LEBANON'S banks have found it easy to prosper in an economic environment which allows them to earn interest rates of around 16 per cent on local currency lending, mainly to the government. Results for the first quarter of 1998 show huge gains. Bank of Beirut recorded a 73 per cent increase in net income. Banque du Liban & d'Outre Mer reported growth of 53 per cent. Byblos Bank topped the tables with a massive 125 per cent boost, although its merger with Banque Beyrouth pour le Commerce (BBC) inflated the figure somewhat.

It is clear though that as long as the budget deficit remains high, earnings from investment in government treasury bills (T-bills) will ensure that Lebanese banks remain highly profitable.

The drawback for the economy is that high interest rates put severe restraints on private investment. 'When they get such a high rate on T-bills, people do not have much interest in lending elsewhere,' says Semaan Bassil, vice- chairman of Byblos Bank.

However, the determination of Prime Minister Rafiq Hariri to cut the deficit and the gradual erosion of rates on T-bills mean that banks are aware that they cannot continue to rely so heavily on this line of income. 'We are increasing our revenue channels to mitigate the risk of lowering spreads on T-bills,' says Joe Sarrouh, advisor to the chairman of Fransabank.

In such a high interest rate environment, bankers agree that retail activities have the most potential for diversification. 'Consumers are less sensitive to pricing,' says Sarrouh. Beirut bankers also argue that they will always have an edge over foreign competitors, enjoying wider branch networks and a more intricate knowledge of the local market.

The development of retail lending activities takes time, but the view of the country's top banks is that it is preferable to be prepared in advance. 'The day that rates start going down we have to be ready to react quickly,' says Bassil. 'It takes time to build a consumer market,' adds Sarrouh.

Although retail banking in Lebanon is still in its infancy, some banks are slowly improving their products. Banks which until recently offered a single retail loan product are now devising specialised loans targeted at particular clients. Credit card facilities are being offered to an increasing number of customers. The government is also providing the banks with incentives to offer more mortgages.

Finding borrowers

Diversification is by no means limited to lending in Lebanese pounds. The structure of the Lebanese economy, with substantial inflows of dollars means that about 60 per cent of the banks' deposits are in dollars. The problem, the banks say, is finding suitable dollar borrowers.

'Utilisation of deposits in foreign currency has dropped from 68 per cent in June 1997 to 54 per cent now,' says Riad Salameh, Banque du Liban (central bank) governor. 'This is reassuring for the central bank,' he adds, 'but means less returns for the banks.'

This over-liquidity in dollars explains why so many banks were keen to get a slice of the government's international bonds issued in March. Over 50 per cent of the total $1,000 million issued was subscribed by local investors. 'Banks are flush with liquidity,' says Marwan Ghandour of Beirut finance house Lebanon Invest. 'The eurobond is one avenue for deploying those resources.'

Other bankers agree. All bemoan the scarcity of lending opportunities. The lack of activity is such that local banks signed their first ever project finance loan for a build-operate-transfer (BOT) project as recently as May this year. Its pricing may in part explain why such loans are few and far between. At 350 basis points over Libor, the cost of borrowing dollars from Lebanese banks is still far from competitive. The most recent bulletin of the central bank notes that the average lending rate for dollars is 11.8 per cent. As long as dollar loans are charged at such high rates, demand is unlikely to be stimulated.

As Lebanese banks prepare for a more competitive future, observers predict that the sector will see more consolidation. Nabil Aoun, chairman of local brokerage Fidus, expects between five and seven strong banks to dominate the market in the medium-term. 'The future will belong to banks that merge,' he says. The country is clearly overbanked with 117 local and foreign banks operating in a country with a population of about 3.7 million.

Certain central bank regulations have precipitated mergers, such as the requirement that banks achieve a capital adequacy ratio of 8 per cent in 1997. 'As we push our standards upwards, this will put constraints on local banks to increase capital or to merge,' says Salameh. The government also offers incentives to merge. Loans are granted at preferential terms for banks to invest in treasury bills. The income can be used to finance the costs of a merger.

Limitations placed on banks also have the effect of encouraging consolidation. Banks are only permitted to open two new branches a year. With the leading banks seeking to expand their retail activities, a merger or an acquisition provides a quick way to boost a branch network.

Byblos Bank clearly had this in mind when it secured a merger with BBC, adding 19 branches to bring its network to 50. It also sees the merger as a good strategic fit. BBC's strong presence in predominantly Muslim areas such as West Beirut complements Byblos' network, which is strongly focused on Christian areas.

Mergers also offer the potential of cutting operating costs. Aoun believes that this is crucial if Lebanese banks are to compete with the international banks entering the market. 'The most profitable bank will be the one which is most careful about costs,' he says. He points out that costs at foreign banks average about 4 per cent of deposits, whereas Lebanese banks have operating costs of 6-7 per cent.

Such challenges are generally viewed as relevant only in the medium term. For the moment Lebanese banks will continue to earn large profits on the back of high interest rates and good spreads. But banks are aware of what needs to done if they are to survive. If the government can continue to control the deficit, as it has done in the first four months of 1998, interest rates will eventually drop. The banks that will survive the fall are the ones who prepare for it now.