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Banking System, Creating a Currency Motion Banking Crisis and a Deep Recession in Iran

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Banking System, Creating a Currency Motion Banking Crisis and a Deep Recession in Iran POLICY BRIEF Those sanctions cracked down on Iran’s oil exports and 19-8 Iran Has a Slow imposed restrictions on Iranian banks that further cut them off from the global banking system, creating a currency Motion Banking crisis and a deep recession in Iran. Following an easing of sanctions after the nuclear treaty of 2015, Iran’s economy Crisis was regaining some strength. But that progress was cut short when the Trump administration resumed draconian sanc- Adnan Mazarei tions in 2018, again focusing on banning oil exports and June 2019 imposing restrictions on Iranian banks. US efforts to isolate Iran from the rest of the world have aggravated problems in the country’s banking system, where Adnan Mazarei has been a nonresident senior fellow at the Peterson Institute for International Economics since January a crisis has been brewing for several decades. Significant 2019. Prior to joining the Institute, he was a deputy director at liquidity and solvency problems are posing a growing risk the International Monetary Fund. to Iran’s financial stability. A substantial portion of banks’ Author’s Note: I am grateful to Razieh Zahedi and Chris assets is impaired and their capital positions are very weak. Collins for their patient help with the research for this paper. I These problems are the result not only of US sanctions have also benefited from discussions with, or comments from, Madona Devasahayam, Shahrokh Fardoust, Joseph Gagnon, but also of the heavy-handed role of the state, banks’ often David Hoelscher, Patrick Honohan, Gonzalo Huertas, Borghan corrupt connections with various semiofficial corporations Narajabad, Ted Truman, Steven Weisman, and especially Ruchir Agarwal. and conglomerates, and the ineffectiveness of the Central Bank of Iran (CBI) to regulate and supervise banks. © Peterson Institute for International Economics. Despite the precariousness of Iran’s banking system, All rights reserved. one adversity that it has not yet experienced is a run on its banks. Given the severity of the liquidity and solvency Until fairly recently, Iran had reason to hope that its problems that Iranian banks face and public awareness of 2015 agreement to limit its nuclear programs—the Joint these difficulties, one would have expected widespread bank 2 Comprehensive Plan of Action1—would help end its runs and a more severe banking crisis. But these runs have economic isolation and revive economic growth. That not yet happened, thanks to the combination of (1) strong outlook has darkened since the Trump administration’s backing of the banks by the central bank (in the form of move in 2018 to reimpose sanctions and wage a campaign unrestricted access to emergency liquidity assistance, a de to again isolate Iran from the rest of the world, issuing veiled facto deposit guarantee for all depositors, and significant suggestions that Washington favored “regime change” in regulatory forbearance) and (2) limited options available to Tehran. The sanctions have led to a sharp cut in Iran’s oil depositors for their assets (due in part to the international exports, a significant fall in the value of the rial, high infla- sanctions). tion, and a serious decline in economic activity. Iran has been subject to a variety of external sanctions since 1979, but perhaps the most stringent were put in 2. There are various ways to define a banking crisis, often place in 2012 by the United States, United Nations, and based on the conditions in the banking system or the actions European Union on account of Iran’s nuclear program. taken by the government to avoid one. For example, Luc Laeven and Fabian Valencia (2018) define a banking crisis as an event that meets two conditions: (1) “significant signs of financial distress in the banking system (as indicated by sig- 1. Iran signed the treaty with China, France, Germany, Russia, nificant bank runs, losses, and/or bank liquidations) and (2) the United Kingdom, the United States, and the European significant banking policy intervention measures in response Union. The text is available at https://2009-2017.state.gov/ to significant losses in the banking system.” However, note documents/organization/245317.pdf (accessed on June 11, that under their classification a bank run is not a necessary 2019). condition for an event to be classified as a crisis. 1750 Massachusetts Avenue, NW | Washington, DC 20036-1903 USA | +1.202.328.9000 | www.piie.com loans (NPLs) at about 11 percent but noted that, unofficially, they stood at 50 percent.1,2 loans (NPLs) at about 11 percent but noted that, unofficially, they stood at 50 percent.1,2 PB 19-8 June 2019 Will these factors continue to prevent a full-blown about 11 percent but noted that, unofficially, they stood at banking crisis in the face of the recent intensification of US 50 percent.6,7 Loans were nonperforming for a number of sanctions? A worsening of the banking crisis can probably be reasons: the country’s difficult macroeconomic conditions; avoided in the short run, but banking distress will continue pervasive government arrears to public enterprises, which to mount, making the system more vulnerable to an external in turn cannot service their bank loans; directed lending shock—especially if Iran’s oil exports are completely halted3 to (often zombie) public enterprises and selected economic or if there is a major military confrontation with the United activities;8 and challenges in evaluating the creditworthiness States—which could lead to much higher inflation and of borrowers because of weak corporate governance and further financial difficulties. accounting practices. Second, the capital position of banks is weak. Systemwide I. WHERE DOES THE BANKING SYSTEM STAND? capital adequacy was 4.9 percent of risk-weighted assets in June 2017, well below the minimum ratio of 8 percent The public sector dominates the Iranian required under Basel I regulations and supervisory require- banking system ments in Iran (IMF 2018). This problem developed over Iran’s banking crisis is rooted in part in heavy state involve- several years of weak profitability in the banking system due ment and controls over banks: The government effectively to the high amount of NPLs, high cost of funds, and high controls about 70 percent of the assets of the banking operating costs.9 system.4 The banking system has a complex ownership structure involving extensive, nontransparent interconnec- Third, the CBI has been actively bailing out banks by providing 10 tions with various public or semipublic institutions and large liquidity injections for many years (figure 1). Banks have corporations and weak internal controls. These features have faced chronic liquidity problems from high levels of NPLs, 11 made the system very difficult to supervise and vulnerable to their holding of illiquid real estate and equity, and the lack mismanagement and corruption.5 of cross-border correspondent banking and trade financing Another important source of the problems has been due to sanctions. The CBI’s willingness to inject resources the large shadow banking system made up of numerous into banks through its emergency liquidity window—at unlicensed financial institutions (UFIs), many of which are high interest rates (34 percent) but without collateral—has connected to public sector entities and the armed forces. turned it into a lender of first resort and undermined its These UFIs have competed aggressively with regulated banks control over monetary conditions. Monetary policy, tradi- for deposits by offering interest rates considerably higher than the CBI’s maximum interest rates paid by regulated 6. IMF estimates placed NPLs in June 2017 at 11.4 percent banks. In the absence of supervision and adequate internal (IMF 2018). The IMF has also reported a broader measure of 1 controls, some of the UFIs have faced difficulties (including NPLs IMF thatestimates includes placed banks’ NPLs illiquid in Jun assets;e 2017 this at second 11.4 percent mea- (IMF 2018). The IMF has also reported a broader 1 IMF estimates placed NPLs in June 2017 at 11.4 percent (IMFsure was2018). 28 percentThe IMF in has June also 2017. reported Provisioning a broader for NPLs is runs on two of them in 2017), requiring the CBI to bail measure of NPLs that includes banks’ illiquid assets; this second measure was 28 percent in June 2017. Provisioning measure of NPLs that includes banks’ illiquid assets; this secoforlow—only ndNPLs measure is 43.6 low—only percentwas 28 percent43.6of official percent in June NPLsof 2017.official in June Provisioning NPLs 2017—partly in June 2017—partly because of the pressure to pay dividends because of the pressure to pay dividends to shareholders. out depositorsfor NPLs isand low—only merge or43.6 close percent many of officialof them NPLs (IMF in Juneto 2017shareholders.—partly because of the pressure to pay dividends ﺣﺠﻢ-ﻭﺍﻗﻌﯽ- ﺗﺴﻬﻴﻼﺕ-ﻏﻴﺮﺟﺎﺭی-ﺑﺎﻧﮑﯽ-۵٠-ﺩﺭﺻﺪ-ﺍﺯ-ﮐﻞ-ﺗﺴﻬﻴﻼﺕ-ﺍﻋﻄﺎﻳﯽ-ﺍﺳﺖ-/to UFIsshareholders. have since been put under CBI supervision. 27. See See www.parliran.ir/ www.parliran.ir/majles/fa/Content/articles/majles/fa/Content/articles.(2018 ,139loans is 50 percent of all loans”) (accessed on March 6 ﺣﺠﻢ-ﻭﺍﻗﻌﯽ-are 13970301122342 (“The true volume of nonperforming ﺗﺴﻬﻴﻼﺕ-ﻏﻴﺮﺟﺎﺭی-ﺑﺎﻧﮑﯽ-۵٠-ﺩﺭﺻﺪ-ﺍﺯ-ﮐﻞ-ﺗﺴﻬﻴﻼﺕ-ﺍﻋﻄﺎﻳﯽ-ﺍﺳﺖ-/As a result,2 See www.parliran.ir/many of the problemsmajles/fa/Content with these institutions/articles 13970301122342 (“The true volume of nonperforming loans70301122342 is 50 percent (“The of all true loans”) volume (accessed of nonperforming on March loans 6, is 50 now contained. 2019).percent of all loans”) (accessed on March 6, 2019). 2019). 8. A prominent example of these operations has been the The situation was already bad prior to 2018 efforts that started in 2007 to promote low-income housing First, banks’ assets are impaired. Officially, over one in by Bank Maskan (Housing Bank).
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