Mohammed Meskarian, chief executive officer (CEO) of Persia International Bank, is matter-of-fact. “We cannot do any business,” he says. “We are not an active bank since we were sanctioned by the EU. The only thing we can do now is just deal with the previous commitments we had and pay back the money of our depositors.”

Sanctions affect business in [many] ways … it affects all banks, whether they [are in] sanctions lists or not

Chris Nicolaou, Capital Intelligence

The London-based bank is owned by Bank Mellat and Tejarat Bank, two Iranian banks which have themselves been hit hard by international sanctions. The EU added the subsidiary to its list of proscribed financial institutions on 27 July, as part of the most recent wave of sanctions against Tehran. Japan and Australia followed in September.

Persia International Bank was set up in 2002 and has been consistently profitable, making a return of e15m ($19.7m) in the year to 31 March 2010. Now, it is laying off staff in both its London and Dubai offices. “We are making redundancies,” says Meskarian. “There is no option for us. We had 55 staff in London and another 14 in Dubai when we were sanctioned. In Dubai, we had to reduce it to five and in London I think we do not need more than 30 people.”

Increasing measures

Iranian government officials and some senior bankers are fond of saying that sanctions are failing to have any effect, but the reality is rather different. Many other Iranian banks also find themselves in difficult positions.

Mahmoud Reza Khavari, CEO of Bank Melli, told the local Fars news agency on 28 July 2010 that “sanctions will not stop, block, decrease or close our activities and we will continue our work powerfully”. However, his own bank admitted, in a statement issued in July 2008, when it was hit by EU sanctions, that the measures “created significant inconvenience and hardship to some of the bank’s customers and counterparties”.

[Private banks have] raised the quality of customer service and brought new products into the market

Ali Mashayekhi, Turquoise Partners

The range of measures taken against Iranian banks has steadily increased in the four years since the UN Security Council approved the first round of sanctions on 23 December 2006, as has the number of countries imposing additional, unilateral measures. As a result, banks are finding it harder to operate overseas and the cost of doing business has risen.

The UN sanctions are tightly focused on preventing Iran from acquiring the means to produce a nuclear bomb. There have been four Security Council sanctions resolutions in all, but only a few banks or bank executives have been explicitly included in the asset freezes and travel bans imposed. Those affected are Bank Sepah, First East Export Bank and Ahmad Derakhshandeh, chairman and managing director of Bank Sepah.

The bigger problem for Iranian financial institutions is the unilateral measures adopted by the US, EU, Japan, South Korea and others. These build on the UN measures and are far more wide-ranging, both in terms of the number of banks affected and the types of activities they cover.

Among the measures adopted, the US has barred its banks from any financial dealings with banks linked to the Iranian government and severely restricted dealings with other, private banks. Both the EU and Japan, meanwhile, have insisted that any financial transaction involving Iran worth more than e40,000 has to be authorised by regulators in advance.

“It’s become more difficult for banks and for a lot of industry players to transfer money globally,” says Ali Mashayekhi, head of investment research at Turquoise Partners, a Tehran-based investment firm. “The costs have increased and that will have an impact on the banks’ business.”

Dollar transactions

One area of international finance that all banks have effectively been cut off from is trade in dollars. Since the US began restricting Iranian banks’ access to the dollar clearing system in 2006 the number of dollar-denominated transactions has tumbled. According to the Central Bank of Iran, the proportion of interbank foreign exchange transactions carried out in dollars fell from 65.9 per cent in 2006-07 to just 1.7 per cent in 2008-09. Over the same period, the share of euro transactions rose from 32.4 per cent to 83 per cent.

“It wasn’t the end of the world for us because, although we did a lot of business in dollars before that, we could move over to the euro,” says Christopher Wakefield, assistant managing director of Bank Saderat plc, a UK subsidiary of the state-owned Bank Saderat. “Although it obviously caused administrative hassle.”

But Wakefield’s bank was also included in the EU sanctions issued in July. Since then, he has been in the same situation as Meskarian – unable to do new business and having to lay off staff.

To date, 12 Iranian banks and their subsidiaries have been included in international sanctions, but even for those that have avoided them, there are problems beyond the issue of dollar transactions. Those not specifically named in the sanctions have also been affected by the far greater level of scrutiny international regulators are now applying to all financial transactions involving Iran.

“We know the sanctions affect business in multiple ways in Iran and I think that it affects all banks, whether they have been included in the sanctions lists or not,” says Chris Nicolaou, senior credit analyst at US credit ratings agency Capital Intelligence.

Yet the picture is far from gloomy for the Iranian banking sector. Despite the problems they face dealing with many international markets, the country’s banks have been thriving over the past decade as the economy has continued to grow. At least nine new banks have emerged and have generally had impressive growth rates in terms of both deposits and profits.

Revolutionised banking in Iran

“The banking sector in Iran over the last 10 years has been one of the best-performing sectors, both in terms of profitability and share price performance,” says Mashayeki. “The new private banks have done very well. The average annual growth in deposits in private banks has been 40 per cent year-on-year, over the last five or six years.

“They’ve revolutionised the Iranian banking system. They’ve raised the quality of customer service and brought new products into the market. They’ve been able to win quite a significant share of the market from state-owned banks and state-owned banks have had to raise their standards to compete.”

However, the success of the sector in attracting new entrants has meant that competition has increased sharply. Growth has started to slow down in the past two years, with deposit growth now closer to 20 per cent for the private banks.

The high growth rates helped to disguise some other problems that have now come to the fore. The Washington-headquartered IMF warned in March that the soundness of the banking sector had deteriorated as a result of slower domestic demand growth and weak credit control during the good times. This in turn has “led to strong balance sheet growth, a decline in capital adequacy ratios and a significant increase in non-performing assets”, the institution said.

The issue of non-performing loans has become one of the biggest headaches for Iranian banks, particularly the private banks. According to Karafarin Bank, 26.6 per cent of all loans by private banks were classed as non-performing at the end of December 2009, up from just 2.5 per cent two years earlier. State-owned banks fared slightly better, but nonetheless the overall rate of bad debts across the entire banking sector stood at 21.7 per cent at the end of last year.

Part of the rise can be attributed to sanctions and the inability of some companies to repay their loans as business levels fell away. But it also stems from a mismatch between interest rates and inflation three or four years ago.

At the time, inflation had risen to about 30 per cent, but the central bank only allowed banks to charge 12 per cent interest on loans. As a result, banks stopped offering loans at 12 per cent and instead offered other products with far higher interest rates, closer to 25 per cent. At the same time, anyone who defaulted on their bank loans could only be charged a penalty of 6 per cent, according to Iran’s banking regulations.

“They can only charge you 6 per cent per annum on the missed payment, which means that rather than paying 12 per cent you’re paying 18 per cent,” says Mashayeki. “If you were lucky enough to get one of those 12 per cent loans you’d be more than happy to pay the penalty and hold on to the loan because, if you did repay it, it would be very difficult to get hold of another 12 per cent loan. A lot of businesses and individuals have held on to their loans and that’s one of the main reasons why bad debt has grown so much.”

However, observers say the difficulties with high levels of bad debts are now being addressed and should start to drop.

Positive trend

“The problems in asset quality seem to be receding,” says Nicolaou. “We are seeing a welcome change in the way banks approve new loans, so we think the problem has levelled off already. The trend now is positive in terms of asset quality. What banks need to do now is increase their capital to make them stronger and safer – and they are in the process of doing so.”

While they seek to raise that additional capital, the risk for many institutions is that political tensions with the West over the country’s nuclear activities will only increase. If that happens even more onerous restrictions are likely to be placed on the country’s banking sector. For those already hit by sanctions, however, there is little they can do but wait and hope that their period in limbo will not last much longer.

“We are still hopeful the situation will improve – and when it does we, are hopeful to get back to the market,” says Meskarian.