End of sanctions offers chance to fix Iran’s banking sector

Iranian banks struggling with high levels of non-performing loans may see their situation improve, but deep reforms are needed and the political situation remains complex

The Central Bank of Iran

The lifting of sanctions against Iran in mid-January looks set to offer respite to the country's troubled banking system, especially after the Central Bank of Iran confirmed all sanctions-hit banks have now reconnected to the Swift network. But economists believe deep reforms are still needed.

The banking sector has long been suffering from slender capital buffers and a heavy weight of non-performing loans (NPLs). The situation was exacerbated by sanctions, with the exclusion of major banks from the Swift payments messaging network making international payments costly and difficult, putting a brake on the economy and worsening the NPL problem.

In a statement on February 17, the Central Bank of Iran said all the banks excluded from Swift under the sanctions – including itself – had now rejoined the network, although a few subsidiaries were still completing the process.

"The opening up of Iran to the global economy will help [domestic banks] because it will increase the value of assets of their borrowers," says Djavad Salehi-Isfahani, a professor of economics at Virginia Tech. He believes some banks are technically insolvent, but the end of sanctions could be enough to restore their equity to positive figures.

Kamran Pakizeh, assistant professor at the University of Economic Sciences in Tehran, says the Swift lock-out was one of the main drivers of the banking crisis. "Access to Swift is a very big issue," he says. "Exclusion from Swift pushes transaction fees up dramatically, so reconnecting to the system will be good for investment."

Iran's banking sector is made up of state-owned banks, which were nationalised during the 1979 revolution, and private banks that began to be established more recently. The latter are much more efficient and innovative, according to Hashem Pesaran, a professor of economics at the University of Southern California. These private banks could be the key to restoring the system to health, he says.

Healthy competition

All three economists say competition is essential. Indeed, Pesaran says many banks will not be able to compete now that Iran is open again to international financial markets.

"This is a good thing in my view," he says. "The key thing for authorities is to consolidate banks without creating a bank run. I think they can, because they control so many of the banks. They could transfer assets to Bank Melli, which is much more solid than others."

Salehi-Isfahani says he hopes foreign banks will compete, and help to break up Iran's monopolistic banking system. Pakizeh believes this will happen, eventually: "There will be tough competition, for sure, from foreign credit institutions. They can provide better services, but it will take time for them to enter."

Iran's economy has stabilised somewhat in recent months. Inflation has come down from a peak of 16.5% in April 2015 to 9.2% in December, and the rial, having undergone rapid devaluations between 2012 and 2015, has held its value against the dollar more recently.

Much hinges on the political will to implement reforms. Pesaran says falling inflation will force banks to face up to NPLs, and competition from the more efficient foreign and domestic private banks may force authorities to act.

He believes the central bank and finance ministry has the technical expertise to make the necessary changes, but notes any such actions could upset the balance of power in Iran. Influential quasi-governmental organisations such as the Revolutionary Guard and the Mostazafan Foundation wield much of their power via state-owned banks, he says, and they will not want to see the banks fail.

"My view is, you cannot dislodge them. So you flood them," Pesaran says. "You cannot get rid of the government banks, so you create more private banks. You give more room for private banks to compete, and the share of the government becomes smaller."

An International Monetary Fund consultation on Iran, published in December, was optimistic authorities would carry reforms through. "The authorities emphasised that there is strong political support to advance reforms," the Article IV report said.

The central bank has conducted a "financial health check" of the banks, mandating higher provisioning, while the government's plans for a money and banking law should strengthen the central bank's price stability mandate and grant it clearer supervisory powers, the IMF said.