The banking system in Iraq has come a long way in the past five years. It has gone from being virtually bankrupt and run down to one where modern practices and products are beginning to be offered at a retail and institutional level. In the first of a series of articles on Iraq's banking industry, Mike Gallagher takes a look at the transformation that has taken place
If ever there was a Middle Eastern country with enormous, untapped potential, then it is Iraq. It is one of the largest countries in the Middle East with an educated and sophisticated population of nearly 30 million, the vast majority of whom are in their late teens to early 20s.
It has potential oil reserves that may equal those of Saudi Arabia and a reasonably modern infrastructure, most of which was built during the boom years of the 1970s. It also has the desirable demographics, land mass and abundant resources that only two other countries in the region can match, those being Saudi Arabia and Iran. In a perfect world, it would be actively competing with the big economies of the Middle East such as Saudi Arabia, Kuwait, Qatar, Bahrain, Iran, Oman and the UAE. However, in this imperfect world, despite painful changes, Iraq has done much to turn itself around.
The country, to all intents and purposes, is a potential goldmine, which is why investors the world over started licking their lips when regime change took place around five years ago. Many were keen to invest in a country that sits at a strategic crossroads between East and West and is known as the cradle of civilisation.
These days, while banks around the world cautiously watch the markets and the US financial meltdown, Iraq's private banks have been experiencing something of a renaissance over the past five years. Private banks in Iraq are expanding their branch numbers, modernising their capabilities and increasing services available to their customers in a move to put the large, oil-rich Middle Eastern nation in a better position to compete with many of its Gulf neighbours. Iraq's private banks are aggressively seeking to give the state-owned banks, who have dominated the sector since 1965, a run for their money and their customers.
A brief history of banking in Iraq
Iraq's banking industry was once the pearl of the Middle East. In July 1964, the first Ba'ath regime implemented a policy of nationalisation that scooped up private banks, insurance companies and a number of industries. The nationalisation decree was followed by a series of bank mergers that eventually resulted in two state owned banks, Rafidain and Rasheed. Through all of this, Iraq's credit rating remained high, until Saddam Hussein bankrupted the country by going to war with Iran, Kuwait and the United States.
During the years of Hussein's rule, state-owned banks were frequently used as outlets for government payments of subsidies, pensions and distributions to Ba'ath party favourites. All government revenue was deposited and distributed via Rafidain Bank and Rasheed Bank. Loans were made to government officials, state owned enterprises and only rarely to private individuals. Scant attention was paid to repayment, so when US and Multi-National Forces arrived in April 2003 to begin assessing and stabilising the banking sector, most loans had long been in default.
Government ministries had for years been blindly directing business to the state-owned banks, regardless of the expense and their ability to deliver high quality, reliable service. Naturally this resulted in correspondingly poor levels of efficiency, poor customer service and severe overstaffing. This practice meant that the state-owned banks did not have to compete for deposits, nor act aggressively to develop loans. That was because both were being delivered by the government. At the same time, Iraqi consumers were losing trust in banks and those without connections to the party or huge amounts of collateral were usually unable to take out loans.
Private banks were not allowed to operate until 1992, following the war in 1991. The regime under Saddam Hussein showed little interest in bolstering the financial sector and instead seemed to spend most of its time and energy attempting to circumvent some of the sanctions which had been in place by the United Nations. During this time, private banks constantly risked being seized by the government if they showed any signs of profit.
Iraq's banking landscape, post-Saddam
In the summer of 2003, a diagnostic financial review of all of Iraq's banks was completed by the US government. It was the first such evaluation in nearly 40 years and the findings showed that virtually all banks were in a desperate financial condition.
Rafidain Bank, Rasheed Bank and four other smaller state-owned special banks held over 90 per cent of Iraq's bank assets and liabilities, consisting mostly of loans to state-owned enterprises or government officials and deposits from the government. The state-owned banks blanketed the country in 2003 with over 300 branches; however, each branch operated mostly as an independent unit. Rafidain Bank and Rasheed Bank were hobbled with billions of dollars of defaulted Iraq government obligations on their books and were completely ill-equipped to deal with the demands of the modern consumer.
Some of the banks were so comprehensively looted and the security situation was so volatile, that many people either sent their money abroad, or kept it at home. The black market naturally thrived in such circumstances and government officials realised that they not only had to create a viable and efficient banking system, but also had to create a sense of security that would encourage entrepreneurship at a local level and encourage foreign investors to keep at least some of their money in the country.
The state-owned banks and branches were top targets of looters, creating many millions of dollars of losses for the banks. At least $1 billion is thought to have been taken from Iraq's banks in a four week period, between mid-March and mid-April 2003, leaving the country's banking system in a critical state.
Iraq's Private Banking renaissance: 2003-2008
Since 2003 there has been steady growth in the private banking sector. The difficult security situation has, to some degree, hampered the numbers, but gutsy investors and emerging market speculators saw the potential in Iraq. In 2004, at the time of the US economic assessment, there were 17 private banks. These private banks operated 89 branches in Baghdad and 50 additional branches spread throughout the country.
The 2003 reviews also revealed serious capital deficiencies. None of the banks were within 50 per cent of the minimum capital required by the Iraq Banking Law of IQD10 billion (approx $8.5 million).
The choices for capital investment expansion included earnings and investments from either stockholders or investors from abroad. The private bankers were advised to target much more than minimum capital because they would soon be competing against new, 100 per cent foreign-owned banks which would have minimum capital of IQD 50 billion (approx $42.7 million). More importantly, the headquarters of these foreign banks would be able to support their Iraq financial institution, if needed, with additional capital as well as providing the latest bank technology and current market experience.
By June 2008, there were a total of seven state-owned and 31 private banks in Iraq, with 11 of the private banks having some foreign ownership. Total private bank assets are still less than 10 per cent of total Iraq bank assets. Most importantly, private bank loans as of June 2008 represent about 32 per cent of total bank loans in Iraq according to the Central Bank of Iraq Research and Statistical Department.
The IQD1,200 billion growth in private bank capital since the end of 2004 has been remarkable, given the difficult circumstances the country has been through. The total capital of the 31 Iraqi private banks was about IQD 1,300 billion; giving an average private bank capital of IQD 42 billion ($35.8 million) as of June 2008. The increase in capital since 2004 amounts to almost $1 billion. About 75 per cent of this capital growth occurred in private banks which are owned by Iraqis, something that officials in Iraq say underscores their commitment to the future.
Deposits in the Iraqi banking system from December 2004 to June 2008 increased by approximately 250 per cent. However, the rate of deposit growth in private banks specifically was more than twice that, evidence that private banks are gaining market share. This success was achieved by the private banks despite the fact that virtually all Iraqi government deposits were directed to the state-owned banks. Nevertheless, there are other factors to consider. The growth in deposits automatically triggers pressure to augment capital because the banking law requires banks to maintain capital at no less than 12 per cent of assets. More deposits, supported by additional capital and an increase in the amount of loanable funds, provides private banks with the additional wherewithal to increase their market share of Iraq's banking business.
To be fair, Iraq's private banks have had a little help. The Task Force to Improve Business and Stability Operations in Iraq (TFBSO), a part of the US Department of Defense, sought to leverage US government spending in Iraq to build the capacity of the private banking sector and move cash off the streets and into banks.
The US spends nearly $10 billion a month on supplies and support for their operations in Iraq. The Iraqi First Initiative was devised to help revitalise the Iraqi economy by driving US government spending to capable Iraqi vendors. It requires that Iraqi vendors of services and supplies be used whenever possible, and that payments to these vendors must be conducted via EFT (Electronic Funds Transfer), thereby requiring vendors to open accounts with private banks that offered EFT services in order to receive payment on their invoices.
Kris Haag, the director of the TFBSO Banking and Financial Networks Team said, "We set out to use DOD spend to get Iraqi vendors into banks. Our approach was to build up account and deposit bases so that lending would come more easily. The program really helped the private banks regain a foothold in the Iraqi banking sector."
The challenges for Iraq's private banks
It goes without saying that gaining the trust of the Iraqi consumer was one of the most significant obstacles faced by Iraq's emerging private banks. The ordinary Iraqi citizen constantly feared having their homes, incomes and other investments confiscated during the decades of the Ba'ath regime. Many resorted to storing their cash in their homes and opted not to show signs of wealth to avoid attracting attention to their families. Thus, a largely cash-based economy emerged along with the state-owned banking system.
Deteriorated rapidly
Bank services deteriorated rapidly and there was no competition whatsoever until 1992 when private banks were allowed to operate again. Between 1992 and 2003, the seizure of private banks by the regime remained a constant and real threat. Many banking services which were taken for granted throughout the world, such as loan products, debit and credit cards, ATM machines and Point of Sale devices, were alien to the Iraqi consumer. Officials knew that marketing the benefits of such products would be a major challenge to the banks because most Iraqi consumers were largely unfamiliar with those sorts of services.
Reversing the brain drain caused by years of conflict has been difficult because security remains somewhat unpredictable. Most of Iraq's business people who were not associated with the regime fled the country, creating a generation of future bankers who are unfamiliar with the concepts and practices of modern banking and financial services. The challenge now, say officials, is to reverse the brain drain, bringing the knowledge of international banking standards and systems gained by these individuals overseas back to Iraq. Common standards, such as anti-money laundering and 'know your customer' procedures are beginning to be implemented, but the task of fully modernising Iraq's private banks remains a challenge.
As with any endeavour in Iraq, security remains the biggest challenge. While there have been improvements, only time will tell if they will last.
Islamic Business & Finance 2008
