Iran Finance Profile 2012

Iran’s economy, the major Islamic economy in the world, has undergone major transformations. A significant deepening of bank intermediation occurred in the past decade, spurred by the licensing of private banks. Private bank assets have become the major in the system following the privatization of large public commercial banks in 2008-09. Iran’s equity markets have become viable channels of finance for the realeconomy. Mutual funds are gaining prominence as a means to encourage secondary market activity. The major private banks are listed on the stock exchange and count part the majority actively traded stocks. The performance of banking stocks is underpinned by the public’s perception that banks are blue chip companies that pay reliable dividends and benefit from implicit government backing.

The economy has played a central role to support increase in a context of relative isolation. To support the economy, the government has intervened in credit allocation and set low lending rates on selected facilities for labor-intensive sectors. While Iran’s relative closeness and implicit guarantee from the government has insulated the system from potential crises, credit policies have led to a relative weakening of bank soundness.

3. A number of significant steps have been taken recently to strengthen the economy. The 5th-Year Development Plan (5th FYDP) in particular extends the Central Bank of Iran’s (CBI) regulatory reach and strengthens its supervisory powers, especially over public banks. The launching of a centralized, real-time database with positive credit data in 2011 is a first step towards establishing a comprehensive early warning system. The planned deposit guarantee is an significant part of a contingency preparedness framework.

THE ROLE OF FINANCE IN IRAN’S ECONOMIC DEVELOPMENT STRATEGY

The financial sector plays a central role in Iran’s increase strategy. In line with the 1983 Law on Usury (Interest) Free Banking, the banking system and the CBI support a broader set of goals and policies of the government, which aim at enhancing economic increase and job creation with low inflation. Additional recently, Iran’s capital markets (Tehran Stock Exchange (TSE); OTC network; commodities exchange) have gained importance in the government’s strategy of promoting a additional market-oriented economy and mobilizing private capital for the financing of the economy. The strategy encompasses the 2010 subsidy reforms, inclunding a wide-ranging privatization program in line with Principle 44 of the Constitution that affirms the primacy of private property in Iran’s economic development. Finally, the 5th FYDP that lays out Iran’s development strategy for the period 2010–15 contains an significant chapter on strengthening and liberalizing the economy (banks, capital markets, CBI)

Iran has a deep banking system and its equity market has developed considerably over the past few years. The anking system’s credit to GDP ratio, a standard indicator of the depth of bank intermediation, is the second highest part comparator emerging market nations considered in this study. Iran’s density of companies listed on the local stock exchanges is the highest part comparators. However, while the government’s privatization program has helped boost market capitalization, trading remains subdued due to the still limited free-float and the absence of mutual funds until 2009.

The significant deepening of bank intermediation that occurred in the past decade was spurred by the licensing of private banks. The depth of banking increased by 50 percentage points for the ratio of credit to GDP, and by 60 percentage points for the credit to non-oil GDP ratio between 2001 and 2010. This increase occurred largely between 2001 and 2005, when private banks were licensed for the first time since 1979. The expansion of private banks coincided with relatively attractive bank intermediation spreads (the difference between lending and deposit rates). Intermediation spreads narrowed in the second half of the decade through better competition, followed by government attempts to boost bank lending against the background of the increasing isolation of Iran’s economy and dwindling access to foreign sources of capital. The narrower spreads of 2006-10 led to a pause in banking sector expansion. Depth is measured as the sum of credit to the non-public sector by amount credit institutions relative to GDP.

Comparator nations comprise Brazil, China, Egypt, India, Russia, Saudi Arabia, and Turkey.

Additional recently, the government has intervened in the banks’ credit allocation to support job creation as the economy’s access to foreign capital became additional restricted. The sectoral credit allocation is set by the Money and Credit Council (MCC). In 2010-11, the MCC recommended that banks allocate 80 % of their increase in deposits to priority sectors—37 % to manufacturing and mining, 25 % to agriculture, 20 % to construction and housing, 10 % to trade, and 8 % to export. The remaining 20 % of the increase in deposits could be used freely, although there are sub-limits on credit for consumer durables or home improvement.

The government has as well attempted to stimulate increase through cheaper credit on facilities for labor-intensive activities. Rates on selected facilities became negative after 2007 in real terms. Additional recently, the past 18 months saw strong credit expansion, as policies to boost credit for low income housing and labor-intensive small enterprises came into effect. The government has launched the Maskan–mehr housing program that aims to increase the stock of usable dwellings by 15 % between 2010 and 2014. Credit increase has accelerated from 16 % in 2009 to 51 % year-on-year by March 2011, mainly from the housing bank. Private banks have as well resumed credit expansion since the launch of subsidy reform in December 2010.

Government choices prompted by economic isolation have weakened bank soundness. Controls on rates of return undermine bank profitability and capital. The recent high credit increase could lead to new loan losses, adding further pressure on profits and capital adequacy. Regulatory forbearance could impact listed bank stocks, with potential spillovers on listed companies in other sectors of the market.

THE ROLE OF ISLAMIC FINANCE IN IRAN’S FINANCIAL SYSTEM

Iran is the world’s major market for Islamic finance.  Iranian banking is unique in that amount banking activities must follow Shari’a principles. Moreover, Islamic banking is regulated by a law,5 whereas other nations hosting Islamic banking have used the regulatory level to introduce provisions for the specific requirements of Shari’a, especially the prohibition of interest and of gambling/speculation.6 The TSE is developing plans for listing sukuk, a market which has not from now on developed in Iran, as it has in Malaysia and GCC nations.

The 5th FYDP provides the legal framework for issuing, trading, and structuring of sukuk. Islamic bonds have existed in Iran since 1994 in the form of “participation bonds” (sukuk musharekat) issued by municipalities or large companies to finance projects. However, the participation bonds are redeemable on request and at face price from the issuing agent and are therefore not suitable for secondary trading. As a result, issuance has been small (less than 1 % of GDP per year) until 2009-10. In 2010-2011, issuance increased to 4 % of GDP. From April 2011 onward, Islamic bonds will as well take the form of many-based sukuk that are not redeemable and must be listed on the TSE.

Iran’s legal framework for Islamic banking envisages types of deposits: request deposits that are intst-free “loans” to the bank; savings accounts (Gharz al hazaneh); term deposits/investment accounts in which depositors share in the general profits of the banks; and since 2011, special-purpose investment accounts in which the investor/depositor restricts the use of funds to designated projects in which the bank is as well an equity partner (generally used by specialized banks). Savings deposits receive some remuneration in the form of “bonuses” in cash or in kind through random drawing. The provisional remuneration of term deposits is set by the MCC each year with a view to ensuring reasonable funding costs. The final remuneration is known a year later, after the bank’s profits are certified by external auditors and profits apportioned to term depositors. In 2011-year deposits yield a provisional 12.5 % and-year deposits 15 %. “Participation papers“ (bank CDs or participation bonds) function in the same way, but pay a maximum of percentage point additional than equivalent term deposits that issuers can use to attract subscribers.

Islamic credit contracts take forms—participatory and nonparticipatory facilities. Contracts are structured around the notion of rates of profits and in reference to the financing of real assets. Some contracts entitle the banks to a share of profits on the investment being financed (participatory facilities). Nonparticipatory facilities are similar to leasing structures, where the banks’ remuneration is the rental rate of the equipment or consumer durable that the bank leases to the borrower or installment sales, where the bank’s remuneration is a mark-up on the acquisition price of the good being financed. Housing facilities are structured as multi-year installment sales. For very short-term debt for working capital, the contracts are similar to swaps backed by a commodity trade, with the borrower paying back the advance at a higher next price. The difference between the next and today’s price is the bank’s remuneration. Overdraft or credit card lending are prohibited.

The MCC sets rates of profit for credit contracts each year. For nonparticipatory facilities the MCC specifies ceilings (11 to 14 % in 2011). Participatory facilities are subject to a floor of 12 %, given their better risk. In 2011, the MCC introduced ceilings on participatory facilities as well, ranging from 14 to 17 % depending on the term, or a maximum 300bp above nonparticipatory facilities of equivalent tenors. As for rates of profits on bank liabilities, the above ceilings are provisional, with the final rates of profits on bank assets being finalized a year later.

Islamic banking does not pose particular issues to CBI surveillance of the financial sector. However, Iran’s unique position as the sole 100 % Islamic banking jurisdiction complicates international comparisons, as mapping international standards for conventional banking into Islamic banking has given rise to issues of interpretation:

•  The terms of participatory contracts that require sharing losses part the borrower, the bank, and the bank’s depositors have not been tested on a large scale because of Iran’s high inflation, as inflation eases borrowers’ debt burdens;
•  Provisioning for impaired assets. Provisions, as the difference between the many’s price at origination and its carrying price, are calculated using interest rates in conventional banking. Provisioning practices as well depend on the price of collateral,
• i.e., less provisioning if the bank’s rights to the collateral are ring-fenced from other claimants and if the collateral can be realized with limited price impact. Islamic banks in a lot of nations often justify reporting lower provisions compared to conventional banks because their facilities are backed by real assets, although the market values of collateral assets can be hard to observe;
•  Accounting rules that are critical in assessing financial soundness in conventional banking do not translate reliably to Islamic banking for equity-like exposures. Under participatory facilities, losses are shared with depositors, assessed ex-post, and only the installment in arrears is classified. In conventional banking, troubled loans are 100 % classified, expected losses must be provisioned upfront and any loss is
• for the bank alone. The 2007 regulation on the classification and provisioning of credit facilities attempts to transaction with this by requiring banks to classify 100 % of an impaired facility (not just installments in arrears) if the borrower’s financials and its sector of operation show diminished ability to pay.9