BANKERS are shrugging off the breakdown of merger talks between Byblos Bank and Banque Libanaise pour le Commerce (BLC). Though the fallout from the collapse of Lebanon's biggest banking merger will be felt throughout the sector, most believe that a clash of personalities and banking cultures lay behind Byblos Bank's decision to end negotiations to acquire a controlling stake in BLC. They are also convinced that the consolidation of the banking sector will continue. 'The failure to fulfil the merger was due to commercial reasons which are proper to them. It's an isolated case,' says Banque du Liban (central bank) governor Riad Salameh.

The handling of the merger negotiations was far from textbook. Analysts say Byblos chairman Francis Bassil had overvalued - at $119 million - the 53 per cent stake in BLC held by the Aboujaoude family, at the time of the original offer in January. The slow pace of the subsequent merger talks set the Beirut rumour mill grinding. Bassil is understood to have wanted to reduce the offer price by around $7 million after growing concerns over BLC's performance last year and doubts about the quality of the bank's assets. 'BLC is in bad shape, losing key staff. Byblos soon realised it had overpaid,' says one analyst.

In the end, BLC chairman Felix Aboujaoude's refusal to budge on the offer price effectively killed the deal. A number of BLC staff were also thought to be unhappy with the proposal, regarding it more as a takeover than a merger. The paternalistic ownership structure of the banks was another obstacle. 'Given that these banks are still family-controlled, merger negotiations can be a painful effort that can have negative repercussions on the market,' says Salameh.

Bankers are likely to draw a number of lessons from the episode, not least about the way such deals are handled. 'Mergers and acquisitions [M&A] needs due diligence, but this merger was heavily publicised and made de facto while both parties were at the engagement ceremony,' says Joe Sarrouh, adviser to the chairman of Fransabank.

The need for stronger, better capitalised banks remains pressing. With 70 commercial banks operating in a country of under 4 million people - the top 16 banks accounted for 84 per cent of total assets in 1998 - there is considerable scope for consolidation. The central bank will continue to encourage mergers, though Salameh says it will block further M&A activity among the bigger banks. 'We will encourage vertical rather than horizontal mergers among the top 10-15 banks at this stage. Mergers among the big banks can disrupt the overall market by creating unfair competition to smaller banks,' he says.

The central bank has offered a number of incentives to promote mergers, including raising the capital adequacy ratio, introducing soft loans and placing restrictions on new branch openings to two a year. Some critics have argued that the bank's pro-active stance has introduced imbalances into the system. In particular, the limit on new branches has artificially inflated the value of some of the country's banks as larger institutions have to resort to acquiring banks to grow their branch networks. As a result, branches have become worth more on the balance sheet.

Much of the recent merger activity has been driven by a need to increase market share but analysts say that banks need to place more emphasis on finding synergies before embarking on link-ups. If consolidation efforts do proceed, the banking sector is expected to be reduced to between 30 to 40 banks, comprising a 'big five', followed by a lower tier of 10-15 medium-sized operators.

Banks are at least aware that the easy days of living off the budget deficit by buying treasury bills are drawing to a close, as spreads continue a slow downward trend. Even so, high interest rates on deposits, combined with the high yields on treasury bills, will continue to boost bank deposit bases for the foreseeable future. Customer deposits rose significantly during the 1990s, accounting for 84 per cent of total sources for bank funds by the end of 1998. 'The balance sheet has developed by deposits alone,' says Bassam Yammine, an analyst at Lebanon Invest.

With around one-third of the banks' funds invested in government securities and local currency interest rates remaining high at around 16 per cent, lending to the private sector has been crowded out. Private sector loans as a proportion of total assets barely rose between 1997 and 1998, remaining at around 34 per cent.

The impetus to develop loan portfolios has also been restricted as earnings growth among banks remains strong. The average return on equity was 19 per cent in 1998, and asset growth was 20 per cent. However, an analyst from Lebanon Invest argues that with loan to deposit ratios in foreign currency at 54 per cent in 1998, well below the central bank's 70 per cent ceiling, banks still have room to expand their lending base. Banks remain highly liquid at almost 70 per cent on deposits of more than $30,000 million but profitability is likely to come under increasing pressure. Most bankers acknowledge a need to transform their liquid balance sheets through more aggressive lending-oriented policies.

There are signs that banks are beginning to look seriously at generating more fee-based income, through offering insurance products, brokerage services and leasing facilities. 'Banks have been funding the deficit for the past 10 years and they've been happy to do it, but they'll only be able to do that for another couple of years. Instead, they should offer value-added services, such as research, asset management and back office services,' says Karim Souaid, an analyst at Middle East Capital Group.

As long as economic activity remains depressed, opportunities for increasing loan portfolios are likely to remain circumscribed. However, retail banking is a largely untapped resource and banks are expected to increase their exposure in this area. Electronic banking is now widespread and credit card use increased by 20 per cent between 1997 and 1998. A recent agreement among leading banks to support a state-backed housing loan programme is likely to provide a further boost to the real estate sector, which accounts for 12 per cent of private sector loans.

Byblos Bank remains the leading retail bank, but Banque Audi has started to target the market with the launch of an interest bearing current account and the acquisition of a 10 per cent stake in insurance group Societe Nationale d'Assurance (SNA), through which it plans to launch a number of insurance products aimed at the low-to-medium income market.

Consumer lending will help provide banks with higher margins to compensate for the squeeze on spreads but is unlikely to lead to dramatic improvements in loan to deposit ratios. 'The development of retail banking will increase loan to deposit ratios in foreign currency, but not significantly. Two per cent a year is a fair projection,' says Banque Audi director Marc Audi.

Banks also have considerable room to improve their operational efficiency as relatively little attention is being paid to cost control and over- staffing is rife. 'Lebanese banks have opportunities they haven't tapped into. Few are doing much about staff reduction. Banks could cut costs by 30-40 per cent,' says Yammine.

Analysts expect shareholders to increase pressure on management to contain costs and trends are moving in the right direction as diminishing political risk should reduce expenses. 'One of the major costs is the cost of interest banks pay on their deposits and this is linked to the political situation. If the political risk is diminished the spreads they pay on their deposits would decrease,' says Salameh.