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The Rial Problem

While all eyes are focused on the streets of Tehran, the real crack-up may be occurring in Iran's banking sector.


Rumors have recently spread among Iran’s jittery populace regarding the state of their country’s banking system. Although these rumors happen to be nothing but a false alarm, the financial sector really is, and has been, in crisis for a number of different reasons.

The current spate of rumors began on Jan. 28, when Iran’s commercial banks were ordered by the central bank to limit each depositor’s daily cash withdrawal to 150 million rials (about $15,000). The order was explained by authorities as a means of implementing the anti-money-laundering legislation just passed by the Majlis, Iran’s parliament, and combating what the finance minister called "financial terrorism." This announcement coincided with an unrelated statement by President Mahmoud Ahmadinejad two days earlier regarding the elimination of "three zeros" from the currency, due to its drop in value, and the government’s intention to restore the Iranian currency to its "real value." These dual developments aroused widespread suspicions among the traditionally cynical rank and file, who were already rightly skeptical of the often exaggerated and frequently contradictory economic statistics coming out of Tehran over the past five years. Sporadic news reports about the banking system’s undercapitalization and the rising number of its nonperforming loans added to mounting anxieties.

Within a few hours, Facebook and Twitter messages spread and amplified rumors about a run on banks, customers rushing to withdraw their savings, and street clashes among depositors. Two of the largest state-owned commercial banks — Mellat and Melli — were said to be on the verge of declaring bankruptcy. Neither the vigorous denials by the two banks, nor the government’s solemn assurances regarding the banking system’s solid financial position, managed to quash the false alarms, and there were reports of ugly encounters in some provincial bank branches.

Curiously enough, the obvious absurdity of the bankruptcy rumors was missed even in some quarters that should have known better. Commercial banks facing liquidity problems in any modern state can always resort to the central bank’s "open window" to borrow needed funds. And the central bank, with a printing press at its disposal, can never run out of money to lend. The bankruptcy of a state central bank, and by implication the failure of state banks, is a theoretical as well as existential impossibility. Depositors in state banks never lose their savings overnight through bank failures, but only through a hidden tax called inflation. Although the Islamic Republic has never established formal deposit insurance, as in the United States, all state bank deposits are de facto guaranteed by the full faith and credit of the central government.

The real problems faced by the Iranian state banking system are rooted in a host of other shortcomings. The banking sector is the most laggard area of the Iranian economy. Iran’s state-owned banks suffer from high overhead costs — too many branches, too many employees, and poor management — with operating costs estimated at four times the world average. Furthermore, the Majlis and government-dictated loans to state entities and public projects at below-inflation rates make them highly unprofitable.

Finally, Iran’s state banks suffer badly from enormous nonperforming assets. These unrepaid loans — estimated at $48 billion, or 2½ times the banks’ own capital — have increased sevenfold in the last five years. To put that figure in perspective, Iranian banks accumulated less than $4 billion in nonperforming assets during the previous hundred years of Iranian banking history! These loans constitute nearly 20 percent of total bank assets — compared with a world average of 3 to 5 percent. Around half of the arrears are owed by state-owned corporations. Seventy percent of the total is owed by only 1,000 entities (including some "shell," or nonexisting, paper corporations). Some $23 billion is owned by four state banks — Melli, Mellat, Saderat, and Tejarat — with Melli carrying the largest burden.

Borrowed funds are not paid back on time for several reasons. Ahmadinejad’s administration limited the banks’ annual lending interest rate to 12 percent — in an economy that is experiencing much higher inflation rates, reaching 29.5 percent in September 2009 — a heaven-sent incentive for borrowers to renege on their obligations and postpone repayment for as long as possible. The difference between the state banks’ borrowing rate on the one hand, and informal bazaar rates on the other, create what economists call an intrinsic "rent" element. That is, the unsupervised funds, borrowed from an Iranian state bank at 12 percent, may be re-lent in the bazaar at rates up to 30 to 45 percent — or even placed in other banks as long-term savings deposits, accruing 18 percent interest. As a result, borrowers rationally decide to forego the "late payment" penalty of six percent and postpone repayment as long as they can.

The Islamic Republic’s endemic cronyism and flawed policies represent a constant impediment to the profitability of Iran’s financial sector. Influential and well-connected borrowers — state entities connected with the Islamic Revolutionary Guard Corps, siblings and grandees of clerical leadership, and clever apparatchiks — easily manage to borrow large amounts without sufficient guarantees for repayment. One single borrower is reported to have obtained $100 million! These politically connected debtors often refuse to pay back their loans, and suffer no penalties. Under one government project, hundreds of small businesses promising to create jobs have managed to receive funds without proper scrutiny of their projects and are now unable to service their debts due to causes that range from the recession to their own incompetence. The sanctions imposed by the United Nations and the United States, and the poor performance of the Iranian economy — GDP growth was just 1 percent last year, even with rising oil prices — has dealt another blow to Iran’s banking sector. An estimated 6,700 businesses were unable to service their financial obligations last year and received a one-year grace period by their banks.

The real problems facing Iran’s state banks — poor management, undue political interference, and the incongruity of mixing seventh-century Islamic finance principles (the foundation of the Iranian banking system) with the exigencies of the highly complicated world of modern international finance — should inspire Iranians to keep a wary eye on their economy’s bottom line.

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