Iraq: a frontier for brave bankers: even a shattered economy such as that of post-war Iraq needs a viable banking sector, but restructuring will be a formidable process.
A dysfunctional banking system can have a severe impact upon real economy--consumption, investment and exports. Iraqi policymakers face the challenge not only of liberalising a repressed financial services industry but also of reforming, or creating from scratch, the institutions required to underpin a market-oriented system.
The interim government in Baghdad has devised a long-term strategy for reactivating economic activity on the basis of structural reforms, including price liberalisation, taxes to promote private-sector participation in the reconstruction process, foreign direct investment (FDI) into industries besides petroleum and banking regulations in tune with best practices in developing countries.
However, such an ambitious policy agenda will also require establishing the legal, institutional and regulatory frameworks for the smooth functioning of markets. Dr. Sinan Al Shabibi, governor of the Central Bank of Iraq, formerly a senior economist for the UN Conference on Trade and Development, told the American-based journal Institutional Investor. There is a great potential in this country. The prospects are very bright. Once security is under control, Iraq will be very attractive to investors." A new central bank--restructured under a nine-member governing board comprising the governor, two deputy-governors, three senior managers and three full-time outside directors--has introduced a law that provides for independence and accountability and prohibits the bank from extending credit to the government.
Henceforth, monetary and credit policy actions will not require the approval of the Ministry of Finance. The central bank's extended powers mean that it now holds the responsibility to control money supply, regulate interest rates, and license and supervise Iraq's commercial banks.
However, as the International Monetary Fund (IMF) noted: "The latitude for proper monetary and exchange rate policy actions is limited by a lack of appropriate instruments, the current low level of foreign exchange reserves, and constraints on institutional and physical infrastructure capacity."
A new commercial banking legislation, based on global standards and adopted in October 2003, lays down stringent fit-and-proper criteria for bank ownership and higher minimum capital requirements, as well as plans to open the sector to foreign competition.
The existing financial system comprises the Central Bank of Iraq (CBI), six state-owned 'monolithic' banks and 19 small private banks--formed during the early 1990s. The CBI and state banks--notably Rafidain and Al Rasheed--were merely fiscal instruments for the Baathist party, or more specifically, they acted as Saddam Hussein's personal bankers and as such were responsible for massive 'flight capital' from pre-conflict Iraq.
According to the US Treasury Department, total assets are now estimated at about $2bn, equivalent to 10% of gross domestic product, while the aggregate equity of Iraq's 25 banks is reported at a mere $42m. The sector's capital-assets ratio of 2.1% is extremely low by international comparison.
Most, if not all of Iraq's banks are 'techically insolvent', possessing negligible capitalisation, while the true value of assets falls well short of liabilities to depositors and other creditors, including foreign banks and western export credit agencies.
Moreover, the bad debts of these 'typical' Iraqi banks exceed their own paid-up capital, while reserves are far too small to cover loan losses. Inadequate accounting systems and poor regulations enabled banks to conceal non-performing loans (NPLs) in their accounts by constantly rescheduling principals and capitalising interest arrears in order to maintain the status quo.
The main reasons for NPLs are excessive directed lending for the financing of ballooning budget deficits, funding operations of public enterprises and large, uneconomical projects during the past three decades. Other irregular practices such as inside lending to former ruling elites/ cronies have also resulted in huge bad debts.
The Old Iraq lacked a commercial banking culture, with lending based on cronyism, not credit quality.
To date, effective competition remains weak, and therefore concentration in the banking sector is extremely high. The two big banks, Rafidain and Al Rasheed, control 85%-90% of total banking assets. During the 1980s, Rafidain (founded in 1941) was the largest Middle Eastern bank with assets of $47bn, but today it owes some $24bn to western and regional Arab banks, as well as Paris Club countries.
Rafidain Bank also carries the old regime's [unpaid] sovereign debts and letters of credit. Until the issue of $127bn-plus external debt is settled, international trade-finance business is closed to state-owned banks. The Trade Bank of Iraq, a consortium of 13 international banks led by JP Morgan Chase (US), was established in December 2003 to handle all trade documentation, covering Iraqi exports/imports and is solely responsible for issuing and confirming letters of credit.
The distressed banks are unable to provide services and products largely taken for granted elsewhere in the world, including corporate financing, structured trade finance, cash management/treasury services, mortgages, insurance, leasing, credit cards, and cash machines (ATMs).
Iraq remains a predominantly 'cash-based' economy, where banking is confined to deposit taking and a few short-term loans. It is estimated that only one-third of the total money supply in circulation is inside the banking sector. Apparently, most Iraqis elect to keep their savings "under the bed".
Meanwhile, the domestic payments system is almost primitive--money transfers between two banks, or even between branches of the same bank, can take over a week. Due to the absence of electronic links and a depleted telecommunications infrastructure, the system is largely 'manually-based', with banks processing checks via messengers. This has often led to long delays and high levels of credit float.
Substantial investment in IT systems is urgently needed. Neither SWIFT (Society For Worldwide Interbank Financial Telecommunications)--a messaging system that facilitates global funds transfers--nor MICR (Magnetic Ink Character Recognition)--a secure, high-speed method of scanning and processing information used by banks--are available in Iraq.
The CBI has raised minimum capital requirements for private banks to help promote consolidation and restore solvency ratios. The move should encourage mergers and acquisitions within the sector. By April 2005, core capital (shareholders' funds) must reach $5m. Among the large private institutions are the Bank of Baghdad, Iraqi Middle East Investment Bank, Commercial Bank of Iraq, Investment Bank of Iraq and Credit Bank of Iraq. The clientele group frequently includes family members or business associates of the owners. A recent Citigroup report shows that the total deposits of private banks were mostly invested in treasury bills and affiliated companies.
Foreign participation can take several forms under the new banking law: Wholly foreign-owned banks i.e. fully-fledged branches; joint-venture banks with one or more foreign or indigenous partners; subsidiaries; foreign ownership of shares in local banks; and representative offices. The latter cannot provide banking services but may facilitate offshore businesses between foreign and local parties. Six foreign banks have already been licensed to begin operations. The CBI is now evaluating over 30 licence applications, many of which expressed interest in acquiring a minority stake in private banks. Nour Nahawi of Arab Banking Corporation (ABC) remarked: "Once the security situation improves, Iraq is a country with great potential which will be a very attractive market for foreign banks."
The six institutions are HSBC, Standard Chartered, National Bank of Kuwait, ABC, Bank Melli Iran and Jordan's Housing Bank for Trade & Finance. The central bank expects the first three banks to begin operations by end-2004 and the rest by end-March 2005. Under the terms, foreign majority-owned subsidiaries must hold a minimum capital of 50bn New Iraqi Dinars ($34m); open multiple branches [at least five]; and adopt supportive lending policies. Staff training programmes and investment in advanced banking techniques--especially in areas of cash management and payment products--are also required.
A host country has certain expectations from an influx of foreign banks, which include modernising the existing banking sector through the transfer of technology and managerial expertise; introducing new capital for trade, industry and construction; promoting foreign investment; and the mobilisation of domestic savings. The World Bank notes: "Foreign banks will help improve the quality, pricing and availability of financial services, both directly, as providers of such enhanced services, and indirectly through competition with domestic banks, which will encourage the latter to introduce similar improvements."
The problems of the non-enforcement of prudential regulations, a lack of commercial lending traditions, the absence of collateral laws, undeveloped accounting rules, bad and dubious debts, negligible capitalisation and a shortage of professional bankers all contributed to 'systemic risks' under the Baathist regime. Rehabilitating an entire banking industry is a long-term process, which will require vast international assistance on a scale similar to that provided to former Eastern Bloc countries in the early 1990s.
The ultimate goals should be the creation of stronger banks underpinned by ample liquidity, capital and solvency, thus facilitating savings, investment and prudent lending. The main challenges will be to foster a vibrant financial system that can channel domestic savings into future productive investments. In a Letter of Intent (October 2004) to the IMF, which outlines economic and financial policies, the interim government has pledged to improve the payments system by establishing an automatic clearing house and passing payments system law to regulate its activities. This will have the effect of making the CBI operations more transparent, particularly through the regular dissemination of monetary statistics and regular ongoing external audits, carried out to international accounting standards. A full restructuring plan for state-owned banks is expected by June 2005.
An upgrading of technological infrastructure requires funding and technical support from the World Bank and the International Finance Corporation. Iraq needs fully computerised, 'Real-Time' network systems, whereby inter-bank clearings are settled in central bank funds and information about participating banks' net credit worth/ daily positions are readily available online. The experience of advanced (OECD) countries shows that a reliable payments system lowers the requirement for working capital and significantly reduces transaction costs while providing the necessary support for an active policy of asset-liabilities management, the basic criteria for fostering a market economy.
Equally important, bank supervisors should receive training in areas including international operations, financial controls and risk-management techniques, which are necessary for the onsite/offsite examinations of banks.
Unlike other Middle Eastern countries, the Basle Committee's 25 core principles of effective central bank supervision, chiefly capital adequacy, stringent reporting of balance sheets, careful monitoring of loans, strict criteria for asset-classification, interest suspension, risk-weighting and bad debt provisions, among others, had no significance in Iraq.
In essence, a prudent supervision system is critical to preserve Iraq's solvency within the industry. As the World Bank pointed out: "An effective regulatory regime creates an environment that encourages prudent risk-taking."
The World Bank could fund the recapitalisation of the six government banks. As occurred in East Asian countries during the 1997/98 financial crises, state agencies could take over bad debts.
Restructuring of public enterprises, as well as development of private debt-and-capital markets, should complement financial reforms.
Efficient financial inter-mediation requires sustained macroeconomic stability, low inflation and positive real interest rates. Such conditions lead to lower transaction costs, reduce commercial risk and foster confidence in the stability of a fledging financial system.
Continuing operational and security risks are seriously hindering the transition to an open, market-based economy, and the reintegration of Iraq into the global financial system.
Abdul Aziz Hassoun, director of Iraq's North Bank, believes security worries "are being exaggerated", and banks reluctant to enter Iraq are missing out on a lucrative opportunity in a "virgin land". However, John Snow, the US Treasury Secretary, put it succinctly: "Capital is a coward. It doesn't go places where it feels threatened."
A recent IMF report commends Iraq's interim government and its predecessor, the Coalition Provisional Authority (CPA), for introducing several milestone reforms--a new currency underpinned by Forex reserves, banking and taxation laws, and restoring much of pre-invasion oil production capacity, despite the "precarious security situation and economic collapse". But widespread disorder and violence remain a formidable problem. The Fund acknowledges: "Iraq continues to suffer repeated attacks by insurgents against government officials and police officers, as well as sabotage of crucial infrastructure ... this has severely hampered the economic recovery and reconstruction."
Thus, the restoration of national security and rule of law, though unlikely in the near-term, are vital for carrying out financial reconstruction as in Central Eastern European countries after the fall of communism.