In 2003, the Lebanese banking sector showed significant improvement in terms of deposit and asset growth, as well as in terms of profitability. The Paris II conference in late 2002 triggered a more efficient monetary policy from the part of the government and the central bank (BDL), which led to a sharp drop in deposit rates in both Lebanese pounds and US dollars, while debit rates, or rates assigned on loans to corporates and individuals, decreased albeit, at a much more reduced pace. Margins hence increased, and with them profits. Higher profits also generated more capital, as banks realized that it was a good opportunity to increase capital organically, given that external means to raise capital are rare. It is worth noting that profitability during 2003 and early 2004 could have been even higher were it not for a new regulatory reserve imposed by the BDL, which account for 10% of foreign currency deposits. This latter reserve at least had the advantage of significantly improving the banks’ liquidity as well as the BDL’s foreign currency reserves and installing a greater air of confidence in the market.

Although profit figures for 2004 are not officially out, the few half-yearly unaudited profit and loss accounts published by some of the larger banks show an improvement in profitability. Indeed, banks have been able to reduce interest rates on deposits even further during 2004, while, as usual, debit rates or rates assigned to loans and T-bill and government debt securities only moved fractionally, further enlarging margins. Although it was the larger banks, which mostly benefited from that situation, the smaller banks suffered more. Some of the smaller banks, or those with total assets well below $1 billion, suffered a decline in profitability, as they could not reduce their deposit rates enough without risking losing their saving deposits to the larger banks. Until now, the main value added of smaller banks to individual customers has been their ability to offer higher rates on both US dollar and Lebanese pound deposits. Lining up their deposit rates with those of the larger banks would clearly signal the loss of business.

The bulk of profits for the overwhelming majority of banks again came from interest income on government debt securities and loans. Banks in Lebanon are still unable to diversify revenues sufficiently, and generate non-interest income of consequent sizes. This reliance on interest income is worrisome, as any downward trend in interest rates and increases in non-performing loans would affect the revenue stream of banks substantially. Lebanese banks are yet to build a reliable and recurrent income stream, and are still highly vulnerable to external conditions (economic, political, social, etc.).

However, the biggest challenge still facing the Lebanese banking sector is the heavy exposure to a debt-laden Lebanese economy and the government, with the latter coming in the form of subscription to Treasury bills and foreign currency bonds issued directly by the State. Assets of banks, which are mainly composed of loans, liquid assets, and government debt securities, are still of a poor credit quality (for some banks it is very, very poor), and the level of non-performing loans in proportion to loans remains abysmal at around 28% (the peer group of banks with deposits between $100 million and $300 million had an average non-performing loans to loans ratio of 46.3% at the end of 2003). This is extremely high, when we can recall that the ratio of non-performing loans to loans for the Argentinean banking sector at the time of this country’s default stood at only 4%. The greatest challenge for Lebanese banks is still to stabilize asset quality and, through higher profits, to increase the level of loan loss reserves to provide better coverage of non-performing loans. Although the trend of bad loans continues, it is widely expected to slow down given the slight improvement of the economy (the highest GDP growth for some years is expected for 2004). Smaller banks will be more hit by a weak asset quality as they usually get retail and corporate debit customers, which are of lower credit quality than those of their larger peers. The smaller banks are expected to be caught in a vicious circle of rising non-performing loans and decreasing profitability, and will find it harder to improve their coverage of non-performing loans with loan loss reserves. Meanwhile, retail lending continues to rise, while corporate loans are being optimized and are stabilizing. Retail loans are more easily controlled, as most Lebanese banks (especially the larger banks) have recent credit models for retail lending, while corporate lending is still an under-developed animal for most banks. Indeed, corporate credit analysis techniques are seldom mastered within a large number of banks.

On the capitalization side, Lebanese banks have so far seen their shareholders’ equity rise to a total of $3.9 billion at the end of September 2004, compared to $3.6 billion a year ago. Such a consolidated level of equity leads to a consolidated equity to assets and equity to loans ratios of around 6.2% and 25.5% respectively. Although such ratios would appear solid in a different country with a more stable economy, in Lebanon they can only be considered adequate, bearing in mind that banks here do not often lend to the private sector (loans account for only 23% of total consolidated assets), and that risk levels are abnormally high. It is also worth noting that more than 80% of the sector’s consolidated equity is accounted for by the fourteen largest banks. The remaining thirty four banks are too small to warrant a meaningful level of equity, and a certain number of them have insufficient capital anyway. Nonetheless, capitalization is improving for the sector in general, as higher profits have allowed a healthy dose of retained earnings and some banks have resorted to capital raising with private investors and issues of preferred shares (e.g. Byblos, Audi, BLOM, Crédit Libanais).

Although regulatory capital (the required level of capital by the BDL) appears more than adequate for the entire sector, with a Cooke ratio (a ratio of equity to risk weighted assets) standing on average between 15% and 23%, economic or real capital is low because of the high risk exposure to the government. Such an economic capital should be expected to drop even further in the coming years, as the Basel II Capital Accord is to start being implemented across the world, including Lebanon. Basel II is a set of regulations that increases the risk weightings on assets if the risk profile of the same assets is high. In fact, it is even expected that regulatory capital for Lebanese banks will drop significantly as a consequence of the implementation of the Basel II regulations, as risk weightings on some assets (mainly government securities) will go from 0% up to the dizzy heights of 100%. A recent calculation by many independent research organizations, including the Union of Arab Banks, showed that the implementation of the Basel II rules should lead to a decrease in the Cooke ratio below 8% (which is the legal minimum) for some banks, and certainly below the current 20% average for most other banks. By then a lot of banks will be thinking about seriously increasing their capital, or even joining hands with other institutions with a better grip on risk management.

The banks’ liquidity appears more than satisfactory on the other hand, with liquid assets (excluding government debt securities) covering more than 56% of total deposits for the sector. Such a ratio is regarded to be higher than the norm by international standards but is appropriate in the case of Lebanon. Although the post Paris II BDL regulation, forcing banks to place 10% of their foreign currency deposits with the BDL at 0% interest, has affected the banks’ profitability a little bit, it has nevertheless forced a massive improvement in liquidity and deposit coverage with liquid assets. Banks can now face any runs on deposits with greater confidence, and have the BDL’s conservative vision to thank. However, funding remains a problem, with most banks having to live with significant maturity mismatches year after year. Indeed, customers’ deposits are only short-term in nature and are used by most banks for medium and long-term lending. Some banks have resorted to issues of medium-term bonds and other kinds of debt securities with longer maturities to fill up this maturity gap, but it is still largely insufficient, and in some cases, just a drop in the ocean. What prevents banks for issuing long-term bonds is simply the high cost of it, which is inevitably benchmarked against the high financing cost of the government.

The need for long-term borrowing by retail and corporate borrowers has never been so urgent, particularly as regards to housing loans. Some banks have been stepping up their mortgage lending and offer long maturities (ten and fifteen years), but the interest rate is still high and conditions quite onerous for borrowers. The housing and mortgage markets in Lebanon are yet to really take off and should be considered a priority by the banking sector on one side, and the regulatory and monetary authorities on the other. The enhancement of the mortgage market would create many opportunities for the Lebanese economy, not only in terms of financial products (issues of long-term bonds, securitisation of mortgage loans, etc.), but also in terms of construction activity. A developed mortgage market would also gradually meet the massive demand for housing by Lebanon’s younger population.

Qualitatively, many Lebanese banks have been addressing the issues of corporate governance (or lack of) and institutionalization. 2004 did not bring about significant changes on that front, with the exception of the Audi-Saradar merger, which created a banking group with a greater degree of institutionalization than many peers, which are still owned and managed by families. Decision making has been slightly diluted amongst the larger banks in particular, but many banks still concentrate strategic decisions in the hands of one individual. This individual is usually the founder or the heir to the founder of the bank and carries the dual title of CEO and chairman. Banks in Lebanon have not yet embraced the Western concept of having a CEO, a CFO, and COO, as the senior managers of the bank. The chairman should in principle be representing the interests of the shareholders and not mingle in the operational aspects, which should be left to the CEO-CFO-COO triumvirate.

The banking sector in Lebanon does, however, benefit from substantial support from the regulatory authorities, which motto is to maintain a solid banking system, that would gradually consolidate into a more compact and efficient group of institutions. The BDL is keen not to let banks collapse, as such events would shake a fragile economy. The larger the bank, the greater its importance to the domestic economy, and the more implicit support it can expect from the regulatory authorities.

Banks are aware of the difficult operating environment, which has lead so far to a rise in bad loans and a lack of earnings diversification, and their current high exposure to the weak credit of the government. They realize that diversification should be carried out away from Lebanon, if revenues are to strengthen and become more recurrent in time. Many banks have already started opening branches in other countries in the region, as well as strengthening their existing franchises in the countries where they are already present. Such a strategy can only be beneficial in the medium to long-term and could in time very well transform Lebanese banks into regional, and perhaps international players. For the moment, the Lebanese banking sector is still considered small in relation to the GCC banking sectors, and lacking asset and earning diversification.

Georges Abou Jawdeh: President, Lebanese Canadian Bank

E: After encouraging developments on the interest rate front, Banque du Liban has once again adjusted the rates upwards. In such an environment, how can the banking sector develop a more efficient corporate and retail lending culture?

Following the Paris II meeting for donor countries to Lebanon and the Lebanese banks’ contribution of $4 billion at 0%, interest rates on credit accounts in Lebanon dropped. And as of January 2004, the banks started to revise their interest rates on debtor accounts, to be more competitive, particularly on the regional market, where interest rates are lower. It is imperative for us now to revise the costs of funds again: in order to encourage lending, banks must reduce the price of lending. At present, we are at a significant disadvantage, internationally speaking.

Just to give you an example, banks are paying between 2.5% to 4.5% interest rates on US dollar credit accounts. Abroad, the rates are at 0.5%, so the difference is significant. Banks need to reduce interest rates to reach between 6% and 9% on commercial loans in US dollars. For deposits in Lebanese pounds, banks are paying between 6% and 8.5%, thereby landing loans in Lebanese pounds at interest rates between 11% and 14%. This is why we need to reduce the cost of funds. If banks are paying a high credit interest, they will be forced to lend at a high interest rate.

The solution to this problem lies first and foremost in the hands of the government. The Lebanese government must decrease its debt, so as to enable it to borrow at a lower cost. As long as the public debt remains as high as it is now, and keeps on growing, the perceived risk will stay high, and the government will keep borrowing at a high interest rate. This in turn affects the cost of lending for corporations and individuals alike – it is a cycle.

By reducing the debt, interest rates will go down, the credit and the debtor interest rate will fall and the business cycle will regain momentum. Looking ahead, what we need in 2005 is political stability – in the region, but even more so in the country, so that the Lebanese central bank does not need to intervene on a daily basis to maintain the price of the Lebanese pound to the US dollar.

At present, the central bank has $12 billion in foreign reserves, which puts us in a good position, but is not enough to ensure long term stability. Political stability would help generate domestic and foreign investments, which could inject fresh capital into the economy, beyond merely the real estate sector. What the banks need to focus on in order to promote healthy lending and credit underwriting is how to encourage small and medium enterprises, so as to gain new clients. In a small country such as Lebanon, where big enterprises are few, the economy stagnating and the number of loans issued dropping, this is the only strategy to pursue.

Shadi A. Karam: Chairman and General Manager, BLC Bank

E: Is there any danger that the current trend of regional expansion by Lebanese banks could lead to overextension, thereby damaging either the bank itself, the sector or the economy?

The regional expansion that some of the leading Lebanese banks have engaged in over the past two years has primarily been motivated by the high level of competition and a quasi saturation of the local market. An insufficient national growth pattern, political uncertainties and the need to reshuffle balance sheets laden with Treasury bills have also been driving factors. Expectations are that a regional expansion would help diversify sources of revenue and smooth out potential fluctuations caused by domestic contingencies. Theoretically, this is a sound strategy.

A closer look reveals that the branching out has occurred in neighboring, relatively familiar markets – Cyprus, Syria and Jordan – which mitigates the risks of expatriation.

Banks such as BEMO, BLOM, Audi and Société Générale are on familiar territory and have established anchor points going back to decades of client networking. This represents an advantage, if only from the sheer risk assessment, “local knowledge” viewpoint.

Naturally, one may deplore that money invested abroad is money not invested in the Lebanese economy, which is in dire need of fresh capital. However, it may be similarly argued that the stronger our banks become and the wider their regional reach is, the higher their added value to our national wealth is. As for the potential dangers this move may represent for the institutions themselves, it boils down to their equity “cushioning” capacity. It so happens that, at least in some cases, there is a satisfactory capital base and financially sound shareholders.

There remains the issue of latent sectorial and systemic risks should this experience turn into a debacle. Obviously one has to acknowledge the risk of local ripple effects should a major bankruptcy in a foreign subsidiary occur. This has happened in the past, and could have far reaching implications. However, given the amounts of capital engaged as a proportion of the banks’ total equity base and assets, the reputation of all concerned institutions for prudent management and their risk-averse track records, I believe the peril to be negligible.

As in every strategic decision management has to make, weighing the alternatives intelligently is half the answer: is it better to stand still and let leaner and meaner banks gradually nibble on your market share or take a measured risk that insures cross-fertilization opportunities and a further reinforcement of your dominant position?

Last but by no means least, a new business opportunity presents itself to banks with a regional presence: the possibility to participate in sizable deals region-wide with clients much larger than what the local market can offer and that could prove to be well “worth the candle” as the French would say.

Gerard Charvet: Advisor to Credit Bank

E: Do you fear any repercussions from political wrangling on the banking sector in 2005? How could this manifest itself and can the banks do anything to limit any unfavorable impact to the sector?

The instability created by the latest changes on the domestic political scene as well as the 1559 UN Resolution have created DE FACTO some degree of volatility in the monetary market. The US dollar has therefore become very much in demand as a result of this instability. The current political environment could over the medium to long-term have a negative influence on depositor behavior during 2005.

The local banks could react to such a situation by raising interest rates on deposits in Lebanese pounds and hence support the local currency for a while. However, such a policy emanating from the banks can only have an impact if the monetary authorities provide their full support. Local banks have no longer the financial capabilities to carry out such an initiative on their own. The local banking environment has become, during the last few years, increasingly competitive and deposit margins have moved downwards from 3.5% to less than 2% in the last five years. In this context of uncertainty, decreasing profitability and preparation for the new Basel II capital regulations, 2005 and 2006 are hence expected to witness a step up in the consolidation process of the banking sector. It is, therefore, desirable that the banking merger law is revived in order to support the much needed consolidation process and, as a consequence, help tackle the social aspect that might derive from such a process.

Nadim Moujais: Chief Strategist at SGBL

E: 2004 saw a classic merger at the top of the industry. What can we expect in 2005, especially among the medium–sized and smaller banks as well as within the Alpha group?

The rule regarding the pursuing of bank mergers in Lebanon cannot be different, although the number of banks per capita is still high. Theoretically, as long as a bank is achieving profits and a return on equity and its risk is well covered, it can continue on a solo trajectory. However, several factors have put pressure on Lebanese banks, irrespective of their size, to move towards the mergers and acquisitions. They include the Basle II capital adequacy, solvency and other requirements; the impact of the new IAS (international accounting Standards) rules and the central bank’s inclination to fortify sound banking practice, counting, in addition to its normal regulatory role, on a bank’s proven capability of management and achieved track record, to enlarge such practice through mergers and acquisitions.

Finally there is the ever-present issue of size, in which size still effectively matters, particularly in terms of capital base and balance sheet size. Whether it is for global asset/liability management (both on and off balance sheet items), or for regional expansion, major Lebanese-based banks have used Lebanon as the cornerstone of their regional development, where the comparison is imposed with some of the regions’ large-scale capital-based banks with their diversified assets composition. Hence, the quest for mergers and acquisitions will still be real in 2005 for banks with vision in Lebanon, CETIRUS PARIBUS on the political level. The real encounter depends of course on the political developments in Lebanon and in the region.