Iran’s Frail Banking Sector Poses a Threat From Within

worldview –Since the 1979 Islamic Revolution, Iran’s banking sector has languished as Tehran has politicized its central bank and monetary policy far more than almost any other country in the world.

U.S. sanctions are putting tremendous pressure on Iran’s extremely fragile financial system by sending Iran into a period of stagnant economic growth accompanied by high inflation.

President Hassan Rouhani has pushed to reform the banking sector and address its systemic issues, but the country’s current economic crisis has short-circuited his efforts.

The continual need to solve short-term economic crises over the years has delayed banking reforms. Tehran, however, has reached the point of needing to address the sector’s problems or risk its collapse.

Editor’s Note: This assessment is part of a series of analyses supporting Stratfor’s upcoming 2019 Third-Quarter Forecast. These assessments are designed to provide more context and in-depth analysis on key developments over the next quarter.

As the U.S. “maximum pressure” campaign continues to hammer his country’s economy, Iranian Foreign Minister Javad Zarif recently offered a message of defiance, vowing that Iran would weather the storm, given its “PhD in sanctions-busting.” His rhetorical description of the Islamic republic’s resilience in the face of outside pressure is certainly apt, given its track record of survival. But this time around, the current U.S. pressure campaign poses a risk to one of the fundamental pillars of Iran’s economy: Its increasingly fragile banking and financial sector. The Big Picture

The United States is hoping that it can use economic sanctions to either force Iran to return to the negotiating table or cause enough economic pain that Iran’s population challenges its government. The sanctions pressure is significant, and if a crisis emerges, it very well may come from the banking sector, which is becoming increasingly fragile, sanctions or not. See Iran’s Arc of Influence

Iran’s economy is certainly suffering under the weight of U.S. sanctions that have taken square aim at oil exports, its biggest source of revenue. In April, the annual inflation rate in Iran hit 51.4 percent. The International Monetary Fund expects Iran’s real gross domestic product to contract by 6 percent this year after already shrinking by 3.9 percent last year, highlighting the pressure its banking sector is under. Clearly, Iran’s economy has entered the dreaded state of spiraling inflation and anemic growth that economists term stagflation, and it has few options available to escape the crisis. Instead of addressing its long-term economic problems — including those beleaguering the banking sector — Tehran will focus on alleviating the short-term pain of sanctions at the expense of necessary structural reforms. Iran’s leaders will likely succeed in staving off a sanctions-induced economic meltdown in the short run, but that course raises the long-term risk of a banking sector collapse. The damage to Iran’s economy and employment picture that would follow such a catastrophe could well spawn a protest movement that could force a substantial reorganization of political power.

Iran’s Myopic Financial Sector

Iran has spent the four decades since the Islamic Revolution in 1979 in a period of near-constant economic crisis management. During that stretch, there have certainly been periods of liberalization and reform, but Iran’s economic strategy has centered on managing the short-term effects of a series of crises — from the 1980-88 Iran-Iraq war to the most recent round of nuclear-related sanctions. Tehran’s need to manage these short-term risks have prevented it from devoting the resources needed to implement long-term economic reforms. Examples of sidelined initiatives include an economic liberalization scheme in the 1990s under former President Ali Akbar Hashemi Rafsanjani and current President Hassan Rouhani’s ambitions to take advantage of the warmer relations made possible by Iran’s nuclear deal with the West to retool the economy.

After 40 years of kicking the can down the road in terms of addressing the flaws in Iran’s economy, time may be running out. For the financial sector, the problems start with the government’s view of the Central Bank of Iran’s role in managing the economy and how it intersects with the government’s spending habits. Since 1979, Iran’s economic strategy has centered on fulfilling a social contract with its citizens based on high government spending, subsidies, government transfers and state-led investment to spur growth. Tehran often also uses these tools to make up for the country’s inability to attract foreign and private investment and to mitigate political threats through patronage. 

The emphasis on government-driven investment has left, in its wake, a string of failed projects that have either been abandoned, such as former President Mahmoud Ahmadinejad’s famed Mehr housing project, or fallen victim to corrupt practices and money laundering. The result has often been a chronic deficit that expanded during periods of sanctions and/or low oil prices. Historically, Iran has called upon its central bank to finance or fund the deficit and allow the government to directly borrow from its reserves. Although authorities formally ended this practice in 2003, it continues indirectly through loans from state-owned banks. 

This practice is the crux of the problem for Iran’s banks. Borrowing directly from a central bank to fund budget deficits is a recipe for high inflation — which in Iran routinely surpasses 10 percent, if not higher — which is why most modern governments refrain from doing so. Iranian leaders do not see the country’s central bank as an independent entity, viewing it instead as a key part of the government that can be called upon to play a critical role in managing its economic strategy. That the government uses it essentially as a piggy bank is just one facet of its lack of independence. While Iran is not alone in treating its central bank that way, the degree to which the bank is beholden to government demands is relatively high.

Iran’s central bank also oversees the country’s exchange rate regime strategy. Iran’s inflationary environment and its limited access to hard cash, coupled with its citizens’ reluctance to hold their wealth in rials or tomans, has had a strong, depreciatory force on the value of the rial. In some ways, this has aided Iran’s import substitution strategy of industrialization, in which it manufactures goods domestically instead of importing them, thereby going some way to fulfilling Supreme Leader Ali Khamenei’s “Resistance Economy” strategy. But that devaluation has also made imports significantly more expensive. This hits Iran in two ways. First, Iran has become increasingly dependent on food and medicine imports, with imported food now thought to total around 50 percent of supply. Second, Iran’s domestic manufacturing capabilities remain limited when it comes to producing higher-quality goods, such as advanced components and electronics.

To cope, Iran has typically used a tiered exchange rate strategy, in which the government subsidizes sensitive goods such as food. The central bank has been the one to oversee that strategy. As a result, the Central Bank of Iran has been less able to focus on what central banks typically focus on — managing the money supply and its benchmark interest rate and ensuring price stability (i.e. low inflation). The bank has even been deprived of some of the necessary tools to perform those functions. Iran’s financial system operates under some of the basic tenets of Islamic finance, which make typical interest rate policies more difficult to implement. A prohibition on usury, for example, requires the use of financial instruments, such as profit-and-loss sharing, that mimic interest payments. Iran’s central bank also has traditionally been banned from using open-market operations to buy and sell government bonds to manage the money supply.

After 40 years of kicking the can down the road in terms of addressing the flaws in Iran’s economy, time may be running out.

The regulatory environment and oversight of Iran’s banking sector — another key function of most central banks since 2008’s global financial crisis — is also extremely lax. Most Iranian banks do not adhere to the operational baselines set by International Financial Reporting Standards, nor do many banks adhere to Basel III requirements, another set of banking standards. According to the latest estimates from the IMF, the capital adequacy ratio for Iranian banks averages 4.9 percent, far below Basel III-recommended levels of 8 percent. Iran also has lax standards when it comes to rules governing the frameworks to combat money laundering and terrorist financing, which make Iranian banks — especially state-owned banks — internationally toxic independent of sanctions. 

The result is a fragile banking and financial sector increasingly susceptible to disruption from external shock. The low capital ratio means that many Iranian banks are in dire need of recapitalization. Another troubling statistic is the nonperforming loan ratio of Iranian banks, which stood at 11.4 percent when last measured in mid-2017. Many of Iran’s banks that are in the most dire need of recapitalization are state-owned banks that authorities often use to dole out economic patronage.

Iran’s Long-Term Dilemma

Rouhani’s 2013 campaign platform included pledges to resolve Iran’s structural economic problems, reduce inflation and negotiate a deal with the West to remove sanctions and unlock greater oil exports and foreign direct investment to spur economic growth. Rouhani was able to achieve several of his goals early in his term. More prudent economic management brought inflation under control: In 2016, it dipped under 10 percent for the first time in 25 years. Rouhani also signed the Joint Comprehensive Plan of Action (JCPOA) nuclear deal in July 2015. 

But two things have short-circuited Rouhani’s economic plan. First, despite being able to increase Iran’s oil exports because of sanctions relief, the global collapse in oil prices in 2014 meant that oil export revenue barely budged. Second, renewed U.S. sanctions have put Iran’s hopes for real economic growth over the next year or so on hold, unless a new deal can be forged. 

This has forced Rouhani — and the Iranian government — to return to crisis management mode. In 2017 and 2018, for example, speculative capital flight and bets against the rial forced Rouhani to respond with a crackdown on currency traders. A month before the United States announced that it was withdrawing from the JCPOA, Iran announced a plan to unify its foreign exchange rates. However, it now seems unlikely that the plan will ever be implemented. Rouhani’s government has also introduced price controls on certain goods in an effort to limit inflation. In May, for example, Iran’s Industry Ministry announced that it would freeze the prices of automobiles — key components of which are imported — for three months. Previously, Iran had announced plans to implement controls on many basic commodities, including bread, rice, vegetable oil, sugar, dairy products and other items. In essence, necessity is now forcing Rouhani’s government to implement many of the policies he had campaigned against before he took office.

Rouhani has continued to push for reforms that would modernize the regulatory environment for banking. But the success of that push remains an open question. In 2016, Iran reached an agreement with the Financial Action Task Force (FATF), an international watchdog tasked with combating money laundering and terrorism financing, by promising to revise the country’s banking laws in the hopes that the body would remove Tehran from the blacklist of countries with deficient regulatory frameworks. But efforts to pass the necessary legislation have stalled in the Iranian parliament under objections from hard-liners concerned that it could undermine Iran’s ability to fund and support groups like Hezbollah.

That said, Rouhani and his allies will try to push through some reforms, arguing that they will be necessary to help Iran deal with the economic crisis at hand. In March, for example, Iran announced that it would merge four banks linked to the military as a way to pool resources and improve efficiency. In February, the Iranian parliament also passed legislation that would tax Iran’s bonyads, religious charitable organizations that are connected to various political elites. In addition, this year’s budget law made it legal for the central bank to finally engage in open market operations for Islamic bonds. The parliament is also pushing to pass a law by the end of September that would increase the central bank’s independence, boost transparency, modernize its bankruptcy rules and give it more powers to implement standards set by Basel III and the International Financial Reporting Standards. 

Because many of these structural reforms could undermine some of Rouhani’s political rivals, the push to create them could encounter resistance. Nevertheless, without reforms, Iran’s banking sector is a house of cards waiting to collapse — something that sanctions pressure could well accelerate. Because it has little room to maneuver, external crises, such as the widespread flooding experienced in Iran’s southwest earlier this year, could precipitate such a collapse quickly. Thus far, the U.S. strategy of sanctioning Iran into submission has struggled to cause an economic crisis severe enough to push Iran’s population to rise against the government. It has become clear that slow-burning crises will not organically create such a moment. Short-term crises, on the other hand, could.

Over the coming months, Iran will try to ensure that it can avoid a crisis spurred on by the immediate impact of U.S. sanctions. But that will come at the expense of addressing its longer-term issues. As a result, Iran’s banking sector will continue to be pushed to the brink, leaving it just one acute crisis away from a major banking sector collapse. The question becomes, then, will Iran once again seek engagement with the West to allow it to address those well-known long-term issues, as Rouhani tried to do, and if so, when? Iran is hoping that it won’t need to travel that path as long as Donald Trump remains in the White House. But it can bide its time for only so long.