Reform the Banking System;

Save Iran’s Economy

By Mahdi Goodarzi & Mojde Rezaee

Introduction

In the past few months, economists, capital market practitioners plus CBI officials have been stressing on the necessity of applying a reform plan to Iran’s banking system, as a pre-requisite to bring prosperity back to Iran’s Economy. The current article deals with the statement of this problem in the first part since the development of the capital market, the facilitation of foreign investment, and the establishment of the relation between Iranian exchanges and their foreign counterparts in the post-sanctions era are going to be based on the banking system infrastructures, rendering its restructuring inevitable.

The lifting of US-led sanctions re-opened the door of Iran Economy to new opportunities of mutual interest with its business partners, putting the country on the path of kicking recession and achieving higher economic growth. Before that, sanctions had pressured banks in two ways:

• A part directly targeted the banking system by depriving Iranian banks of the opportunity to cooperate with their foreign counterparts, which resulted in their lower profitability;
• They also indirectly raised transaction costs, which also resulted in needing more liquidity by institutions that had already hard time repaying their debts to the banking system.

Now that a part of the said penalties have been removed, the following are expected:

• the injection of new resources via investment, a part of which will be naturally deposited at banks, strengthening the banking cash flow and therefore, alleviating the current credit crunch;
• the increase in profitability due to participating at international arena;
• the decline in the non-government debt to the banking system and therefore, the plunge in the non-performing loans; and
• the entrance of foreign banks, which might create a competitive environment in this sector along with the introduction of new instruments and technologies, expanding the market.

However, there are some issues which are not solved merely as the result of sanctions removal of which the following can be named:

• the government authority to meddle in the banking system;
• the domination of Iran’s money market over Iran’s financing system and therefore, Iran’s economy;
• banks’ financial statements which are not useful enough for investors and decision makers;
• Iranian banks not complying with standards offered by Basel Committee; and
• lack of credit rating agencies in the banking system;

Statement of the Problem

The intensification of credit crunch has acted as a huge impediment ahead of achieving sustainable economic growth during the past years by reducing access to facilities and increasing their costs. Administrations’ pressure for quantitatively increasing banking credit multiplied with structural issues, legal weaknesses and lack of risk management infrastructures in the market have ended in the accumulation of non-performing loans, unpaid government debts and other toxic assets in banks’ balance sheets, lowering their financial stability and lending power. This has increased banks’ demand for attracting resources and consequently, the interest rate, irrespective of the fall in the inflation rate.

Setting the achievement of sustainable economic growth and reduction of the vulnerability level of the economy as two major targets for the country, while financing is interpreted as the most important factor in realizing economic prosperity and the improvement of the banking system is a major player pushing economy vulnerability downward, the importance of implementing a reform plan for the banking system is deeply felt.

Irrespective of the significant drop in the inflation rate in the last 3 years, the interest rate has not gone through the same trend. The main reason should be sought more than anything in banks’ cash flow problem, which has eventually appeared in the form of sticky interest rates. The considerable amount of non-performing loans in banks’ balance sheets, the high rate of government debts and the recession in real estate have made a huge part of banks’ assets stuck, resulting in the credit crunch phenomenon. This has been revealed in banks’ unhealthy competition over attracting resources and the rise in interest rate. Taking the direct relationship between risk and reward into account, with higher interest rates, only projects with higher risks will be eligible to receive facilities; this, on the other hand, has the potential to add to banks’ non-performing loans and weaken their fundamentals.

Furthermore, other than the drop seen in banks’ profitability indices, those related to bank stability, including the NPL and the capital adequacy ratios, are raising concerns over banks’ health. Comparing the current situation with countries that have experienced severe weaknesses in their banking functions along with investigating banks’ balance sheets lead us to assume that the weakness in the banking system health is the predictable outcome of the imbalanced financial development in the 2001-2010 period. Here, the correct diagnosis of factors involving in this illness is the pre-requisite of its treatment.

To be more specific, banking system problems fall within 3 layers. The first is the fundamental problems which have their origins in the structural and organizational issues. For instance, the weakness in the monetary and banking laws, supervisory regulations, corporate governance, government deep interference in the banking system, and the shallow depth of other financial markets, including the capital market, can be mentioned.

The second layer deals with problems with banks’ revenue making assets, which have turned into what is now called as toxic or frozen assets because of economic conditions.  Such assets themselves are divided into three categories of NPL, government debts and banks’ investment in projects which are liquid only by realizing loss under the current situation. Added to these, banks becoming larger in size but not raising their capital has dragged the capital adequacy ratio down, which therefore, has weakened banks’ ability to survive in economic shocks; this in fact plays a key role in establishing the correspondent relationship between Iranian banks and their foreign counterparts.

The third layer refers to the problem of banks’ cash flows, seen as the drop in the facilities over deposit ratio; despite their mission, i.e. absorbing deposits and lending facilities, banks have allocated a part of their resources to investments, which have unfortunately become stuck in the housing market and therefore, frozen assets, lowering such a ratio.

The necessity of Reform

Taking a look at the tables below, might give readers an idea over the conditions of Iranian banks, proving the necessity of such a reform.

In 2010, deposits worth about IRR 1,990,000 bn have been absorbed which reached IRR 6,940,000 bn in 2015, posting a 250% increase.

Over the last 6 years, inter-bank facilities have largely been offered, reaching from IRR 260,000 bn in 2010 to IRR 2,170,000 bn in 2015, i.e. 9 times only within 6 years. This in fact indicates banks’ need to more resources in order to meet their commitments on time, including those made to the CBI, which has resulted in banks’ borrowing from each other.

In the past 6 years, banks’ non-performing loans went under a 150% surge demonstrating the incorrect allocation of resources among non-credit-rated clients, which has altogether resulted in the loss of a great part of facilities.

Based on what we mentioned and the tables above, it appears that this system has continuously been weakened until 2015 and unless treated soon, the CBI has to step in which might itself result in nothing but higher inflation rate and longer recession period.

The current situation in the banking sector is the result of market players’ actions and reactions to motives arising from rules and regulations by the country’s monetary and banking bodies within the available infrastructures. Such a situation will not go away on its own; in fact, it will become even worse by applying temporary policies or actions by decree. In order to change it, rules of the game must change. This, however, is not to happen sustainably without applying structural reforms in the rules determining the interbank market players’ relations, market structure, banking business environment, risk management infrastructures plus the CBI regulatory role and policy making. The continuance of such conditions will only lead to deeper destruction of financial markets’ health. Therefore, the role of the regulator as well as those of shareholders and facility takers must go under change, having the rebuilt of the financial framework in mind, in order to strengthen and guarantee the health, lending power as well as the financing ability of the banking system.

In this regard, it seems that attempts must be taken to erase the price war effect on the interest rate, raise banks’ capital, organize government debt and solve the NPL problem, in addition to strengthening the policy making and regulatory role of the CBI in order to improve banks’ cash flow and lending power and therefore, reduce toxic assets pressures and provide them with opportunities to apply fundamental reforms to the financial system.

All being said, it is worth mentioning that moving Iran’s financing system from a bank-centered system towards a capital market-oriented one, considering banks’ role in the Iranian culture, is time taking; consequently, the only practical solution under the current conditions is to implement such a reform plan to help the money market keep playing its role until such a move takes place.

The present article will continue next week introducing a reform plan which will be implemented by governmental economic institutions, headed by the CBI in the current year. Its major target will be to improve the banking system health, enhance the relationship between banks and the government, and strengthen the supervisory and regulatory role of the CBI which altogether will result in interest rate fall and credit crunch alleviation along with keeping the inflation rate down. One of its most important advantages will also be the increase in Iranian banks’ ability to establish correspondent relationships with foreign banks, which itself, will decrease the financing cost for Iranian industries raising their profitability and therefore, realizing economic boom in the country.

DISCLAIMER:  This report has been prepared and issued by Agah Brokerage Firm on the basis of publicly available information, internally developed data and other sources believed to be reliable. The information contained herein is not guaranteed, does not purport to be comprehensive and is strictly for information purposes only. Agah does not assume any liability for any direct, indirect or consequential loss that may result from the reliance by any person upon any such information or opinions. Any expressions of opinions are subject to change without notice. 

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