Moody's recently confirmed that the outlook for Lebanon's banking system remains negative. The outlook reflects banks' high and growing exposure to B1-rated Lebanese government securities, which renders their modest capital buffers susceptible to sovereign event risk; asset-quality pressures caused by weak economic growth that continues to be adversely affected by the ongoing conflict in neighbouring Syria and domestic political tensions; and high provisioning needs and limited new business generation that will dampen profitability. Over the next 12-18 months, however, Moody's also expects banks to continue to grow their stable deposit-based funding profiles and maintain solid liquidity buffers.
The ongoing conflict in Syria and domestic sectarian tensions that escalate into sporadic violence within Lebanon will continue to weigh on key sectors of the economy, including tourism, real estate and construction. Political uncertainty will also lead to reduced private investment and impair the Government's ability to enact structural reforms. At the same time, Moody's expects the budget deficit to rise to 11 per cent of GDP for 2014, with the Government relying on the domestic banking sector for financing. Against this backdrop, the rating agency expects subdued business generation and nominal credit growth of six per cent - nine per cent in 2014, well below the average annual credit growth of 24 per cent during 2007-10.
Lebanese banks' high and growing exposure to Lebanese sovereign risk (B1 negative) will remain a major source of credit risk over the next 12-18 months, rendering these institutions susceptible to sovereign event risk. Government securities and Central Bank (Banque du Liban, BdL) certificates of deposit (CDs) account for an estimated 43 per cent of system assets as of end- 2013, representing five times the system's Tier 1 capital. In addition, the challenging operating domestic environment, together with Lebanese banks' operations in high-risk countries, primarily Egypt and Syria, will drive further loan quality deterioration. As a result, Moody's expects loan-loss provision expenses to remain high at around 1.5 per cent of gross loans and non-performing loans to rise above six per cent of gross loans, from Moody's estimate of five per cent at year-end 2013, for rated banks.
Capital levels will remain stable, with the system regulatory Tier 1 capital ratio estimated at 11.5 per cent as of December 2013. Moody's considers the sector's capital buffers to be modest in the context of downside risks arising from the country's challenging operating environment and banks' very high sovereign exposures. Moody's notes that banks have sufficient capacity to absorb losses under the rating agency's central scenario, which is based on its current macroeconomic forecasts for Lebanon. However, current capital buffers would be insufficient to absorb losses under the rating agency's adverse scenario, albeit a low probability event that assumes an escalation of regional instability, as well as a significant deterioration in government creditworthiness.
Moody's expects that the system's solid liquidity buffers and depositor- based funding will continue to support system stability over the next 12-18 months. Lebanese banks' reliance on market funding is minimal, as customer deposits fund more than 80 per cent of system assets. Inflows of remittances from the Lebanese diaspora, which are equivalent to 15 per cent-20 per cent of GDP on an annual basis, largely originate in the economically benign Gulf region, and will continue to drive growth in bank deposits. Potential funding weaknesses for Lebanese banks include the predominance of short-term maturities and a high degree of dollarisation at 66 per cent of deposits as of year-end 2013. However, risks are mitigated by solid systemic liquidity buffers, with banks' core liquid assets (cash, placements at the Central Bank and international placements) amounting to 22 per cent of total assets as at year- end 2013, while Moody's estimates that Lebanese banks' international placements and BdL's foreign-currency reserves cover 50 per cent-55 per cent of foreign-currency deposits.
Lebanese banks' profitability will remain under pressure because of high credit charges, low fee income generation and net interest income growth, and pressure arising from banks' operations in the Middle East and North Africa (MENA) region. A reallocation of resources to longer- term and high-yielding sovereign securities, will, however, support net interest margins. Moody's expects that rated Lebanese banks will post a return on average assets (RoAA) of between 0.9 per cent and 1.1 per cent in 2014, below the 1.1 per cent and 1.2 per cent RoAA recorded in 2013 and 2012, respectively.
Despite the significant challenges outlined above, Moody's notes that Lebanese banks are accustomed to operating in a stressed environment, and have demonstrated resilience under stress over the past decades. Furthermore, in our opinion, the long- term economic outlook holds a certain degree of promise, particularly in terms of the potential exploitation of offshore oil and gas reserves, which is currently stalled.