Industry Spotlight: Banking
/By Connor Bulgrin, Research Associate
In 1979, the fledgling Islamic Republic nationalized the banking sector. In that same year, the United States began enforcing economic sanctions against the new Iranian government in response to the hostage crisis; these were just the first in a long line of U.S. and international sanctions to be imposed on Iran over the next few decades. Though this hardly seems a promising environment for a strong financial market to emerge, the Iranian banking sector has been surprisingly resilient over the years. Although international banking restrictions have prevented Iranian banks from amassing large currency reserves, Iran has still managed to become a hub of Islamic banking in the Middle East.
Islamic banking prides itself on its just nature and its accordance with Sharia law. As of 2019, Iran was home to the wealthiest Islamic banking system in the world, holding 29% of the assets within the entire system. The primary focus of Islamic banking is on interest. In many passages, the Quran forbids the practice of charging riba (usury/interest). In Iran, the government passed the Riba-Free Banking Act in 1983 mandating that Iranian banks readjust their lending strategies to be compliant with Sharia and avoid the use of fixed interest rates. Despite these restrictions, banks continued to see returns on their investments by participating in profit and loss sharing (PLS) arrangements that allow banks to receive a legal (though not predetermined) rate of return on their investments.
While these new arrangements allowed lending to occur and kept banks solvent, they also produced severe uncertainty among average investors. In 1992, the Money and Credit Council, a part of the central bank focused on banking policy, issued a decree expanding the role of provisional profit in the banking system. Provisional profit, in practice, functions very similarly to traditional interest rates. The Money and Credit Council regularly alters the maximum permitted rate of provisional profit (Mobadala) in order to promote just rates and a sound lending system. However, at times, the Mobadala is set below the free market interest rate. Through careful regulation, the Iranian banking system has, at least nominally, upheld Islamic principles, though it still faces other, more daunting challenges.
Meanwhile, the Iranian government has sought to change course by privatizing its banking sector. Immediately, these efforts met with structural resistance. Article 44 of the Iranian constitution calls for the banking sector to be under government control. In the early days of the Islamic Republic, this Article was strictly interpreted and private banking was considered illegal; only non-banking credit institutes were allowed to operate in the private sector. The government later reinterpreted Article 44 to dictate government control over regulatory agencies and a twenty percent government stake in privatized firms.
Iran’s first private bank, Karafarin Bank, was established in 2001. The privatization of state-owned banks, however, has been slow and limited. Often, government-linked organizations purchase stakes in private banks, limiting their ability to operate independently. Additionally, state-controlled banks still control approximately 70% of the assets in the Iranian banking system. While the Iranian government has been eager to reap the gains associated with privatization, it remains unwilling to allow private banks a free hand in allocating credit, worried that private institutions might undermine its economic and political priorities.
Over the years, government’s experiments with privatization have been accompanied by attempts to achieve greater monetary soundness. In the early 2000s, in a failed attempt to keep Iranian fiscal and monetary policies separate, the government barred itself from borrowing from Bank Markazi, the central bank. While well-intentioned, this policy has encouraged the government to borrow from semi-privatized banks to fund its budget deficits. These private banks, in turn, borrow from Bank Markazi to meet the government’s incessant demand for capital. As of 2018, Iranian banks are indebted to Bank Markazi to the tune of 11.5 quadrillion rials. These large debts could prove catastrophic. If the Iranian government defaults on its debt obligations, private banks will remain on the hook for their debts to Bank Markazi and will be left without a means to pay.
The government’s lack of fiscal discipline has thrown its financial sector into a potentially disastrous situation. The average capital adequacy ratio (a key measure of financial stability) of Iranian banks is only 5% which is considerably below the 8% recommendation of the Third Basel Accord, signaling that Iranian banks are taking high risks that threaten future insolvency. Runaway inflation exacerbates these risks by eating away at returns on investments. Insolvency persists as a concern due to both Iranian banks’ reliance on borrowing from the central bank and the lack of liquidity within the banking sector. The latter issue has both domestic and international causes.
Despite Iran’s stagnant economy, financial markets in Iran have been booming, though this has provided little reprieve to the banking sector. Lulled in by Iran’s privatization efforts and the stock market’s high returns, investors in the Tehran Stock Exchange have seen total annual returns in the triple digits. President Rouhani has enthusiastically remarked on “the astounding rise” of the exchange’s general share index price. The growth of the Iranian stock market has also resulted in a rapid growth of liquidity. Under President Rouhani, liquid assets have grown 440%. But since these gains have not fostered real economic growth, they primarily contribute to the inflation that devalues the reserves in the banking system. Furthermore, assets that enter the stock market do not easily migrate to the banking sector as the latter is subject to numerous international restrictions.
Perhaps most harmful to the Iranian banking system is the country's inclusion on the blacklist of the Financial Action Task Force (FATF). In early 2020, after failing to pass laws and sign treaties that combat money laundering and the funding of terrorism, Iran was again placed on the FATF blacklist. As a result, foreign companies are less likely to conduct transactions with Iranian banks as their financial transactions will be subject to costly scrutiny. Moderates and hardliners within the Iranian government are split over whether new legislation should be passed in an attempt to be removed from the FATF blacklist.
Even if the Iranian government can get itself removed from the blacklist, Iranian banks are still subject to unilateral U.S. sanctions. In 2020, the U.S Department of Treasury independently sanctioned 18 Iranian banks and warned foreign companies doing business with them that they could be the target of “secondary sanctions.” This has had a chilling effect on foreign investment and engagement.
In recent months, international sanctions, including those on Iran’s banking system, have been a crucial topic of discussion between the United States and Iran. Abdolnaser Hemmati, governor of Bank Markazi, has called for “The removal of sanctions against the central bank, Iranian banks, SWIFT, and any money transfer between them and major foreign correspondent banks.” Even if Western countries remove their sanctions, however, many Iranian officials fear a change in policy might not alter market sentiment. The Supreme Leader Ayatollah Ali Khamenei has stressed that sanctions relief must exist “in practice, not just in words or on paper.” While foreign capital could provide Iranian banks a temporary boost, they also have long-standing internal issues that need redress.
Domestically, the Iranian banking system faces long-term structural difficulties. Although Iranian banks have been lending money at the historically low rate of -11% and are promising a 15% rate of return on deposits, investors remain uninterested due to the unpredictably high levels of inflation (1). The banking sector has also been rife with corruption. Funds have been embezzled by high-level bankers and those with political connections. Both wealthy businessmen and retirement funds (like the Iran Teachers’ Reserve Fund) have been victims of fraud. Consequently, those wishing to conduct financial transactions often embrace informal alternatives like the hawala market and cryptocurrencies.
In the years ahead, Iranian banking faces several challenges. While the government hopes a reduction of sanctions will allow inflows of foreign cash to save their heavily indebted banks, this relief —should it come— will be only temporary without substantive internal reform. Iranian banks must battle their tendency to over-borrow. They must prove an attractive store of value in the face of inflation. They must continue to free themselves from the influence of the state. And they must eliminate corruption from the top-down. With competent management and government coordination, the banking sector could increase its professionalism while maintaining its Islamic characteristics. While sanctions relief could provide Iranian banks an opportunity for growth, it will be up to Iranian bankers and the government to seize it.
Footnotes
(1) A -11% interest rate means that banks are committed to paying borrowers an 11% premium for borrowing money. In practice, inflation eliminates the real value of this premium and Iranian borrowers end up paying a positive real interest rate.
