Banking Sector: Piecemeal Reforms Set To Dissuade Investors


BMI View: Although Iraq's banking system is underdeveloped by regional standards, we expect reforms to remain piecemeal. As a result, foreign banks will be unwilling to enter the market directly despite significant untapped potential, and the lack of a growth-enhancing financial system will hinder the expansion of the non-oil economy.

Iraq's banking system shows several weaknesses, which have contributed to hinder its development to date. We highlight:

Dominance of State-Owned Banks: Iraq' banking system is made up of the 7 state-owned banks, 32 private banks and 15 foreign banks. That said, the playing field is uneven, with state-owned banks dominating approximately 90% of the sector. The government and its state-owned companies are only allowed to deposit with state-owned banks, while state companies cannot take loans from private banks, and taxes and other payments to the government can only be made through public banks. Moreover, as state-owned banks enjoy an implicit guarantee from the government, customers prefer to deposit with them rather than take the risk associated with a private sector bank.

Weak Financial Infrastructure: According to the World Bank, improvements are much needed in areas such as credit registry, the collateral framework, judicial systems, and accounting and auditing skills, which are crucial to ensuring transparency and allowing banks to identify creditworthy clients. Although a large majority of banks have active SWIFT connections (a widely used global communication network that facilitates exchange between financial institutions) and all banks are connected to the Iraq Payments System operated by the Central Bank of Iraq and therefore able to transact domestic payments, electronic banking is still a novelty, and it remains inaccessible to many people due to lack of IT infrastructure and expertise.

Inadequate Supervision: Although the Iraqi system of banking laws and regulations provides a workable framework for the exercise of banking supervision, several hurdles remain. The central bank of Iraq is often unable to perform its tasks without political interference when it comes to state owned banks, ensuring that supervision of those banks remains ineffective. Moreover, according to the World Bank, financial and prudential information remains unreliable and not rapidly accessible, while obligations to publish timely audited financial statements should be enforced more forcefully.

Only Piecemeal Reforms On The Cards

Reform of Iraq's banking sector is proceeding slowly. For one, the restructuring process of Rafidain Bank and Rasheed Bank - the first and third largest state-owned banks in the country, respectively - which was first agreed in 2006, has not yet been completed, and their balance sheets remain in precarious state. Given that the banks' restructuring may force more transparency on the government's fiscal activity, a move that lawmakers might be unwilling to make, progress will likely remain piecemeal. Moreover, although the Iraqi regulators are embarking on some changes to improve competitiveness in the private segment, some changes are proving counterproductive. For instance, while capital adequacy is normally measured as a ratio of capital to risk-weighted assets, the CBI has instead imposed absolute levels of capital to the level of IQD250bn (US$0.2bn) by the middle of 2013, regardless of the size of the banks' loan books. While such move has increased consolidation in the sector, it has also forced the closure of smaller banks. Finally, significant efforts are being undertaken by the CBI to enhance banking supervision and reduce money-laundering. However, according to reports, the CBI has imposed an unrealistically burdensome anti-money laundering regime, making the environment tougher for private banks.

Still Underdeveloped
MENA - Banking Sector Total Assets as % of GDP, 2011

Great Potential, Risks Elevated

Iraq's banking sector offer s significant potential for foreign investors. According to the World Bank , the asset to GDP ratio of Iraq's banking system was only 73.0% in 2011, compared to the average of 124.8% in the same period in the Middle East and North Africa (MENA) region. In addition, an estimated 80.0% of Iraqis lack access to a bank account, compared to approximately 50.0% in Morocco, a country with relatively low banking penetration rate. Finally, Iraq currently has approximately one local banking branch for every 60,000 people, which is low by regional standards (for instance, the average in Saudi Arabia is of one branch for every 3,500 citizens). As a result of base effects, growth rates of up to 200% in a single year are not uncommon. For instance, Baghdad-based North Bank recorded deposit growth of 45% to IQD917bn in the first half of 2012.

Most foreign banks operating in Iraq are from Lebanon, the Gulf and Turkey, and include Abu Dhabi Islamic Bank and Qatar National Bank . While UK-based HSBC owns since 2005 a 70.0% share in Dar Es Salam , a private Iraqi investment bank, no Western bank has opened a branch in Iraq to date. That said, several foreign banks have expressed interest in entering the market directly over the past few quarters. Among them is UK-based Standard Chartered Bank, which is planning to set up three offices in Iraq. The bank already has a representative office in Erbil, the capital of the semi-autonomous Kurdistan region, and it is currently applying to the CBI for licenses to upgrade its office to full branch status this year, and open a branch in Baghdad and one in the southern city of Basra in 2014.

That said, the hurdles which government policies, financial regulations and political stability present to foreign banks are likely to limit foreign investment in the sector. Such difficulties are exemplified by the recent decision by HSBC to review its operations in the country, a move which was announced by the bank's chief executive for the MENA region Simon Cooper in April. Sources suggest that the bank might be close to pulling out of the country, given its inability to play a significant role in a sector dominated by state-owned players.

Oil Driving Growth
Iraq - Components Of GDP, IQDtrn & Real GDP Growth

Hitting The Non-Oil Economy

We forecast real GDP growth in Iraq averaging 9.8% over the 2013/17 period, the highest in the MENA region. However, growth will mainly by triggered by elevated oil exports, while domestic consumption and gross fixed capital formation will expand at a slower pace ( see our online service, April 16, 'Solid Growth Despite Instability' ). The lack of a growth-enhancing financial system will compound this situation. Indeed, according to USAID , less than 5.0% of small and medium-sized enterprises ( SME) in the formal sector had ever received a bank loan as of 2011. As the pace of reform of the banking sector will remain slow, limited access to credit for SME's, start-ups and entrepreneurs is set to continue hindering the expansion of the commercial private sector, while the lack of a developed financial system will constrain the inflows of foreign direct investment in the non-oil economy.

This article is tagged to:
Sector: Country Risk
Geography: Iraq