Banking + Insurance E1:R1
◢ The Rouhani administration is pursuing an expansionary monetary policy, trying to free up capital from the banking sector through lower interest rates and lower reserve requirement
◢ However, many Iranian banks are carrying a high load of toxic debt, and the Central Bank of Iran needs to be careful not to destabilize banks through its policies
The Importance of Banking
In the last decade, banking has grown in significance in the Iranian economy, particularly as bank shares became a mainstay of the country’s stock market, accounting for 20% of the market capitalization of the Tehran Stock Exchange. Iran’s banking sector will be a key driver of post-sanctions economic growth. But there remain numerous structural challenges in the banking sector before the sector can reach its growth potential.
Iran’s banks have lacked cohesive strategies over the last decade, leading to the acquisition of burdensome holdings and investments that are now limiting growth. Valiollah Seif, the governor of the Central Bank of Iran (CBI) has noted that a significant portion of bank capital is tied-up in non-performing loans and in investments in real estate. Additionally, the Capital Adequacy Ratio (CAR) of Iran’s banks currently stands between 8% to 10%, lagging behind the regional average of over 13% to 14%. The Central Bank of Iran has therefore prevented Iranian banks from distributing profits to shareholders, mandating instead that the banks increase their CAR by selling surplus assets in order to bolster reserves.
Iran’s banks are also relatively bloated. As demonstrated by the recent salary scandal, in which senior bankers at Iran’s key government-owned banks were caught receiving salaries 290 times higher than countries minimum wage, violating legal salary-caps, banks over-allocate revenue towards compensation packages. Moreover, the large number of bank branches and related staff creates significant overhead.
However, in light of these challenges, there has been recent drive led by the Rouhani administration and the forward-thinking private banks to improve the health of the banking sector. A new law drafted by the Central Bank of Iran will place limits on the activity of banks in the real estate market and in the acquisition of surplus assets. Holding surplus assets beyond a set date will trigger a 3% tax penalty. At the same time, the effort to remove risky assets will also enable Central Bank of Iran to reduce the reserve requirement ratio from 13% to 11% in an effort to free-up capital and to support the expansionary monetary policy of the administration. At the same time, falling inflation has enabled interbank lending rates to be reduced from 28% to 15%.
Toxic Debt Mounts
For some banks it is already too late to address weaknesses through these reforms. A recapitalization program is expected in which the Central Bank of Iran will allocate funds received as part of sanctions relief towards a shoring-up of the Iranian banking sector. A recent report circulated in parliament has warned that lax regulations have led several Iranian banks to reach the brink of insolvency as liabilities outpace reserves.
A look at the balance sheets of Iran’s banks shows that the non-current debts of the banks are at an alarming level when compared with their collective capital reserves. Audits conducted by CBI suggest that up to 64% of bank debt is toxic. The value of this debt stands at IRR 602 trillion, which approaches the collective capital of banks at IRR 715 trillion. Of this debt, 21% is in arrears, 13% is outstanding debt, and 44% is bad debt.
Whenever the debts of the banks exceed the capital, the banks enter into the phase of a non-capital operation during which bank debts are paid with the incoming deposits and no contributions are made to the underlying capital. In this situation, the credit and liquidity risk of the bank becomes highly unpredictable.
Generally, Iran’s banks do not separate delinquent receivables from their profit calculations. The banks treat the related amounts as materialized profits. This hugely undermines the quality of the assets stated on their balance sheets. In other words, capital which the bank cannot be sure that it will recover is considered as contributing to the profit potential of the bank. Unfortunately, investors trade on the reported profit potential of the banks, and this creates a major systemic risk for the banking sector is share prices do not currently reflect underlying weakness.
New Interest Rate Takes Effect
Recently, the banks in Iran have voluntarily reduced their interest rate of deposits from 18 percent to 15 percent. While this move has been encouraged by the Rouhani administration as a response to the successful reduction of the inflation rate, a further reason for the move is a lack of sufficient funds in banks to pay the interest owed to depositors. In one notable example, one bank had a shortfall of IRR 28 trillion of the amount owed as interest and the available capital from loan repayments, requiring it to mobilize other resources to meet the shortfall.
At the same time, the lower interest rate is expected to reduce the amount of capital deposited in banks. Analysts expect Iranians to seek higher returns by purchasing foreign currency, gold, equities or real estate assets.
Decreasing the interest rate does expose the banks to certain risks. They include the withdrawal of the deposits and directing them to other markets such as the foreign currency market as well as the gold market by the clients. However, given that the majority of deposits in banks are worth less than IRR 500 million, it is unlikely most depositors will move funds into riskier asset classes to seek just a few points improvement in returns.
Following the decrease of the deposit interest rate to 15%, the interest rate for loans provided by the banks has accordingly decreased to 18%. This will be welcomed by industries that need loans or specifically those that have outstanding debts to the banks. Accordingly, those industries can negotiate with the banks to refinance their debts based on the new interest rates. This will in return enable the banks to reduce the burden of delinquent payments.
Insurance Sector Struggles
Much like the banking sector, the insurance industry is under pressure. Claims are putting pressure on revenues. Insurance Figures on the performance of the insurance industry released in March 2016 show that the sector generated over IRR 220 trillion in written premiums, while settling IRR 140 trillion in claims with their clients. These figures correspond to a 9.73% increase in premiums received against an 18.45% increase in claims. Despite the average, insurance premiums actually fell across eight leading companies in a rare trend. High overhead is also hurting profits.
Additionally, much like banks, Iran’s insurance companies have similarly high levels of liabilities burdening their balance sheets. In some companies these liabilities amount to 70% of total assets, while in others they equate to 70% of total sales value. Insurance companies risk falling into a situation where the inability to collect on liabilities will prevent the payment of claims. Many of Iran’s largest insurance companies are related to or owned by bank holding companies. This leaves the insurance sector exposed not only to its own financial weakness, but also that of the banking sector. It is important that regulators do not ignore the situation in the insurance sector as they focus on the troubles in banking.