There was a brief moment of respite for Iran’s beleaguered banking sector in mid-June as the noose around the country’s economy and finance industry tightens still further. As the US prepared to enforce new, tougher sanctions from 1 July, the UK government was told to remove Bank Mellat, the Islamic Republic’s largest privately owned bank, from its sanctions list by the country’s highest court.

In the judgement on the case, issued on 19 June, Lord Sumption said the UK Treasury had “singled out Bank Mellat from other Iranian banks”, a move it described as “irrational” and “disproportionate”.

Minor victory

Although the ruling was welcomed in Tehran, in reality, it is a minor victory – the significance of which is still far from clear. More than 50 similar cases are pending at the EU’s two highest courts, including the EU General Court, where Bank Mellat has also scored a victory against sanctions imposed on it. The EU is planning to appeal.

These successes and other similar cases will put pressure on the relationship between the EU and the US, which relies on European backing for its attempts to cut off Iran’s links to the global economy to force Tehran to abandon its nuclear programme. “I consider this ruling as opening the door for the lifting of sanctions against Iran’s banks,” says Sarosh Zaiwalla, senior partner at Zaiwalla & Co, the UK law firm that represented Bank Mellat.

One of the key arguments of the Bank Mellat case concerned whether it was lawful for the UK to have enforced sanctions against the bank without having first given it the chance to respond to allegations that it was involved in financing Iran’s nuclear programme. Bank Mellat has always denied any involvement in Tehran’s nuclear ambitions.

“The ruling means that the UK government cannot ruin Bank Mellat just to put pressure on the Iranian government,” says Zaiwalla. He adds that Bank Mellat is currently calculating a damages claim against the British government as a result of winning the case, which will be “at least £500m ($760m)”.

Several other lenders are now planning to use the ruling in favour of Bank Mellat to unpick sanctions against them. Since winning the Bank Mellat case, Zaiwalla has been back to Iran to advise other banks on their attempts to overturn UK sanctions. “The other banks are delighted with this ruling,” says Zaiwalla. “I have told them the way to fight Western sanctions is not by shouting that they are unjust, but by challenging them in law.”

Significant as the UK Supreme Court ruling may be, it does not unwind the full raft of sanctions now affecting Iranian banks, imposed by the US, the UK and the EU. Washington has imposed trade embargoes on Iran since 1979, and as Western pressure to get Tehran to abandon its nuclear programme has intensified, so has the web of sanctions.

In November 2011, the US named the entire Iranian banking system as potentially aiding and abetting terrorist activities. President Barack Obama also issued an executive order that month preventing foreign financial institutions from handling oil sales with the central bank in Tehran, which handles most of the Islamic republic’s oil payments. More recently, in June, the US took steps to penalise foreign banks that hold or trade the Iranian rial, in an effort to force the further devaluation of the currency. The sanctions mean that any Iranian entity is now effectively shut out from the US financial system.

Short-term profitability

As a whole, the sanctions now make it impossible for Iranian lenders to hold assets or deal with any financial institution in the US, the UK, or the EU. Some of the sanctions also target specific banking industry executives.

Gauging the true impact of the sanctions on Iran’s banks is difficult. Disclosure is poor. For many banks, the last set of financial results released is for the Iranian year 1389, which ended in March 2011.

Those results appear to show a sector performing better than many would expect. Deposits are rising, loan and asset growth is strong, and the banks have enjoyed a fairly low operating cost base and broadly increased profitability. It would appear that despite several years of sanctions against their activities, Iranian banks have survived in relatively good health.

Digging deeper, however, it becomes clear Iranian banks are sitting on a raft of problems that will eventually have to be dealt with, regardless of how much longer the sanctions against them continue. Non-performing loan (NPL) rates are worryingly high, and look even worse considering that Iranian lenders only start to classify loans as non-performing after six months, rather the international standard of three months.

At the end of 2010, NPLs in the banking system totalled $50bn, while the combined capital of the banks was $29bn in March 2011. Depending on the recovery rate for NPLs, the banking sector could already be technically insolvent. “The inescapable conclusion is that the Iranian banking system is bankrupt,” says Andrew Cunningham, founder of UK-based financial markets research firm Darien Analytics. “In simple terms, the true value of its assets is less than the true value of its non-equity liabilities.”

Questionable practices

The high level of NPLs, which represents about 25 per cent of all loans, also raises questions about the quality of credit-checking before loans are approved. It also prompts concerns about what role the central bank is playing as regulator of the lenders.

According to the Washington-based IMF, provisioning only covers about 32 per cent of NPLs. It also warns that under-provisioning is probably a sign that banks are overstating profits and their capital positions.

How the situation for bank deposits has developed since March 2011 is unclear. While the value of the rial has continued to fall against the dollar, the central bank has made some moves to try to attract deposits. In January 2012, it succeeded in getting President Mahmoud Ahmadinejad to back down in a squabble over raising interest rates on deposits. After decades of central-controlled interest rates, lenders were finally given freedom to charge whatever they wanted to attract deposits. As a result, some banks are now advertising that they will pay depositors 15 per cent interest.

The impact of this is that to fund such high deposit rates, banks will have to charge interest on loans of about 20 per cent. Such high interest rates could present problems to many borrowers, especially when most companies operate with the twin challenges of a declining exchange rate and sanctions.

As if the external challenges were not enough, lenders also face internal threats. In 2011, it was revealed that a local investment firm, set up by businessman Amir-Mansour Khosravi, had embezzled $2.6bn from at least seven Iranian banks over a period of four years. The scandal reached the highest levels of government, with accusations that members of Ahmadinejad’s administration were involved, and ended with four death penalties, two life sentences, and 33 jail terms of up to 25 years for those involved. Although the president denied allegations that his government was involved, it resulted in the head of Bank Melli fleeing the country, and the removal of several senior bankers from their posts.

Damaged reputation

More worrying is the reputational damage. Even if senior administration figures were not involved in the fraud, it went on for four years under their noses, implying the supervision of the banking sector is either corrupt or incompetent.

Even if the Bank Mellat ruling is the beginning of the end of sanctions against Iran’s banks, it will not undo years of mismanagement. Nor will it have any impact on the high level of NPLs and the lack of provisioning for them, the freefall in the value of the currency, or the impact of being virtually shut out of the international finance system for several years.

The noose may slacken, but Iranian banks could yet hang themselves.

Key fact

Non-performing loans make up 25 per cent of all loans in the Iranian banking sector

Source: MEED