General background

Before the civil war erupted in 1974

Lebanon was the Middle East’s banking center.

The strict secrecy law and the free exchange system attracted money

from all Arab countries

During the civil war period

The picture became totally different.The picture became totally different.

“ “In the 1980s banks grew more In the 1980s banks grew more reliant on lending to government, reliant on lending to government, either directly or via three month either directly or via three month treasury bills”treasury bills”

(EIU (EIU Country Profile 1997-1998Country Profile 1997-1998, p. , p. 25). 25).

Following the civil warFollowing the civil war

Lebanon has been a dollarized Lebanon has been a dollarized economy (Khoury, 1999, p. 26). economy (Khoury, 1999, p. 26).

65.6 per cent of deposits and 89.2 65.6 per cent of deposits and 89.2 per cent of credits are dominated in per cent of credits are dominated in US dollars (Banque Audi, US dollars (Banque Audi, 1st Quarter 1st Quarter Economic ReportEconomic Report, 1999, p. 5). , 1999, p. 5).

The days of banks’ healthy profits The days of banks’ healthy profits and easy money are coming to an and easy money are coming to an

endend The Lebanese government The Lebanese government

succeeded in saving interest succeeded in saving interest payments by switching from payments by switching from domestic to international borrowing.domestic to international borrowing.

A decline in the Treasury bill yields A decline in the Treasury bill yields and a decrease in the banks’ profits and a decrease in the banks’ profits manifested this success. manifested this success.

Pressure is mounting on the Pressure is mounting on the smaller banks and acquisitions smaller banks and acquisitions are picking up.are picking up.

To minimize the risk facing the banking To minimize the risk facing the banking industry in Lebanon, the Central Bank has industry in Lebanon, the Central Bank has been working hard to promote merging been working hard to promote merging between banks by offering:between banks by offering:

low cost loanslow cost loans two-years tax holiday two-years tax holiday Exemptions from employment legislation Exemptions from employment legislation

to acquirers for five years. to acquirers for five years. ““In 1997 the Central Bank also imposed In 1997 the Central Bank also imposed

new capital requirements to encourage new capital requirements to encourage undercapitalized banks to merge” undercapitalized banks to merge”

(EIU (EIU 1998-1999 Country Profile1998-1999 Country Profile, p. 21). , p. 21).

Table I shows that 19 banks have been taken

over by larger ones in the period 1993-1999.

Need for the study

During the post-war period 1992-98 Lebanese During the post-war period 1992-98 Lebanese commercial banks enjoyed making huge profits commercial banks enjoyed making huge profits by offering short-term deposits and reinvesting by offering short-term deposits and reinvesting the proceeds in high-yielding government the proceeds in high-yielding government Treasury bills.Treasury bills.

Charles Olivier (1999) reports that a significant Charles Olivier (1999) reports that a significant chunk of Lebanese commercial banks’ profits chunk of Lebanese commercial banks’ profits between 55 and 70 per cent has been made by between 55 and 70 per cent has been made by taking 45 days deposits (offering 12 per cent) and taking 45 days deposits (offering 12 per cent) and reinvesting the proceeds in government treasury reinvesting the proceeds in government treasury bills (where two-year paper yields 16 per cent). bills (where two-year paper yields 16 per cent).

There is, however, a darker side to this There is, however, a darker side to this

rosy picturerosy picture

The short maturity of the deposits has The short maturity of the deposits has prevented commercial banks from prevented commercial banks from lending to firms on medium or long term lending to firms on medium or long term basis.basis.

In addition to this, the emphasis of the In addition to this, the emphasis of the Lebanese government on borrowing from Lebanese government on borrowing from abroad has caused the Lebanese interest abroad has caused the Lebanese interest rates to go down rates to go down

((EuromoneyEuromoney, June 1999, p. 280). , June 1999, p. 280).

, “In late 1995, however, the steam began , “In late 1995, however, the steam began to run out of the construction boom” to run out of the construction boom”

(EIU (EIU Country Profile 1998-99Country Profile 1998-99, p. 13). , p. 13).

Internet waves have arrived on Internet waves have arrived on Lebanese shores and the transactions Lebanese shores and the transactions moved up from ATM to Pay-by-the-moved up from ATM to Pay-by-the-Phone to E-banking. Phone to E-banking.

Customers at few-alpha group banks Customers at few-alpha group banks (banks whose deposits are over US (banks whose deposits are over US $500 million) such as Saradar, HSBC $500 million) such as Saradar, HSBC Bank Middle East, Credit Libanais and Bank Middle East, Credit Libanais and Banque National de Paris, Banque National de Paris, Intercontinentale (BNPI) can sit at Intercontinentale (BNPI) can sit at home and enjoy browsing few banking home and enjoy browsing few banking servicesservices . .

Convenience, customer satisfaction and Convenience, customer satisfaction and low cost are the name of the game in low cost are the name of the game in this information age. The big banks are this information age. The big banks are able to play the game. They are able to play the game. They are customer driven and working hard on customer driven and working hard on satisfying customers’ needs and satisfying customers’ needs and retaining customers. retaining customers.

Knowing all of these, it becomes Knowing all of these, it becomes imperative to ask what will happen to imperative to ask what will happen to the smaller banks?the smaller banks?

“ “The general sentiment among The general sentiment among analysts is that Lebanon’s bank merge analysts is that Lebanon’s bank merge process is on track” (EIU process is on track” (EIU Country Country Report, 2nd Quarter 1999Report, 2nd Quarter 1999, p. 27). , p. 27).

If Lebanon plans on having big If Lebanon plans on having big competitive banks it can expands competitive banks it can expands regionally into countries having regionally into countries having underdeveloped banking systems underdeveloped banking systems and tight control such as Iraq, Syria, and tight control such as Iraq, Syria, Jordan and Palestine. Today, Jordan and Palestine. Today, “Together with Bahrain, Lebanon is “Together with Bahrain, Lebanon is considered a regional leader in considered a regional leader in derivatives trading” derivatives trading”

(EIU (EIU Country Profile 1997-98Country Profile 1997-98, p. 29)., p. 29).

Purpose of the study

There are 59 commercial banks in There are 59 commercial banks in Lebanon which make their financial Lebanon which make their financial statement available to the public. These statement available to the public. These financial statements are published in an financial statements are published in an industry publication, industry publication, Bank Data: 328 Bank Data: 328 Financial Statements AnalyzedFinancial Statements Analyzed . .

52 financial ratios are calculated for each 52 financial ratios are calculated for each of the banks, and the banks are ranked of the banks, and the banks are ranked based on their performance for each ratio.based on their performance for each ratio.

For decision makers trying to For decision makers trying to compare banks, analyzing 52 compare banks, analyzing 52 financial ratios may be too roughfinancial ratios may be too rough

It would seem more appropriate It would seem more appropriate to look at a smaller number of to look at a smaller number of ratios that explain nearly as ratios that explain nearly as much as the 52 ratios do.much as the 52 ratios do.

Analysis

Factor analysisFactor analysis is used to find seven is used to find seven financial ratios that adequately explain the financial ratios that adequately explain the differences in bank performance. differences in bank performance.

Cluster analysis Cluster analysis is then used to separate is then used to separate banks into four different performance banks into four different performance clusters. clusters.

MultidiscriminantMultidiscriminant analysis analysis is then used is then used to quantitatively examine the differences to quantitatively examine the differences in performance between these clusters. in performance between these clusters.

This research is organized as follows:

A review of the literature is provided A review of the literature is provided in the next sectionin the next section

The data are described in the The data are described in the following section. following section.

The application of factor analysis as The application of factor analysis as data reduction technique is shown in data reduction technique is shown in the section after this.the section after this.

The application of multidiscriminant The application of multidiscriminant analysis to examine the differences analysis to examine the differences between clusters is shown in the between clusters is shown in the following section. following section.

The predictive ability of the model is The predictive ability of the model is shown in the penultimate section shown in the penultimate section while the concluding remarks for while the concluding remarks for merger between banks are merger between banks are presented in the final sectionpresented in the final section

Review of literature

Bridging the gap between advanced Bridging the gap between advanced multivariate statistical analysis and multivariate statistical analysis and financial ratio analysis for studying industry financial ratio analysis for studying industry characteristics has been growing steadily in characteristics has been growing steadily in the financial literature, e.g. Charbaji and the financial literature, e.g. Charbaji and Ali (1995), Altman (1968), Collins and Ali (1995), Altman (1968), Collins and Green (1982), Deakin (1972), bond ratings, Green (1982), Deakin (1972), bond ratings, e.g. Beaver (1966) and mergers and take-e.g. Beaver (1966) and mergers and take-over, e.g. Stevens (1973), Pinches over, e.g. Stevens (1973), Pinches et alet al. . (1973). (1973).

The dataThe data

The data used in this study are 52 The data used in this study are 52 different financial ratios that have been different financial ratios that have been calculated for 59 commercial banks in calculated for 59 commercial banks in Lebanon for the fiscal year 1999.Lebanon for the fiscal year 1999.

All of these data were taken from the All of these data were taken from the

publication, publication, Bank Data: 328 Financial Bank Data: 328 Financial Statements AnalyzedStatements Analyzed, by Fredi Baz , by Fredi Baz (1996).(1996).

In view of the sensitivity of the In view of the sensitivity of the results to the assumption of results to the assumption of normality in the observed sample, it normality in the observed sample, it was decided to use the common log was decided to use the common log transformation of the financial ratios. transformation of the financial ratios.

Because of having missing Because of having missing observations, nine banks were observations, nine banks were deleted from analysis by the use of deleted from analysis by the use of SPSS. SPSS.

Table II shows the skewness of the Table II shows the skewness of the seven financial ratios that were seven financial ratios that were selected by factor analysis Skewness selected by factor analysis Skewness of two financial ratios (X15 and X44) of two financial ratios (X15 and X44) are shown before and after log are shown before and after log transformation in Table II.transformation in Table II.

Skewness of significant financial Skewness of significant financial ratiosratios

x0950.0040.0030.0020.0010.000.00

Fre

qu

ency

30

20

10

0

A Graphical Representation of A Financial Ratio

Before Transformation (Highly Skewed)

Mean =7.07Std. Dev. =12.08

N =49

LOGX92.001.000.00-1.00-2.00

Fre

qu

ency

10

8

6

4

2

0

A Graphical Representation of A Financial Ratio

AfterTransformation (Almost Normal)

Mean =0.40Std. Dev. =0.709

N =46

Application of factor Application of factor analysisanalysis

Factor analysis was used to find seven Factor analysis was used to find seven financial ratios that adequately explain three financial ratios that adequately explain three dimensions of bank performance. The three dimensions of bank performance. The three dimensions of bank performance were:dimensions of bank performance were:

The The profitabilityprofitability factorfactor The The investmentinvestment factor factor The The liquidityliquidity factor factor The oblique solution from the factor analysis The oblique solution from the factor analysis

is shown in Table III.is shown in Table III.

Oblique rotation factor solution

Pattern matrixPattern matrix

..

Structure matrixStructure matrix

..

Definition of the significant financial ratios

Profitability ratiosProfitability ratios

X5 Interest margin = (Interest income from X5 Interest margin = (Interest income from loans and securities – interest expense on loans and securities – interest expense on deposits and other debt issues)/Total assets. deposits and other debt issues)/Total assets. The net interest margin measures how The net interest margin measures how large a spread between interest large a spread between interest revenues and interest costs revenues and interest costs managementmanagement has been able to achieve by has been able to achieve by close control over the bank’s earning assets close control over the bank’s earning assets and the pursuit of the cheapest sources of and the pursuit of the cheapest sources of fundingfunding

X8 Total spread = (Interest X8 Total spread = (Interest income/Earning assets) – (Interest income/Earning assets) – (Interest expense/Interest bearing liabilities). expense/Interest bearing liabilities).

Spread measures the Spread measures the effectiveness of the bank’s effectiveness of the bank’s intermediation function in intermediation function in borrowing and lending money and borrowing and lending money and also the intensity of competition also the intensity of competition in bank’s market area. in bank’s market area.

Greater competition tends to squeeze Greater competition tends to squeeze the difference between average asset the difference between average asset yields and average liability costs. yields and average liability costs.

If other factors are held constant, the If other factors are held constant, the bank’s spread declines as competition bank’s spread declines as competition increases, forcing management to try increases, forcing management to try other ways to make up for an eroding other ways to make up for an eroding earning spread.earning spread.

X15 Interest paid/Interest received. X15 Interest paid/Interest received. Shows how much of the interest Shows how much of the interest received goes to interest to be paid. It received goes to interest to be paid. It measures operating conditions and measures operating conditions and cost efficiencycost efficiency . .

Investment ratiosInvestment ratios

X34 ROE = Net income after X34 ROE = Net income after tax/Total equity. It is a measure of tax/Total equity. It is a measure of the rate of return flowing to the the rate of return flowing to the bank’s shareholders. bank’s shareholders.

It approximates the net benefit that It approximates the net benefit that the shareholders have received from the shareholders have received from investing their capital in the bank.investing their capital in the bank.

X39 Net return on average equity to X39 Net return on average equity to hurdle rate. The hurdle rate is the hurdle rate. The hurdle rate is the

required rate of return in a required rate of return in a discounted cash flow analysis. discounted cash flow analysis.

This rate must be equal to the This rate must be equal to the increment cost of capital. If expected increment cost of capital. If expected

rate of return on an investment is rate of return on an investment is below hurdle rate, the project is not below hurdle rate, the project is not

undertaken.undertaken.

Liquidity risk ratios

X24 Total net liquid assets/Total deposits. X24 Total net liquid assets/Total deposits. Banks issue liabilities that are redeemable Banks issue liabilities that are redeemable at par. Saving accounts are deposits that at par. Saving accounts are deposits that pay interest. Checking accounts are pay interest. Checking accounts are deposits that have no maturity. deposits that have no maturity.

Current accounts are similar to saving Current accounts are similar to saving accounts but subject to income tax. accounts but subject to income tax.

Fixed deposits are deposits blocked for a Fixed deposits are deposits blocked for a period of time and pay higher interest period of time and pay higher interest rates. rates.

Banks and correspondents are placement Banks and correspondents are placement accounts that a bank opens with its accounts that a bank opens with its

correspondent bank.correspondent bank.

They are of two types: call accounts with a They are of two types: call accounts with a two days notice before withdrawal and two days notice before withdrawal and

blocked accounts with longer maturities. blocked accounts with longer maturities.

The liquid assets consist of cash with banks, The liquid assets consist of cash with banks, plus securities, which are the short term plus securities, which are the short term

Treasury Bills by the Lebanese government.Treasury Bills by the Lebanese government.

X44 T Bills/Tot DepositsX44 T Bills/Tot Deposits

Classification of banks into homogeneous groups

Cluster analysis Cluster analysis was used was used to identify to identify four relatively homogeneous groups four relatively homogeneous groups with the 50 commercial bankswith the 50 commercial banks that that had complete information on the financial had complete information on the financial ratios that were determined by factor ratios that were determined by factor analysis. analysis.

The banks are classified into four The banks are classified into four cohesive clusters, depending on their cohesive clusters, depending on their profitability, investment and liquidity risk profitability, investment and liquidity risk factors.factors.

Group IGroup I consists of Bank of consists of Bank of Beirut and Arab Countries sal., Bank Beirut and Arab Countries sal., Bank of Kuwait and the Arab World sal., of Kuwait and the Arab World sal., Bank of Lebanon and Kuwait, Banque Bank of Lebanon and Kuwait, Banque Lebanaise Pour le Commerce sal.Lebanaise Pour le Commerce sal.

(This bank is under consideration to (This bank is under consideration to be taken over very soon by UBL: be taken over very soon by UBL: United Bank of Lebanon), Byblos United Bank of Lebanon), Byblos Bank sal., Banque Audi sal., Banque Bank sal., Banque Audi sal., Banque Libano- Francaise sal.Libano- Francaise sal.

Banque Misr Liban sal., Banque de la Banque Misr Liban sal., Banque de la Bakaa, Banque de la Mediterrennee Bakaa, Banque de la Mediterrennee sal., Banque du Liban et d’ Outer Mer sal., Banque du Liban et d’ Outer Mer sal., Credit Bancaiare sal., Credit sal., Credit Bancaiare sal., Credit Lebanese sal., Fransabank sal., Lebanese sal., Fransabank sal., Lebanese Canadian Bank sal., Lebanese Canadian Bank sal., Lebanese Swiss Bank sal., Lebanon Lebanese Swiss Bank sal., Lebanon and Gulf Bank sal., Saudi Lebanese and Gulf Bank sal., Saudi Lebanese Bank sal., Societe Generale.Bank sal., Societe Generale.

Libano-Europeenne de Banque sal Libano-Europeenne de Banque sal

Group I Group I is is characterized by having very characterized by having very high T bills/Total deposits, the highest high T bills/Total deposits, the highest interest paid to interest received, interest paid to interest received, average total spread, close to average average total spread, close to average interest margin, above average ROE and interest margin, above average ROE and above average total net equity to total above average total net equity to total deposits.deposits.

Group IIGroup II consists of Al Mawarid Bank consists of Al Mawarid Bank sal., Allied Business Bank sal., BEMO- Banque sal., Allied Business Bank sal., BEMO- Banque Europeenne Pour le Moyen- Orient, Banque Europeenne Pour le Moyen- Orient, Banque Lati sal, Banque Pharoan et Chiha sal.Lati sal, Banque Pharoan et Chiha sal.

Banque de l’Industrie et du Travail sal., First Banque de l’Industrie et du Travail sal., First National Bank sal., Jammal Trust Bank sal., National Bank sal., Jammal Trust Bank sal., Metropolitan Bank sal., Middle East & African Metropolitan Bank sal., Middle East & African Bank sal., National Bank of Kuwait (Lebanon) Bank sal., National Bank of Kuwait (Lebanon) sal., Near East Commercial Bank sal.sal., Near East Commercial Bank sal.

Societe Bancaire du Liban sal,Societe Bancaire du Liban sal,

Group IIGroup II is characterized by having the is characterized by having the minimum ROE, minimum total spread, minimum ROE, minimum total spread, minimum interest margin and they are minimum interest margin and they are middle on interest paid to interest middle on interest paid to interest received and are low to middle on T received and are low to middle on T bills/Total deposits and are below bills/Total deposits and are below average on total net equity to total average on total net equity to total deposits.deposits.

This segment of banks is known for This segment of banks is known for having specialized types of banking having specialized types of banking transactions.transactions.

Group IIIGroup III consists of: HSBC Bank consists of: HSBC Bank Middle East, Banca di Roma, Bank Middle East, Banca di Roma, Bank Saderat Iran, Intercontinental Bank of Saderat Iran, Intercontinental Bank of Lebanon sal., Saudi National Lebanon sal., Saudi National Commercial Bank, Habib Bank Commercial Bank, Habib Bank Limited and Limited and characterized as being characterized as being the highest the highest on: on:

ROE, total net equity to total deposit, ROE, total net equity to total deposit, interest margin, total spread and the interest margin, total spread and the lowest on two financial ratios: T lowest on two financial ratios: T bills/Total deposits and interest paid bills/Total deposits and interest paid to interest received. to interest received. This segment This segment of banks is known for its short-of banks is known for its short-term and small amount of term and small amount of profitable loansprofitable loans..

Group IVGroup IV consists of the following consists of the following banks: ABN Amro Bank N.V., Arab banks: ABN Amro Bank N.V., Arab Bank plc., Bank Al-Madina sal, Bank of Bank plc., Bank Al-Madina sal, Bank of Beirut sal., Bank Nationale de Paris Beirut sal., Bank Nationale de Paris (Intercontinental).(Intercontinental).

Banque Saradar sal, Banque de Banque Saradar sal, Banque de Credit National sal., Citibank, ING Credit National sal., Citibank, ING Banks and the Syrian Lebanese Banks and the Syrian Lebanese Commercial Bank sal., Commercial Bank sal., Group IVGroup IV is is characterized by having high ROE, characterized by having high ROE, minimum total net equity to total minimum total net equity to total deposits, below average total spread, deposits, below average total spread, middle interest paid to interest middle interest paid to interest received and high T bills/Total received and high T bills/Total deposits. This segment is known for deposits. This segment is known for its huge transactions outside its huge transactions outside Lebanon.Lebanon.

Assessing the relative importance of the discriminant

financial ratios The question of interest is whether the banks The question of interest is whether the banks

that are broken into four segments can be that are broken into four segments can be differentiated in terms of these financial differentiated in terms of these financial ratios.ratios.

Since there are four groups, three equations Since there are four groups, three equations

are extracted. Table IV shows that the eigen are extracted. Table IV shows that the eigen value associated with the first equation is value associated with the first equation is 3.817, and this function accounts for 68.7 per 3.817, and this function accounts for 68.7 per cent of variance in the data. The second cent of variance in the data. The second function has a smaller eigenvalue while the function has a smaller eigenvalue while the third has the smallest (the first is superior). third has the smallest (the first is superior).

Eigenvalues and Wilk’s Eigenvalues and Wilk’s LambdaLambda

To test the null hypothesis of equal To test the null hypothesis of equal group centroids, the three equations group centroids, the three equations are considered simultaneously. The are considered simultaneously. The value of Wilks’ Lambda λ value of Wilks’ Lambda λ transformed to a χ2 that is significant transformed to a χ2 that is significant beyond 1 per cent indicates that no beyond 1 per cent indicates that no functions have been removed. The functions have been removed. The three functions together separate three functions together separate between the four groups.between the four groups.

An examination of Table V indicates a An examination of Table V indicates a large coefficient for interest paid to large coefficient for interest paid to interest received and low coefficient interest received and low coefficient on T bills/Total deposits on function I. on T bills/Total deposits on function I. Function II has relatively very high Function II has relatively very high coefficient for total spread and low coefficient for total spread and low coefficient for total net equity to total coefficient for total net equity to total deposits. Function III has very high deposits. Function III has very high coefficient for total spread and very coefficient for total spread and very low coefficient for ROE.low coefficient for ROE.

Standardized canonical Standardized canonical discriminant function coeficientdiscriminant function coeficient

..

Structure Matrix

Table VI shows that variables with large Table VI shows that variables with large coefficients for a particular function are coefficients for a particular function are grouped together as shown by grouped together as shown by asterisks in the structure matrix. asterisks in the structure matrix. Financial ratios are ordered by size of Financial ratios are ordered by size of canonical (discriminant) loading canonical (discriminant) loading (correlation with function).(correlation with function).

T bills/Total deposits and ROE are T bills/Total deposits and ROE are grouped together while total spread, grouped together while total spread, interest margin, interest paid to interest margin, interest paid to interest received are grouped togetherinterest received are grouped together..

Net return on average equity to Net return on average equity to hurdle rate is not included in analysis hurdle rate is not included in analysis by the stepwise procedure.by the stepwise procedure.

The first function separates between The first function separates between groups I and III in terms of T groups I and III in terms of T bills/Total deposits and in terms of bills/Total deposits and in terms of interest paid to interest received. interest paid to interest received. The second function separates The second function separates between groups II and III in terms of between groups II and III in terms of total spread and separates between total spread and separates between groups III and IV in terms of total net groups III and IV in terms of total net equity to total deposits. equity to total deposits.

The third function separates between The third function separates between groups II and III in terms of ROE and groups II and III in terms of ROE and in terms of interest paid to interest in terms of interest paid to interest received.received.

Predictive ability of the model

The classification results based on The classification results based on this analysis are shown in Table VII, this analysis are shown in Table VII, which convey that 100 per cent of which convey that 100 per cent of the cases are correctly classified.the cases are correctly classified.

Classification resultsClassification results

..

Addressing globalization and future Addressing globalization and future implications it is suggested that banks in implications it is suggested that banks in group I merge horizontally while banks in group I merge horizontally while banks in groups I and II merge vertically. Such a groups I and II merge vertically. Such a model may be of interest to:model may be of interest to:

decision-makers in Lebanon.decision-makers in Lebanon.

Academics may apply the present model Academics may apply the present model to different industries in Lebanon and the to different industries in Lebanon and the Arab world. Arab world.

Practitioners in Lebanon may find this Practitioners in Lebanon may find this model helpful in their credit rating model helpful in their credit rating schemesschemes

THANK YOUTHANK YOU