The prospect of billions of dollars of hydrocarbons-linked liquidity flooding into Iraq’s financial system is whetting bankers’ appetites. Even if Iraqi banks are only able to tap a fraction of the financing requirements associated with reconstruction projects, it would provide a unique growth opportunity for a still embryonic banking system. Projects could range from the oil and gas sectors through infrastructure to mass housing developments.

The general inefficiency of the banking system provides opportunities for the few banks doing the right things

Shwan Ibrahim Taha, Rabee Securities

Yet, while the opportunities are immense, capitalising on them presents an enormous challenge for the state-dominated Iraqi bank sector. Iraq remains a cash-based economy, with only one in three transactions involving a bank. Lending levels are, not surprisingly, low – less than 5 per cent of Iraqi small and medium enterprises have ever received a bank loan.

Banking mentality in Iraq

Bank earnings are generated by fees and interest income derived from the reinvestment of deposits, rather than extending credit to companies and consumers.

“The mentality of banks taking deposits and lending money for business is not there yet,” says Shwan Ibrahim Taha, chairman of Rabee Securities, Baghdad’s largest brokerage house. “But the general inefficiency of the banking system provides a huge opportunity for the few banks that are doing the right things.”  

Banks are small, with an asset-to-gross domestic product (GDP) ratio of 73 per cent, compared with a 130 per cent average for the Middle East and North Africa (Mena) region as a whole. The corollary of this is that banks are highly liquid; foreign assets and deposits at the Central Bank of Iraq (CBI) amount to 63 per cent of assets.

According to a World Bank financial sector review of Iraq undertaken in 2011, staff skill levels are often weak, the range of services provided by many banks is still limited, and loans are mainly short-term and linked to wholesale and retail trade.

Many of Iraq’s banking sector problems can be traced back to the legacy of state dominance from the Baathist era. To this day, seven state banks dominate the banking system, led by Rafidain Bank, Rasheed Bank and Trade Bank of Iraq (TBI). Together, these account for an estimated 86 per cent of bank assets.

The 36 private banks in Iraq are generally small. Because of this, private banks are not yet able to finance large projects and syndication is still a novel concept.

Private banks are also at a competitive disadvantage to state banks. According to the World Bank assessment, state banks benefit from the perception of a de facto deposit guarantee and from restrictions imposed on the operations of private banks. The government, government agencies and state-owned enterprises are not allowed to place deposits with private banks. Nor can state-owned enterprises receive loans from private banks.

Access to the lucrative business of issuing letters of credit (LCs) for imports is restricted to state banks, with TBI enjoying a virtual monopoly issuing LCs to state-owned enterprises.

If Iraq is to build a modern banking system capable of channelling financing to its nascent private sector, the dominance of the state-held institutions will need to be addressed. “Like everywhere else, the state has no business being in the banking sector,” says Taha. “No bank should be under the government’s control.”

One of the biggest threats to Iraqi lenders is the increased politicisation of the banking sector. In a controversial move in June 2011, TBI chairman Hussein al-Uzri was served with an arrest warrant and forced to flee the country after Prime Minister Nouri al-Maliki ordered a judicial inquiry into the bank. This followed a committee comprising officials from the anti-corruption commission discovering alleged financial violations at the state-owned lender.

Allegations of a political motivation behind the purge of senior management staff at the bank has given foreign investors eyeing the banking sector serious pause for thought. 

Tarnished banking reputation

TBI’s plight is a sign of the fragility of Iraq’s banking system, as well as an uncertain investment climate. The new management claims to have recovered some of the $900m of loans alleged to have been improperly awarded during Al-Uzri’s tenure, but whatever the truth, the affair has tarnished the wider sector’s reputation.

At least part of the problems can be attributed to the bank’s novel structure – state owned, but given licence to operate as a private commercial bank. “TBI was operating in its own universe, neither government nor private,” says one Iraqi analyst. “There are some positives and some negatives, but on balance there was a very good bank. And for Iraq, it was a big bank.”

The TBI affair represents the nadir of Iraq’s post-war banking history. Not all the news from Baghdad’s financial sector has been as bleak. Even Rafidain and Rasheed, regarded as the most inefficient state lenders, have seen some improvements in lending ratios, boosting loan-to-GDP ratios from 4 per cent in June 2006 to 6 per cent in October 2010.

Under an internationally monitored restructuring programme, the two state banks have built up management and core banking staff and have focused on reducing non-performing loans (NPLs), with reserves-to-NPL ratios at the two rising from 10 per cent in June 2006 to 18 per cent in 2010.

Across the banking sector, credit is increasing (although from a low base). The World Bank says that over the past three years, credit to the economy has expanded by close to 40 per cent on average.

In September 2011, a report on Iraq’s private banks by research house IraqiXchange stated that credit portfolios rose from $636m in 2008 to $1.7bn in 2010. Wholesale and retail business borrowers accounted for more than two-thirds of the loans.

The burgeoning loan portfolios are being reflected in a shift in the earnings composition of private banks. While fees still account for nearly half of income, loans contributed 37 per cent – up from single digits in only a few years. Investments, which used to contribute up to 40 per cent, were down to 14 per cent.  

Deposits are slowly increasing. Between 2006 and 2010, the listed Iraqi banks established a compound annual growth rate in deposits of 32.6 per cent. Deposits in 2010 amounted to ID55 trillion ($47.3bn), equivalent to 57.3 per cent of GDP, not too far from the Mena average of 75 per cent.

Growth trend in private bank deposits

According to IraqiXchange, the growth trend in private bank deposits – from $1.38bn to $4.3bn over four years – is especially significant, because the government withdrew all state and public institution deposits from private banks in 2009.

However, there is still some way to go. If government deposits at the state-owned banks are taken out of the equation, the deposit-to-GDP ratio drops to a less impressive 37 per cent.

Private banks are looking to leverage their smaller size and more nimble balance sheets, compared with the loss-laden state behemoths, to compete for business. Some are opening modern, Western-style branches and offering online services to their customers. Technology improvements should soon enable the country’s estimated 700 ATMs to be interconnected, facilitating greater ease of use.

Private banks may soon have to compete with – or join forces with – foreign entrants to the market. Banks from other Arab countries and Western institutions have all signalled interest in establishing a physical presence in Iraq, with HSBC leading the way in 2005 with the acquisition of a 70 per cent stake in Dar Es Salaam Bank.

Others are joining the fray. Citigroup has formed a partnership with Bank of Baghdad – owned by Kuwait’s Burgan Bank – that provides access to Citi’s global network across more than 107 countries for cash management solutions and other banking services.

Foreign banks are not entering the Iraq market under any false pretence. As one senior adviser to a major Iraqi bank told MEED last year, most foreign banks do not want to work with the other banks in Iraq, “as they haven’t recapitalised, half the management is sitting in Jordan, and they don’t have international auditors”.

Finding a route to taking equity positions in Iraqi banks is not proving a simple task. MEED reported in January that the UK’s Standard Chartered had ceased its pursuit of a stake in Warka Bank for Investment & Development.

This came just a few months after the bank was reported to be in final stages of negotiation of a possible takeover that would have enabled the Iraqi bank to raise its capital to the minimum ID100bn as required by the CBI.

The major investment banks will continue to eye opportunities in Iraq, with institutions such as Morgan Stanley and Goldman Sachs seeking mandates for advisory work on stock market flotations. The three telecommunications operators Zain, Asiacell and Korek are preparing initial public offerings (IPOs), with foreign banks holding the advisory mandates.

This is likely to prove a long process. One source familiar with the mobile operators’ plans says the IPOs are unlikely to materialise for 12-24 months. The operators are reluctant to sell equity in the current climate and the regulatory apparatus is not yet fully in place to allow IPOs to get off the ground.

Still, firms such as Asiacell have reached a stage where they can tap into the international markets. HSBC in October last year organised a $24m medium-term facility to finance telecommunications equipment and systems for Asiacell, in the first-ever export credit-backed loan seen in Iraq’s telecoms sector. “The deal was a small, but very significant one, given the fact it was the first ECA deal in Iraq for a couple of decades,” says Simon Lee, director of the Middle East project finance team at HBSC.

Consolidated approach

Consolidation may afford more opportunities for foreign banks to partner with local players. In October 2010, the CBI issued new instructions for raised bank capitalisation levels, with a minimum required capital of $213m by 30 June 2013, and two intermediate steps – $85m by mid-2011, and $128m by mid-2012. These requirements are intended as a trigger to reduce the number of banks by as much as one-third and create a smaller but stronger sector.

For foreign institutions prepared to take the plunge, Iraq could offer substantial rewards. Retail banking is still in its infancy, with only a few banks offering credit cards and ATM facilities. With plans under way for building millions of homes, mortgage lending is another potential growth area.

“Iraq is primed for a very healthy mortgage market,” says Rabee Security’s Taha. “That is the first area of lending. The second is for infrastructure projects and projects related to infrastructure. We need brick factories, new roads, new pipe factories, and all of this will require bank funding.”

If the country’s massive investment commitments materialise as predicted, there should be no shortage of opportunities for those willing to enter one of the Middle East’s last untapped markets.