An initial glance at the income statements of the major Lebanese banks gives little indication of the country's tumultuous recent past, which culminated in Hezbollah's show of strength on the streets of Beirut in May.

Bank sector profits have held up strongly, with the year-on-year average profits for the five listed banks - Byblos Bank, Blom Bank, Banque Audi, Bank of Beirut and Bemo Bank - growing by 18.5 per cent in 2007. That resilience reflects the continued strength of customer deposits, which increased by 11 per cent over the year. The strong net income showing has continued through the first quarter of 2008, with the biggest banks showing, on average, 20 per cent increases in profits.

Political turbulence

"We had a good year last year," says Alain Wanna, head of finance at Byblos Bank, which reported profits of nearly $100m in 2007. "Net income was up 25 per cent and our balance sheet grew by nearly 16 per cent."

Lebanon's depositors are not easily deterred by political turbulence, according to ratings agency Moody's Investors Service. Deposits have grown in each of the past three years, which have been marked by serious disruption, notably the assassination of former prime minister Rafiq Hariri in 2005, the Israeli bombing campaign of 2006 and the Hezbollah-led blockade of government buildings in 2007.

The strong profits also reflect the calmer year Lebanese banks enjoyed in 2007 compared with 2006, when the summer war between Hezbollah and Israel delivered a massive blow to the local economy.

Some improvement would therefore be expec_ted, but the healthy growth across the board attests to robust confidence levels. Since deposits are the primary source of government financing, intermediated via the banks, this is also a cornerstone of Lebanon's economic wellbeing.

Lebanese banks are adept at transforming domestic challenges into external opportunities. Over the past few years, a steady stream of institutions have enhanced their overseas footprints, opening branches and acquiring institutions across the Middle East and beyond. These have provided a strong source of earnings, offsetting weaker lending opportunities in the sluggish local economy. Geographic expansion has afforded the means of deploying liquidity that would otherwise have little use in the local context.

The two largest Lebanese banks - Banque Audi and Blom Bank - have accumulated the largest number of franchises outside the country's borders, from as far afield as Algeria and Armenia. Having extensively penetrated nearby markets in Egypt, Jordan and Syria, Lebanese banks are now targeting the lucrative Gulf market. In May, Blom Bank obtained regulatory approval to set up a Saudi-based investment company with local investors, with the Lebanese owning 60 per cent of the shares. Blom has also been given permission to set up in Qatar. One of the country's oldest institutions, Fransabank, is in the process of finalising an acquisition in the former Soviet Republic of Belarus.

Adding depth

The overseas diversification of funding and income streams gives the banks greater strategic depth, particularly in light of the small size of the local economy. "We have about $85bn in assets and $70bn in deposits in the system," says Joe Sarrouh, adviser to the chairman of Fransabank. "This tells me this is well beyond the needs of the public and private sector in Lebanon."

Banque du Liban's (central bank) liberal regulations allow banks to book loans domestically even if the exposure is physically outside the country. A further bout of reorganisation and the streamlining of processes have also facilitated the move overseas.

"Banks have been developing human resources and migrating technologies, and implementing Basel II regulations," says Sarrouh. "There is an understanding of the need to expand, but the real issue is whether they can bring added value to where they are going."

Lebanese banks continue to yield high returns accrued from investing in government securities. Local banks hold just over 51 per cent of total government debt, now estimated at $43.2bn. Moody's says about 45 per cent of the banks' total interest income derives from sovereign-related investments and placements with the central bank.

That level of exposure remains a structural weakness, yet also a source of near-term profitability, given that the domestic economy has failed to register substantial lending oppor_tunities that might yield more sustainable income streams.

Ultimately, it is the banks' ability to draw in the deposits, largely from Lebanese expatriates and wealthy GCC citizens with some link to the country, that underpins the sector's confidence in times of instability.

The strength of the banking sector appears out of kilter with an economy that has struggled to grow by 2 per cent over the past year. Yet Lebanese banks have long been effectively decoupled from the Lebanese economy. According to credit ratings agency Standard & Poor's, Lebanon's banking sector assets represent about 3.5 times the country's gross domestic product (GDP), estimated at $24.4bn in 2007.

Local banks are not just decoupled from the local economy, they have also been able to shrug off global credit concerns. Like other Middle East banking systems, Lebanon's has not been seriously affected by the fallout from the US sub-prime crisis, since it does not rely on financing on the international market, and banks are barred from investing in structured products.

Beirut's bankers appear increasingly confident about the future in the wake of the Doha agreement, reached on 21 May when Lebanese political factions met to elect General Michel Suleiman as president. This ended the political stalemate and paved the way for the nomination of a government of national unity. Credit spreads have narrowed since the signing of the agreement, and the price of government paper is improving. Bankers note rising demand from international investors for such paper.

Byblos Bank intends to capitalise on this optimistic outlook. "We see this continuing, especially after the Doha agreement," says Wanna. "Things are moving again and if the economy starts to move, loans will also start to increase. We already see demand from corporate clients starting to pick up."

Bankers say improved perceptions of sovereign risk post-Doha will have a material impact. "If you look at overall margins, they will improve in line with the prices of financial instruments, whether fixed income or equity," says Wanna.

Doha effect

The much-vaunted Doha effect could deliver a wider economic uplift that will allow banks to improve on their sluggish lending performances. Riad Salameh, governor of the central bank, expects GDP growth to outpace the 2-3 per cent projected by the International Monetary Fund (IMF) as a result of the deal. It will also feed through into a better retail performance.

Yet Lebanese banks' loan franchises remain weak, making up less than one quarter of total balance sheets. This is a reflection of conservative lending strategies, amid weaker macro_economic conditions. It is another area where bankers expect to register improvement, though this may take more time. Moody's is maintaining a cautious outlook for now. "If the reforms do materialise, it will have a positive impact on the banking system," says Nondas Nicolaides, an analyst at Moody's. "A corporate pick-up is likely if things stabilise. But business confidence is still subdued and it remains to be seen if the Doha agreement will be fully implemented."

The larger banks look well positioned to grow in the consumer market, having developed an array of products such as credit cards, car loans and housing loans. "We are starting to see retail growth, particularly from housing loans," says Walid Raphael, deputy general manager of Banque Libano-Francaise (BLF). "Since the Doha agreement, we see strong interest in the real estate sector."

Lebanese banks face other obstacles. A significant challenge looms on the human resources front, as Lebanon's financial market sophistication has made the country a recruiting ground for the Middle East's banks. This could leave the local sector weakened if it continues. "The key issue is to have access to talent and be able to retain them," says Raphael. "We need these key people for expanding our overseas presence."

The other big challenge is the need to consolidate. Although the sector is highly concentrated - the top 10 banks control about 75 per cent of the sector's total assets - Lebanon is still overbanked, with more than 60 institutions catering for a population of 4 million.

The banks' headlong rush into overseas markets has meant that many have taken their eye off assets in the local market. Only a handful of deals have been completed in the past couple of years, including Fransabank's acquisition of BLC Bank's local operations for $153m last year.

The larger banks are likely to look favourably on the prospect of picking up a smaller local bank with a strong fit. "Consolidation will continue on a faster track because of Basel II requirements," predicts Wanna.

Basel II regulations forbid the excessive holding of non-investment-grade government debt. For smaller banks, the only way to compete in these circumstances may be to link up with bigger institutions.

Yet Lebanese banks still appear to be looking overseas when it comes to merger and acquisitions strategies. The more attractive offerings may still lie outside Lebanon's borders. Banque Audi, the largest Lebanese bank in terms of assets, has held talks this year with Egyptian brokerage EFG-Hermes over a possible merger.

This particular thrust ties in with Lebanese bankers' vision of growing opportunities emerging from the wider region, rather than the domestic market. "There is a lot happening in the region," says Sarrouh. "Liquidity is awash and we are seeing regional investors pursuing ownership of some major banks. Beirut looks a good place to be."