LIMASSOL — The outlook for Lebanon's banking system is stable, reflecting Moody's expectation

of a modest pick-up in economic activity and continued inflows of foreign deposits, helping banks to finance the government and the economy, Moody's Investors Service said in a report on July 3.

Potential negative political developments affecting the pace of economic reform and depositor confidence are a key risk.

Moody's report, "Banking System Outlook – Lebanon: Modest economic pick-up and sustained deposit inflows drive our stable outlook" said "operating conditions in Lebanon have stabilized but will remain challenging," said Alexios Philippides, a

Moody's Assistant Vice President -- Analyst. "We forecast a modest rise in real GDP growth to a still weak 2.5% in 2018 and 3.0% in 2019 from 1.9% in 2017. This will be driven by greater economic policy coordination and our expectation that the government will resume long-delayed public investment projects."

Renewed political or geopolitical unrest could however derail the reform agenda and damage confidence. With interest rates rising, Moody's expects modest domestic credit growth of 2-3% over the next 12-18 months.

Any failure to implement reforms - which would also help unlock the $11 billion in concessional loans and

grants by the international community in support of Lebanon's capital investment program - would keep

confidence weak and economic activity stagnant, and leave businesses struggling with deteriorating basic

infrastructure. Large external and fiscal deficits will remain in place over Moody's outlook period.

Banks' heavy sovereign exposure will grow, increasing financial risks for banks. Large fiscal deficits of around 8% this year and next will again be financed primarily by the banks. Sovereign exposure made up about half of banks' total assets at end-2017, linking their creditworthiness with the heavily indebted Lebanese government (B3 stable) and exposing them to interest rate and liquidity risks.

Continued pressure on the banks' loan quality is expected, driven by seven years of sub-par economic growth, rising interest rates and the impact of low confidence on the real-estate sector and consumption. Moody's base expectation is that Lebanese banks will continue to attract the needed inflows of customer deposits, much of this from the Lebanese diaspora. Deposits should grow by around 5-6% over the outlook period. A significant slowdown in deposit inflows would challenge both the banks' ability to finance the government and the economy, and is the main risk to Moody's stable outlook.

The Lebanese financial system maintains considerable liquidity buffers, driven by the Banque du Liban's large gross foreign reserves, to weather a period of slower financial inflows or short-term outflows and conversions into foreign currency, partially mitigating the risk of deposit flight.

Moody's says that it continues to consider the banks' capital buffers to be modest, with sector-wide equity to assets at around 9%, in view of their heavy exposure to the sovereign and the challenging operating environment. Rated banks already meet the higher Basel III capital requirements that must be phased in by the end of 2018.

Moody's expects banks to post a net income to tangible assets of around 1.0% over the outlook period. This is below the 1.2% average recorded for Lebanese banks during 2017. Subdued business generation, higher provisions costs from low levels in 2017 and higher taxes will trim banks' profitability. — SG