in three weeks from Lebanese pound to foreign currency. This represented roughly $6 billion and was really a big challenge.

So it was an exceptional achievement?

It was really an achievement and after this success, we really were surprised to see a reversal in the whole conversion campaign by customers shifting again from dollar to Lebanese pound. In terms of figures, the total drop in the deposit base was around one billion 500 million dollar, which is nothing compared to the total assets of the banks which today stand at around $67 billion. We can recover that in two or three months.

In this context, what are your expectations on banking sector performance for the whole of 2005 in comparison to last year?

We don’t expect the same growth in the deposit base as in 2004. But the banking system is super-liquid, resources of banks are really larger than the need of the country and that is one reason why the banks are expatriating their activity outside Lebanon. So for banks there is no problem of financing the Lebanese economy. But as we are comparing year on year, we will see a slight difference due to the major event of this year. We will see recovery and expect also growth by yearend 2005. In my opinion, we will see between seven and nine percent growth of the deposit base, whereas in 2004 we had about 12 percent.

Then you would share the view that the current period is indeed hopeful?

Some perceived it also as the end of the tunnel with the withdrawal of the Syrian army and the regaining of the self-confidence of the Lebanese, especially under consideration of the new political process which is now being conducted under the auspices of the United Nations and international controllers coming to control the political elections and the political process. What was done showed a mark of confidence not only in the banking sector but also the political system and the future of Lebanon.

In this light, would you say that Lebanon’s sovereign rating should increase in the near term?

It is early to expect such but we are sure that it will happen, because with the new parliament and new government we expect a new policy and program. Starting from now the international community, World Bank, IMF, and the Association of Banks in Lebanon are all really busy to draft plans for the new era.

These plans will include two factors. The first will entail to make a major fiscal adjustment by re-analyzing the development spending and also undertaking a review of the operating cost of the public administration and some public utilities. With the liberation of Lebanon, the corruption process will slow or stop by itself and also by government policy, which must now really move to fight corruption and reform the administration.

What is the second factor?

The second factor is to plan or prepare for economic development. If we don’t have economic growth, we will face problems. The base of any economic government policy in the next era will be how to promote growth again for the economy. We had 5 percent growth in the economy last year. This year we will face a drop, which I expect to be a slighter drop if we can overcome the election problem before the summer season. We are expecting a good summer season. The fourth quarter of the year will be the quarter of the recovery and we will see in my opinion a different Lebanon after the political process will be terminated.

Will the ABL present its own proposal for economic growth to the government?

No, this is a government duty. We are participating with the government of Prime Minister [Najib] Mikati in a joint team. This team is discussing all schemes on how to emerge from the situation and draft priorities.

What would be the key wishes of the ABL towards the government in the new Lebanon?

The first wish is to promote private sector competitiveness and enhance private investment through removing the hurdles faced by the private sector and reducing the cost of business. This means streamlining the administrative procedure, reducing red tape, modernizing the legal framework and government private sector activities, as well as providing incentives to private investments. We must have a new spirit in welcoming and assisting investors.

The second point is implementing the fiscal adjustment as soon as possible. This is really a major issue and in my opinion we need also some efforts from the international community because the problem of the public debt is becoming more and more difficult for the country to overcome only by techniques or mechanisms. We need some restructuring of this debt. I am here evoking the Paris II conference. We need a new conference, which will be backed by real positive government attitude.

So you would be in favor of what by want of a better term is being called Paris III?

Yes. The Middle East is facing big challenges. These challenges are not only political ones. A major challenge is poverty and economic destabilization. I think stability of Lebanon is important for the stability of the region. Here we must expect from the international community a comprehensive program, which like Paris II will not be based on donations but on lending and restructuring the debt, helping Lebanon to upgrade its rating by having a better restructured debt with better maturity and easier debt service.

Following Paris II the banking sector was relied upon quite substantially by the Lebanese state for supplying a financial contribution by way of subscribing to zero-interest T-bills. Would you see it possible that the banking sector would be called upon again in a similar matter after a new debt restructuring conference?

In the Paris II conference, the banking sector was a major player. We provided about $ 4 billion as loan to the government with zero percent interest rate for two years. The reason of this participation was based not in any pressure from the government. It was a voluntary participation based also on the banks’ own interests. It helped to upgrade the rating of the country. The reward for the banking sector was very important because our T-bill portfolio, despite being devaluated, was appreciated. We were buying stability and better ranking and at the end, we also gained as we could lower interest rates on our deposit base, and we shared those benefits with the state. This was the explanation of the process. The situation today is completely different.

In what way?

Today we are overpaying our depositors to keep the deposits in the country. Thus we are helping in the restructuring process of the economy by fighting to keep our resources in the country. This is really an important contribution which is for us more costly than the first participation, due to a slowing economy. After the assassination of Mr. Hariri, we had now about three months of vacancy in the economy. We are covering this and we are restructuring our debt portfolio with our customers as our customers are also facing problems. We are not able to increase our interest rate on the loan side and we are increasing our interest rate on the deposit side. So we are overpaying to keep the resources and we are acting softly with our loan customers to help them to recover and reemerge again as profitable customers.

Isn’t this very costly to the banks?

There is a real dilemma here and we are very conscious of this. We are at the forefront and the strategic reserve of this country and helping to finance the government at a stage where it is difficult to raise any capital on the international markets. At the same time, we are still also financing our customers to keep going. So we are playing a very important role in this economy. This is our economy and our market and it is in our interest to keep it safe. But it will have an important cost to us.

You told us what the ABL recommends for improving things on national economic scale. Would you have special requests to the new government on behalf of the financial services industry?

We are very satisfied with the financial environment. Sure, we need to develop it and especially develop the capital markets; this is an important issue. But our claim is not on the activity of the banking sector. We need to reform the investment climate and ease the government requirements on any investment activity. The best solution here would be to navigate towards e-government as the best way to deal with the administration and have a standard approach, which is now missing.

Do you have specific suggestion for legislation on capital markets?

We really need legislation to create a real capital market. We have a capital market but this is not an active capital market. So we really need new legislation here. 

But you would not ask for special incentives to the banking industry such as supporting mergers or expansion?

We have the appropriate laws. If we will participate in a wider approach to the economy, it would be by asking the government to have a special scheme to develop small and medium size enterprises and to give subsidies to some new activities, which must be developed. All our suggestions will be related to development and economic growth and also to fighting poverty because the big threat to the banks, to the political system, and to the economic system in the country is poverty in some areas and regions. Poverty is not only an economic threat. It is also a political threat and there is contamination.

With a new government, financing needs for public sector projects might arise, such as socioeconomic projects or developing rural areas. How would you foresee the banking sector to respond to more public sector demand in project finance?

We are for private sector intervention. We don’t see the government or the public sector capable of managing rural development projects. This is a country of private initiative and I see any assistance coming to Lebanon as coming to the private sector. The banking sector will help and cooperate in any project and it will also initiate some projects, as we are now very active in microfinance and financing of small enterprises.

Do you expect major changes in the portfolio composition of Lebanese banks to the end that T-bills and sovereign debt would soon play a lesser role?

I expect permanent demand from the government. Because the need is still there and the deficit is still there and the banking sector is able to satisfy this demand, especially since we now have large experience in international markets and are directing some of these funds outside. There is still demand and confidence on the Lebanese paper.

Some stakeholders in the economy recently emphasized that they see politics and business in Lebanon as being inextricably intertwined. Is it impossible to separate politics and economy in Lebanon?

For the banking activities, I can assure that there is no important interference of politics. It is a major strength of the Lebanese banking sector that there is no real political intervention on banking decisions. Perhaps there is some intervention in some investments which are related to public activities but the banking sector is really very well defended by its decision makers. We are complaining from some bureaucratic difficulties but the climate is acceptable. This is a country of private initiative. You have here a big fragmentation of society and a very important diversity. Nobody can enforce control and in my opinion, having such diversity is a really favorable climate for democracy.

VOICES FROM THE INDUSTRY

With total assets amounting to more than three times the Gross Domestic Product and accumulative deposits only a shade below 300 % of GDP, the Lebanese banking industry is the fortune maker and fortune teller of the national economy. With 51 institutions, the sector’s diversity and diversification is enormous, even after undergoing several years of non-confrontational consolidation through mergers and acquisitions. Banks shone in the recent months as they did in previous years as guarantors of stability. Nonetheless, they can never afford to slacken in working for their future which holds sure challenges for the sector, one of them being the need to achieve compliance with the new global Basel II framework of standards for banking organizations, due to be implemented in G10 countries by end of next year. In approaching decision makers at a cross section of leading and innovative banks in Lebanon, Executive asked them to paint a picture of the sector’s and their institutions’ priorities, projects and expectations in fields as varied as corporate, retail, private banking, domestic growth and international expansion.   

What developments do you expect for the next few quarters in the banking sector? As the implementation of the Basel II set of banking rules is edging nearer in advanced markets, do you see the ability of Lebanese banks for achieving Basel II readiness impeded by the difficult period we have seen in Lebanon?

Freddie Baz, advisor to the chairman, Audi-Saradar Group

I don’t believe that the political climate that we went through in the last three, four months, affected our ability. In terms of financial flexibility, we could absorb the shocks and maintain our operating conditions, spread, commissions, costs, at a very acceptable level without being detrimental to profit growth. The context today is much better than it was in the first quarter. I see no more pressure on the pound; thus there is no more pressure on our liquidity, and therefore not on our profitability.

We are expecting two things. When the size of the economy grows, it will obviously translate positively at the level of public revenues and public deficits. There will be more revenues, and less deficit or no more deficits. This is very important. On the other hand, we expect and push that after the elections there will be assistance for Lebanon. We have given our opinion to political decision makers about how this assistance could be implemented and we see the only way as being through assistance at the level of debt restructuring. This could be done through a Paris III [conference] but a real Paris III, with participation of donors, not merely grantors. Donor contributions will reduce the principal [of the Lebanese debt], in addition to which long-term soft loans will be replacing short term high-cost loans.

On the implementation of Basel II regulations, I know that very shortly, the banking control commission will start issuing circulars in coordination with the central bank. But this will mainly be on the level of the second pillar, in terms of procedures to enable Lebanon to better assess and master interest rate risk and operational risk.

There is still no review on the first pillar, regarding capital requirements. Because of the special context of Lebanon, there is some delay. If we have to weight eurobonds at 100 %, it would not be fair, because they are supposed to be risk free. Probably Pillar 1 will be treated at a certain point in time but I don’t believe that there is a clear prospect when. Pillar 3 depends on Pillar 1, because they cannot start asking for disclosures to markets and ratings agencies and all implicated external parties while they haven’t settled issues on Pillar 1. When the capital requirements will be defined, Pillar 3 automatically also will be. We are ready.

Which aspect or issue of the financial services industry in Lebanon do you regard as most urgently deserving attention, and what developments do you hope to see in the relationship between policy makers and the banking industry and in dealing with public sector needs?

Salim Sfeir, chairman, Bank of Beirut

What we should be looking at is the topic of the Lebanese financial markets. It is unacceptable to have the financial markets in this country neglected as much as they have been so far. We have historically been the first country in the area to have a very active stock exchange. Since 1993, the Lebanese financial markets did not take off. I think it is now the right time, for whoever is concerned, to look seriously on how the financial markets can be invigorated.

We know what we want from the public sector. Regretfully, the public sector in Lebanon for the last period was not dealing to the satisfaction of the banks. Our dealings with the public sector lately were not very professional. The people operating in the public sector are not dealing professionally with the financial institutions, only a few of them are professionals. If this is going to be the case in the future – which I assume not – the public sector would be very much deceived from not getting the right assistance from the financial sector. They should know that dealing with the financial sector means that they need to have stability in their policies. As long as there is no stability in their policies, as long as each minister that comes changes what was agreed upon with the previous minister, it is a catastrophe. Regretfully, we had experienced that in the past.

The needs are always there and if political stability is going to be our aim for the near future, the needs will be much larger, be that in the public or the private sector. As far as Bank of Beirut is concerned, we will be certainly very active as far as the private sector is concerned. As far as the public sector, we have a segment where we are very much interested to play an active role. We are equipped to serve a certain need of the public sector that is linked to the oil industry more than the construction industry.

Within a strategy of cross-border expansion, what do you see as the most important ingredients to realize regional growth capacities of Lebanese banks and how do you implement your bank’s development priorities throughout the organization?

Semaan Bassil, general manager, Byblos Bank

The most important thing for our bank and probably also for other banks who are looking at expanding in the country or outside the country, is the human element. Preparing the human element and the future pool of human resources [HR] who will be exported to the countries where we are developing, is a challenge. At the end of day we are extending credit in these countries. Therefore we have to graduate people with the same corporate culture and the same credit culture philosophy. With it, we have to have the right technology. So we are investing in technology. Third, we are investing in procedure, in systems.

We are investing in HR at all levels, rising stars, front sales staff, but also in the back office. Because these guys are controlling the risk of the bank, we are trying as much as possible to centralize our back office and credit decisions in Beirut. The direct relationship between senior management and the bank’s rising stars or high achievers is very important. We have to treat above average performers always differently in terms of relationship and in terms of financial benefits. We are also increasing training and sending some senior people to attend specialized training in Europe, in management, leadership, some functional areas too.

We also invested into the number one HR management system in the world, which is Peoplesoft. This system is in the process of being implemented and is going to help us better manage the development of people in the bank, in addition to the administrative part of the HR. We are the first bank here to start implementing it and Byblos Bank hired a special consultant from the US, to help us make sure that when it is deployed, this system is deployed in the optimal way and everybody is using it.

Our three objectives are HR, technology and maintaining an entrepreneurship spirit. The challenge is to recruit, develop and motivate human resources. In order to have a strong corporate culture, we want to as much as possible grow the international units from our own people rather than recruiting from outside. The fact that we are growing outside of Lebanon is a tool to not loose these good people, because we are giving them more and new responsibilities to carry.

How important is corporate lending for the Lebanese economy and how do you expect corporate lending activities to develop in the remainder of 2005 and beyond?

Samih Saadeh, general manager, BEMO Bank

If we go back to the last years when banks started lending and found the need to lend to corporate customers, it was really because of the lack of needs by the government after Paris II. There was huge liquidity in the local market and nothing to do. There also was a bit of an economic revival last year when everybody needed money to some extent. The corporates started to realize that they have to start moving from sole individual or family proprietorship towards becoming institutions. The market was flourishing last year, with tough competition among banks in order to lend corporate clients money out of the excess liquidity held by the banks.

As everything was on the safe side and moving up, you disregarded the sovereign risk even in corporate lending. You would look at their financial background, their financial assets, their management and how leveraged they are, what industry they are in, and as last issue you asked what will happen in the political and economic environment.

Starting in September of last year, we all of a sudden had a different aspect. But back then everybody still thought that things would be mended. Then the bad blow [of the Hariri assassination] came and in view of the country and its market risk, everybody pulled the reigns. Accordingly, in the first half of the year, things in the corporate lending side started to bear the consequence of a wait and see. We as ourselves will not seek new business but we maintain what we have and try not to loose it. Even with the interest rates rising worldwide, we did not increase the rate on corporate lending.

As things look now after the time for the elections has been set, everybody will maintain their positions but starting to prepare themselves for better days. If the country picks up again and there are projects, we will certainly finance them. BEMO is a small player. We are a bank that tries to be a boutique bank and provide financial advisory be it on the lending side, the cash management side, or the private banking side. In the second half [of 2005], banks will have to retrench and think how we can join efforts to create more productivity. It is in the interest of everybody.

Where do you see opportunities to develop the domestic business of a Lebanese bank, and how much growth potential do you see in the local market?

Marwan Kheireddine, general manager, Bank Al Mawarid

We believe that Lebanon is one of the right places to be for growth in the private sector. As Al-Mawarid we have identified several niches where we believe that a good return on investment can be achieved.

These niches can be grouped into three types: one, services industries, mostly hotels. In our opinion, the demand for decent hotels in Lebanon is by far larger than the supply. So anyone building an international standard hotel in or around Beirut will have a good business, especially when they rely partially on financing given by banks which is subsidized by the central bank of Lebanon. 

The second is in real estate development. We do believe that the middle class is growing in Lebanon and will continue to grow for several years to come. That will lead to an increase in demand for decent housing for this growing middle class. So again, anyone engaging in real estate development projects that satisfy the market demand in size and terms of price can and will make decent returns.

The third business that we believe ought to be developed is anything and everything related to retail banking. We believe that the market potential is huge and the market is not being served, meaning that for the next few years, retail banking can be a main source of profits and income for banks.

We are concentrating on that. However, we are not great believers of branch banking. We have 12 branches and have not established any new branches for a few years now and do not plan to establish any new branches for several years to come. We have invented delivery banking. We will go to the client wherever the client is; we don’t ask the client to come to us.

We are growing cheaply. It is by far cheaper to market yourself and grow internally than to acquire. Between 1994 and 2004, taking away the effect of mergers, Al-Mawarid would be the number one bank growing organically in the sector. But there will come a time where internal growth may be limited. It is much easier to grow from $200 million to $400 million than from $400 million to $800 million or from $800 million to $1.6 billion. We are still able to grow today, because with all the growth figures that we have achieved, we are still a medium-sized bank.

Please assess for us how you see the future of private banking in Lebanon, and what does it take to succeed in this specialized wealth management realm?

Yasser Mortada, deputy general manager, First National Bank

Private banking is a very diversified service. Private banking clients are looking for financial advisors more than pure banking services. Unfortunately, our market looks at private bankers as if they are salesmen, because we are used to the European and American style of private bankers who travel to the area and are basically trying to sell an investment product to an individual or an institution.

This is where a Lebanese bank can come into the picture, because a JP Morgan will not look at a merchant in Lebanon whose net worth is 5 or 10 million dollar and consider him as a viable business opportunity. The Lebanese banker is in a position to offer these financial advisory services and eventually deliver the services and the product to the clients. I think private banking will grow much more and play a very important role in the banking business in Lebanon.

We are still faced with a gap of knowledge between the client and the financial advisor. The clients need to go through an education process and have to become more serious in their planning. In the industry, we also lack the right people who have the experience and the knowledge. You find a few of them and to recruit them is not an easy task, because these people are coming from international institutions where they were paid at different pay scales.

When we started private banking at First National Bank towards the end of 2002, we bought the horse before the cart, meaning we hired two people that had the knowledge and the experience and who are directly responsible for private banking. We treat it as an investment and are trying to develop our customer base.

After the events of February 14, people were looking at the Lebanese risk and we heard from people asking about instruments and products in non-Lebanese risk. Bad events are sometimes good for other parts of the business. I cannot say that our business in private banking increased during the most recent period but I can tell you that there was more interest in this kind of product. I think there is room for private banking in Lebanon and for the region, as today a lot of our private banking money is non-Lebanese. 

Can Lebanese consumers expect to see more advantageous retail products, such as loans and credit cars, and a relaxation of retail loan requirements?

Philippe El Haji, head of retail banking, Fransabank

For the last few years, the retail market has witnessed a quick and ongoing activity on the product and on the marketing side. Fransabank since a long time has provided retail banking and personal loans but we are presently in the process of diversifying the personal loan itself. The Lebanese consumer has an appetite for personal loans; that is why we are diversifying our products.

We have the normal personal loan where the client does not have to specify the purpose of the loan. If he writes on the application that it is for personal use, it is ok; we do not investigate. The diversification is coming in two or three aspects. We have presently introduced the car loan, which has special features and is a competitive product. And we are also in the process of introducing a PC loan and a school tuition fee loan in the second half of 2005.

We have ambitious targets for these products and are sure to meet them, because we studied the market very well. Our car loan is offered at an interest rate of 4.5 percent for up to five years for a new car and for the used car, we go up to four years.

We will not speed up the processing of loan applications because we did that already. From the time a client steps into the branch until the disbursing the funds in a personal loan, it does not take more than one week and we advertised that we answer to a car loan application on the spot. We have structured handling car loan applications so we have an immediate response that does not take more than 24 hours.

In the card market, diversification is also taking place. Everybody is launching new cards with new features and some are advertising that they have 10, 20, 30 cards – of which 80 percent are not operating. We have around 30 cards, which are all operating, and we are introducing new cards, such as the recent Lebanese Lira card, whose special feature is that in repaying, you can start 5% of your monthly expenditures, instead of 10% which is common in the market. With this card, the applicant also can have a credit limit that could reach six times the salary.  In 2004, our increase in cards was around 40%, and we are heading for an increase in 2005 as well.

From the view of a foreign bank, how does the Lebanese market look today, and do you notice any changes in the way how Lebanon is perceived internationally, including by your own organization?

Anthony Ussher, head of consumer banking, Standard Chartered Bank

As a foreign bank, we are very excited about the prospects of the Lebanese market right now. Obviously, the events of February 14 were a huge shock to us both personally and from an industry point of view. But the crisis itself has been very well handled by the authorities and the regulator here. If anything, we think the prospects right now are better than they were four months ago.

Foreign banks are looked upon here to exert some leadership in the market in terms of new products, new marketing, and new ways of doing business. Service standards, here at Standard Chartered, are a huge part of what we aspire to. We have a very large internal project going which we call outserv. It is a global project to bring general bank service standards, which we acknowledge as having over the years been fairly poor, to well beyond industry averages and in fact a leadership position. That is what we are working on in terms of service quality and in Lebanon we are very much part of this project. Our basic strategy is to move full speed ahead.

As far as our bank, the general risk view of Lebanon in the medium and long term is no different than it was before. But while the country risk side is one thing, there is also an awareness of the opportunity in Lebanon on a level that wasn’t there a couple of months ago. Before, Lebanon was not a particular area of tremendous interest. Now, people are waking up and thinking there is actually business in this place, and we can make something of the strategic opportunities here. My phone rings a good deal more with calls from Dubai than it did before. 

There is also a tremendous increase in interest in investing in Lebanon from non-resident Lebanese [NRL], whose business is a mainstay of our bank. A fantastic amount of money in the gulf would love to come and invest in Lebanon if it was made halfway easy to do that. If Lebanon controlled itself in the near future, I think people will be amazed at the amount of investment that wants to come in here. If we all play our cards right, we may be stunned by the response.

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.