Bankers in Iran are hoping that new President Hasan Rouhani will follow through on hints that reform is coming to the industry, which is saddled with dangerous levels of bad debts. Mr Rouhani's economic advisor, Masoud Nili, was quoted in the Tehran Times saying that the banking sector was one of the four main areas in need of reform; new central bank governor Valiollah Seif promised to tackle the rampant inflation in his first official statement. However, it is bad debt that is the focus of insiders.
A veteran of the Iranian banking sector, who asked to remain anonymous to protect his relationship with the central bank, laid out how dire the situation was. "At least 50 per cent of the financial institutions do not deserve to be saved," he said. "Sooner or later we have to realise that we are throwing away good money in order to save certain sick institutions."
Over the past eight years both public and private banks have run up huge amounts of bad debt, thanks to policies encouraged by Rouhani's predecessor, Mahmoud Ahmadinejad. These are now putting a heavy strain on the government's shrinking financial resources as it protects the most indebted players from bankruptcy. Yet vested interests and the need to prevent fear among banking customers from destabilising the economy mean that the new president has little room to force insolvent institutions to close.
Ramin Rabii, the managing director of Iranian investment fund Turquoise Partners, estimates that bad debts in the banking system average about 20 per cent, with big institutions Bank Saderat and Bank Melli in the worst positions.
"The banking sector in Iran has some major difficulties at the moment and if I want to point to one big issue it's the bad debts," he told Middle East Monitor (MEMO). "It's four to five times the global standard and that makes a lot of the banks in the sector, from an investment perspective, insolvent."
In his September investment note, Rabii said Seif and Minister of Economic Affairs and Finance Ali Tayebnia signalled that interest rates on deposits would need to rise in order to combat inflation and absorb excess liquidity in the economy. Rates were raised in 2012 to 21 per cent for the same reason, but to little effect, and the cost of funding for banks is high.
"However," said Rabii, "even with current interest rates, the total cost of funds (or cost of borrowing) for banks is nearly 25 per cent… given their high cost of borrowing banks are having a difficult time in finding credible clients."
Furthermore, Rabii told MEMO that interest rate spreads were already being exacerbated by below-inflation interest rates on existing commercial loans. "Some of these bad loans have an interest rate of 18 per cent, which was the norm for a long time in the past… and they have a clause in the contract saying if they don't pay on time they're going to get a 6 per cent penalty. [That] comes to 24 per cent, whereas inflation today is over 40 per cent. It's to [the companies'] advantage to not pay back the loan and to just keep paying the interest and the penalty."
He said that the brand new Middle East Bank and Pasargad Bank, one of Iran's biggest banks and originally one of Ahmadinejad's non-bank institutions, were the only two without these problems, the latter because its big balance sheet meant bad debts only amounted to 5 per cent of its capital.
According to a report from the central bank released on Tuesday to the Iranian media, the current inflation rate is 36 per cent.
Since Mahmoud Ahmadinejad came to power in 2005 the banking sector boomed then stumbled, said Middle East economy expert Professor Nader Habibi.
Ahmadinejad froze the privatisations begun by his predecessor Hashemi Rafsanjani, pushed for the creation of non-bank institutions owned by the Revolutionary Guards and Basij, and forced state-owned banks to lend to the government in order to reduce its central bank borrowings. Finally, these same banks were encouraged to offer interest-free loans to small business and people on low incomes, and to invest in "quick return" projects which were expected to provide returns within two to three years but ultimately failed or took far longer than expected to succeed.
The most recent national data published by the central bank was in 2010, but with some detective work it is possible to see where the problems lie.
On January 19, then-central bank governor Mahmud Bahmani said total bad debts stood at US$58.7 billion, using the official exchange rate at the time of 12,260 rials to the dollar. This fell to US$28.8 billion on July 6 when the government devalued the currency by about half.
As of December 2012, official data showed that the combined debt owed by private and government banks and non-bank credit companies to the CBI was US$39.1 billion. Moreover, the required reserves to be deposited with the CBI in 2012 totalled US$38.4 billion, indicating that banks had borrowed their required reserves from the central bank. In effect this forces any default on bad debts onto the central bank, already struggling from the loss of foreign currency reserves.
International sanctions have exposed the banking sector's deficiencies. Where once the central bank could convert foreign currency into rials and use that to plug the budget gaps in domestic banks, sanctions have choked off foreign exchange flows.
In the short term, experts such as Prof. Habibi say nothing much will happen but they agree the system of infinite government support for insolvent institutions can't continue. "In the past 12 months the reduction in governmental revenues [due to sanctions] has been quite noticeable and it's already causing some financial restrictions in the government's behaviour, in terms of budget and how much it can spend to influence the economy," he said.
The professor from Brandeis University added that he expected Rouhani to spend the next year focusing on reducing the impact of sanctions and therefore the economic pressure, before thinking seriously about restructuring the worst banks. The veteran banker said that the government could continue to devalue the currency and use the liquidity to prop up sinking banks, but only so long as the oil money held out.
"As long as we have the oil revenue the crisis may be or will be postponed… I think from the date that we come to our senses and face up the inevitable, it will not take more than six months that we are going to see not one but more than half of our financial institutions to be in serious predicament," he concluded.
The views expressed in this article belong to the author and do not necessarily reflect the editorial policy of Middle East Monitor.