Lebanon's financial system resilient to conflict

Lebanon's financial system resilient to conflict

Most Middle Eastern economies staged a recovery of sorts last year, after the turmoil that swept the region in 2011. Lebanon is unfortunately an exception to this trend, due to events just beyond it borders, but the strength of its financial system provides reassurance.

Buffeted by the worsening Syrian conflict next door, Beirut’s capacity to shield its economy from it’s neighbour’s violent implosion has been limited. The impact on Lebanon’s economic growth has been significant, with the IMF downwardly revising GDP growth for 2012 and 2013 to 2% and 2.5% respectively, from 3% and 4% previously. This represents a big step down from the impressive average 8% GDP growth rates racked up in the 2007-2010 period, and is markedly below the Middle East and north Africa (Mena) average of 3.8% last year.

Lebanon’s fabled immunity to political risk events has come into question, with a mixture of external and internal tensions adversely affecting investment, tourism, exports and foreign direct investment.

The public finances have felt the pinch, with figures released by the finance ministry in February revealing that the fiscal deficit rose 77% in the first 10 months of 2012 to $2.7bn compared with the previous year.

The financial system – the pivot for the Lebanese economy – has not escaped the collateral damage. Bank profits were down slightly in 2012, with a 0.6% contraction in net profits and lending was down 8% to $4.1bn.

Pressures on spreads and margins, slow fee income growth and higher provisioning requirements have all hit banks’ bottom lines.
Saad Azhari, group chairman of Blom Bank, one of the country’s three largest lenders, says: “There is no doubt that domestic and regional tensions have left their mark on the local and regional economies and, consequently, on the Lebanese banking system.

As a result, the growth of Lebanese banks in 2012 was less than half of what it was during the 2007-10 period. But it is also a mark of the system’s resilience and strength that it registered decent growth in 2012, and remained profitable despite booking $400m in provisions on their Syrian exposures alone.”

The five listed Lebanese banks – Blom, Byblos Bank, Bank Audi, Bank of Beirut and Bemo – posted an aggregate 2.4% growth in profits to $1.01bn in 2012, but stripping out the sale of 81% of Audi’s LIA insurance arm to Morocco’s Saham Finances for $44.5m, this group would have shown a decline in net income.

Operating conditions are getting tougher due to the low interest rate environment, which is putting pressure on spreads says Marwan Barakat, assistant general manager and chief economist at Bank Audi. “The interest margins in Lebanese pounds and foreign currencies are being adversely affected by the low interest rate environment. The profit decrease is not huge, but banks have been accustomed to double-digit earnings growth for a number of years.”

Lebanese banking chiefs acknowledge the pain, but emphasise their resilience to internal and external shocks. Azhari says: “Lebanese banks have naturally acquired a lot of experience and expertise in operating under conditions of risk and uncertainty, and their hallmark is a conservative strategy that stresses adequacy of capital, liquidity, and quality of assets. That is in addition to a sound supervisory and regulatory system that strives for adequate control over risk, safety and adherence to international rules and regulations.”

Shock absorbers
Banks have addressed problem loans on their balance sheets and though further deterioration in loan quality is expected in the coming quarters, noted Standard & Poor’s in a January 2013 report on Lebanon’s financial sector, banks remain in a position to absorb such deterioration as they continue to bolster collective provisioning that started in 2011 in anticipation of a potential increase in nonperforming loans, especially in Syria and Egypt.

Deposit growth looks sustainable since Lebanon relies on remittance inflows from expatriates who show no inclination to stop transferring money back home, however challenging the political climate looks.

Barakat says: “The moderate growth in our deposit base is satisfactory within the current regional turmoil and its corollary, the adverse effects on the Lebanese economy. Last year Lebanese banks witnessed an increase in the deposit base of $9.3bn, and the year before it was $8.5bn, so we are talking about an 8% increase which is more than we need given that the threshold – what is needed to finance the public and private sectors – is about 5%.”

This resilience, imbued by the diaspora’s confidence, is important as the financial sector remains the backbone of the Lebanese economy. Customer deposits are 2.7 times larger than loans, and are largely channelled towards Lebanese government debt that dominates the capital market and banks’ balance sheets.

With a ratio of assets to GDP exceeding 360% and a ratio of credit to the private sector to GDP of more than 100%, the banking system is the main conduit for private savings and investments in the economy.

Azhari says: “It is also financially sound and stable, with a capital adequacy ratio of 12% and a liquidity ratio of more than 60%, and a reserve position – vault cash and deposits at the central bank – of $50.8bn, close to a third of assets. And despite political instability at home and the near abroad in 2012, total assets increased by 8% to $151.9bn and loans to the private sector rose by 10.4% to $43.5bn.”

The balance sheets of financial institutions grew a respectable 11.6% to $1.217bn at the end of November 2012, compared with $1.09bn at end-November 2011.

One core area of vulnerability is Lebanese banks’ footprint in war-torn Syria, where economic activity has collapsed. The violence in Syria has exacted a heavy toll on the performance off Syrian affiliates of Lebanese banks, which reported a 69.4% decline in net consolidated profits to $7.6m in the first three quarters of 2012, attributed to the impact of increasing provisions on loan impairments.
The banks’ asset base in Syria may have contracted, but they have taken all steps necessary to maintain asset quality.

In comments to the media in mid-February, veteran central bank governor Riad Salameh said he did not expect any negative surprises from the Syrian situation on Lebanese banks, having scaled down their operations.

Analysts agree. “The Syrian subsidiaries have suffered a bit but the impact on overall banking sector is minimal because their exposure to subsidiaries does not exceed 10-15% of total assets,” says Joelle Samaha, a banking analyst at Credit Libanais.

Some Lebanese banks have even been able to book profits in Syria, says Joe Sarrouh, executive adviser to the chairman of Fransabank, one of eight Lebanese banks with Syrian franchises. “Because of the devaluation of the Syrian currency, most have registered profits, but lending activity is almost nonexistent and many Syrian businesses have moved their factories to Egypt and Algeria,” says Sarrouh.

Lebanese banks are confident that they will not lose money on Syria. “Ultimately the Syrian business community will pay their dues, maybe with some delay but they will pay as they need the banking system,” says Sarrouh.

Improvement on the horizon
Lebanese bankers’ somewhat chipper demeanour suggests better news may be in store this year. One source of support is the decision of the central bank – the Banque du Liban (BdL) – to bring in a fiscal stimulus package in January that is designed to support lending and bolster economic growth.

BdL is issuing £Leb2.2trn ($1.46bn) in credit facilities to commercial banks at a 1% interest rate, most earmarked for real estate projects.

Salameh said the stimulus package had become necessary after banks exhausted subsidised loans by utilising free reserve requirements. Under the new scheme, Lebanese banks are obliged to place 15% of their Lebanese pound deposits and 15% of foreign currency deposits in the central bank at 0% interest.

Barakat says: “The aim is to provide support to growth in the economy by giving banks favourable conditions. They can get liquidity from the central bank at low rates of interest and lend in domestic markets.”

Banks lent $4.1bn in 2012 to the domestic economy, helping to avert recession. The stimulus measures will also help to offset pressure on interest margins, says Barakat. He adds: “Liquidity is very costly and we have a negative carry on primary liquidity in foreign currency, so we are interested in lending just to alleviate pressure on interest rate margins.”

Future revenue growth will still be determined by organic growth domestically and regionally with improving outlook for the period 2013-15. “Lebanese banks are dynamically operating in many regional countries and international ones and would play later a vigorous role in financing the reconstruction of Syria,” says Makram Sader, secretarygeneral of the Association of Banks in Lebanon.

“Lebanese banks are innovating constantly, especially in the area of retail banking and are making use of advances in technology. There is always scope for regional expansion which is a function of good profit opportunities and financial liberalisation.”
The BdL’s stimulus package is not a precursor to a more interventionist stance by the central bank, though Lebanese financial institutions have reacted frostily to government proposals to raise the tax on interested on deposits from 5% to 7%.

The BdL’s light-touch regulatory approach will continue, the independence of the central bank undergirding the banking sector’s resilience through all the shocks – both external and internal – that have afflicted Lebanon over the decades.

Azhari says: “The Lebanese banking system has always been open, free, and devoid of government interference – and I see no danger that this attitude will be changed. Of course, banks are subject to effective regulation by the central bank, but that is part of the governance system that any reputable banking system is subject to.”

In addition, the Lebanese banking system has constantly provided funding to meet the government’s financial needs – carrying 54% of the public debt – though has always voiced its concern regarding the government’s recurrent budget deficits and the need to control them.

“Lebanese banks are committed to fund the economy and help its growth without having to be interfered with by the government, “says Azhari.

International compliance
BdL has also given a strong push to ensure bank preparedness for Basel risk management requirements. Strict BdL rules on Basel III requires banks to hold 8% common equity, 10% core tier 1 ratio and 12% total capital ratio by the end of 2015, some three years ahead of the Basel Committee’s deadline.

Lebanon’s financial system can provide lessons for others in the region, as the heightened risk environment that institutions in Beirut have long been accustomed to becomes a regional norm.

Azhari says: “What the Lebanese banking system can offer other countries is the importance of being conservative, precautionary, and to ‘keep it simple’ – in the sense of avoiding excessive risk and ‘exotic but toxic’ assets – besides the importance of having a vigilant supervisory authority that maintains effective cooperation with the banks.”

Though the sluggish domestic economy and regional unrest may push up the cost of risk in the next few years and momentarily stall banks’ asset diversification away from sovereign exposure, warns S&P, other Arab economies could do worse than follow Beirut’s template.

“Monetary policy in Lebanon can play an important lesson for those Middle East countries that are witnessing pressure on exchange rates and on their international reserves,” says Barakat.

Further risk events will doubtless be on the horizon, with parliamentary elections scheduled for June 2012. Before then, an electoral law will need to be passed, and this remains a bone of contention between the opposition 14th March movement, which draws in an anti-Syrian coalition of mainly Sunni Muslim and Christian parties, and the so-called 8th March bloc that is supported by Hezbollah, among others.

There remains a big divide between the rival political camps over the law, with controversy surrounding the proposed redrawing of electoral constituencies. A period of extended political drift would be bad for business. Azhari says: “No doubt, the Lebanese economy badly needs confidence-enhancing measures, and prime among these measures are good political and security conditions.

In this respect, if the elections in June were to add to these conditions, then it will have a favorable impact on the economy, through a better investment and business climate and more capital and tourist flows. This is turn is bound to enhance banking activity and the prospects for more active financial markets.”