The Convoluted Role of Lending in Iran

Banks dominate Iran's financial system, largely because the stock market is small and underdeveloped. The only way firms can raise funding for new ventures is by borrowing from banks. This condition enslaves the businesses and the wider economy to lenders. Over reliance on loans has been exposed as sanctions and poor lending practices left banks crippled in recent years, exacerbating recessionary trends in the economy. 

The notion that banks were "too big to fail" came to haunt free market economies in the global recession of 2008. But in Iran, with its largely state backed economy, this notion gains an even more troubling dimension. With the absence of developed equity markets and with bond markets at embryonic stages, combined with high business risk, savers are left with only one logical option: deposits. Iran's capital markets only raised $8.85 billion in the 2014/15 fiscal year. That would stand at just nine percent of all the lending by banks during the same period.

The reliance on banks as the sole conduit for turning savings into business investments gives banks exaggerated influence. Thus, if a bank in financial distress is not properly isolated, the effects across the wider economy could be catastrophic. Understandably, officials have never tested these waters. "The central bank and the government feel obligated to support [the banking system], but if it wasn't for that support, many banks would be in trouble," said former Central Bank of Iran governor Mahmoud Bahmani, in a recent interview with Tejarat Farda magazine. 

But having a turgid function in the economy is not the only drawback of Iran's banking system. 

Iran's major lenders are state-owned and even many private lenders are part-owned by state affiliates through holding entities. As such, the government gets too much say in how the banks are run. 

Considering that Iran's technocrats are not shy about meddling in corporate affairs when expedient, little is left for the banks to decide in terms of strategy and policy. Recently, the CEO of Bank Melli (National Bank), Iran's largest lender, criticized parliament for interfering in Melli's governance and budget planning, citing it as the main reason for the company's poor performance. Furthermore, the Central Bank of Iran caped lending and borrowing rates, in an attempt to boost business lending, regardless of the fact that most banks are in desperate need of funds and low rates cannot attract depositors. Thus, Iranian lenders have become levers of state control, and states have a poor track record in running businesses.

Government intrusion in banking policy not only reduces their efficiency, but also endangers the entire financial system and with it the economy at large. "Compulsory facilities"– loans state-owned lenders were forced to pay at cheap rates to fund government initiated schemes– have piled up bank balance sheets with at least $938 trillion rials ($33.1 billion at official exchange rate) of bad debt. The number becomes staggering when you consider that clients borrowed 3.2 quadrillion rials ($95.2 billion at market exchange rate) from Iran's commercial lenders during 2014/15 fiscal year ending March 21, 2015.

State-owned banks had to provide "Compulsory facilities" at low interest rates, while paying upward of 22 percent on one-year deposits. To cover lost revenue, they raised lending rates and embarked on risky enterprises. Lax oversight by regulators, legal loopholes and corruption abetted the banks in this regard. Now, the government is trying to solve the mess it made, regrettably with the same method: heavy handed intervention.

Though financing is not the only reason behind meager business activity, it plays a prominent role. Until Iran's capital markets grow to an adequate size and take their place in the financing cycle, banks will continue to be the only plausible source of funding. 

Even with the lifting of sanctions in sight, foreign banks are reluctant to do business with Iran, and reintroduction of Iran's banks into the global arena will take years, largely due to the issues outlined here. 

Unsurprisingly, the solutions are challenging and time consuming. The state must change its culture of interference, and instead privilege measured regulation. Moreover, the central bank has to isolate itself from political matters and increase its supervision of the banking system. Bankruptcy laws must be revised and bank charters changed accordingly.

Photo Credit: Reuters