66105 September 2011 – Number 44 IRAQ: FINANCIAL SECTOR REVIEW Sahar Nasr, Arne Petersen, Jan Van der Vossen, Nabil banks have foreign participation and eight Hashad, Richard Britton, Sibel Kulaksiz, and Erik operate according to Islamic principles. Huitfeld 1 Estimates indicate that state banks account for 86 percent of bank assets and 69 percent of Introduction: The link between sound and credits. Overall, the banking system is well-developed financial systems and economic relatively small, with an adjusted asset to GDP growth is fundamental. Efficient and prudent ratio of 73 percent compared to 130 percent for allocation of resources by the financial system the Middle East and North Africa (MENA) is critical for increasing productivity, boosting region. Although growing rapidly in 2010, economic development, enhancing equality of lending only amounted to 10 percent of GDP opportunity, and reducing poverty. compared to 55 percent for the MENA region as The Iraqi Financial System: The financial a whole. As a corollary, banks are very liquid sector in Iraq remains underdeveloped and and foreign assets and redeposited at the underperforming. The banking system is by far Central Bank of Iraq (CBI) amount to 63 percent the most important part of the financial system, of assets. accounting for over 75 percent of assets and is State-Owned Banks: The operations of overwhelmingly state-owned. Non-bank Rafidain and Rasheed Banks, the two largest institutions and markets are small and under- state banks, are inefficient and both suffer from developed. Access to finance is impeded by a the legacy of past losses, as well as from weak financial infrastructure, which needs performing quasi fiscal operations. Reforms strengthening in all areas: credit registry, the have been significantly delayed, especially collateral framework, judicial systems, and compared to the time-line in the 2006 accounting and auditing skills. It is also Memorandum of Understanding (MOU) important to keep in view the political context. between the CBI and the Ministry of Finance. A The difficult security situation imposes costs World Bank project has been supporting the and constraints, the complex political situation reform process since 2009. The reform process impedes decisive policy action, governance needs to be accelerated, including removing issues linger, and the impact of state disputed items from their balance sheets and intervention continues despite reforms. transferring these to a new asset/liability The Banking System: Seven state banks management company. As part of the overall dominate, in particular, Rafidain Bank and strategy, state banks must become subject to Rasheed Bank. Private Banks are generally normal supervision by the CBI. quite small and many have been established More fundamentally, the authorities need to relatively recently. Seven of the 36 private consider the relative roles of state-owned and private banks, including the role to be assigned 1 This Quick Note is based on the Iraq Financial Sector to the TBI. The TBI was set up as a specialized Review prepared by a World Bank team led by Ms. Sahar trade bank, but now operates as a general Nasr. The review will available in full on September 23, 2011 and can be accessed at www.worldbank.org/iq. This commercial bank and has become an important Quick Note was cleared Mr. Simon C. Bell, Sector Manager, player in the financial system. Finance and Private Sector, Middle East and North Africa Region, The World Bank. Private Banks: These face an uneven playing appear. Accounting and auditing standards are field. State banks benefit from the perception of lax and banking supervision needs to be a de facto deposit guarantee and from strengthened. Still, most banks appear to be restrictions imposed on private bank well capitalized, and with strengthened operations. Government agencies and state banking supervision and a leveling of the owned enterprises cannot place deposits with playing field, the majority of private banks private banks. Nor can state-owned enterprises should continue to grow and gradually provide receive loans from private banks. Moreover, the financial underpinnings for stronger non-oil payments to the government (taxes, etc.) cannot growth. The planned gradual increase in be undertaken by checks drawn from private minimum capital requirements will help banks. Discussions are under way among promote consolidation and further strengthen private banks to set up a self-funded deposit private banks. guarantee fund, but these are at an early stage. The banking system does not appear to give The strength and business expertise of the 36 rise to significant macro-prudential risk at small private banks appears to be improving. present. Private banks are small, highly liquid, Several offer a range of products, including and have strong prudential indicators. While consumer loans. However, staff skills are often Rafidain Bank and Rasheed Bank clearly weak, the range of services provided by many require recapitalization, they are still highly banks is still limited, and loans are mainly short liquid, with cash, deposits at the CBI, and term loans related to wholesale and retail trade. foreign assets covering 97 percent of private Because of their small size, private banks are deposits. Bringing the capital level of all state not yet able to finance large projects, as banks up to the new minimum level by June syndication is not yet used. Some observers, 2013 could require a capital injection equivalent including CBI officials question the to 1.4 percent of GDP. professionalism of private banks and are concerned that they are not yet able to Access to Finance Issues: As noted, bank credit effectively support rapid economic growth. is relatively low and access to other forms of finance also needs improvement. A USAID Foreign banks have shown increasing interest in project team estimates that less than 5 percent conducting business in Iraq. Currently, many of SME’s in the formal sector have ever foreign banks mainly focus on foreign received a bank loan. The authorities and companies in oil and related activities. donors have only recently started to focus on However, over time they should help improve micro-finance. There are no good estimates for the overall banking climate and spur the unsatisfied credit demand. As a simple development of the financial sector. yardstick, to bring the credit to GDP ratio from 10 percent of GDP to the MENA average of 55 Profitability of banks is generally good, but a percent will require an increase in credit of ID decline in profits for private banks in 2010 45 trillion or approximately $400 million. The needs watching. State banks are de facto planned increase in bank capital levels will be exempted from meeting prudential sufficient to support such a lending level. requirements, and some of them would However, depending on whether or not credit otherwise fail because of low capital. Prudential growth does outpace the banks’ risk indicators for most, though not all, private management skills or the capacity of the CBI to banks are relatively strong. Prudential and supervise banks’ rapid growth, such an performance indicators for Islamic and increase in credit within a short time may bear conventional private banks are broadly similar. the risk that asset quality deteriorates. Islamic banks fund themselves more from capital and give a larger share of long term The Financial Architecture: Weak financial loans. infrastructure is a clear impediment to access to finance in Iraq. Actions are needed in all areas, Challenges in the Banking System: There are including a credit registry, the collateral concerns that banks may be weaker than they framework, judicial systems, and accounting September 2011 · Number 44 · 2 and auditing skills. Improving accounting and CAMELS2 system need to be monitored to auditing skills and eventually moving to prevent further slippage in safety and international standards are particularly soundness. The Banking sector’s financial and important. This would help ensure the prudential information needs to become more transparency of banks and allow banks to reliable and more rapidly accessible by identify creditworthy clients. More reliable introducing International Financial Reporting accounts are also critical for better quality share Standards (IFRS)-compliant accounting issuance prospectuses, and for the development standards, internationally acceptable auditing of a reliable financial media. The authorities standards, and a chart of accounts to assure must also undertake a concerted effort to consistency across the system in compiling improve the business environment and to figures needed for IFRS compliant accounts. strengthen the real economy. Obligations to publish timely audited financial statements must be enforced more forcefully. The Payments System: This is relatively well Islamic banks must be brought under the developed, representing, in part, significant purview of regular CBI regulations and technical support from foreign donors. A Real supervision through rapid adoption of the draft Time Gross Settlement System (RTGS) and an Islamic banking law, and the associated electronic netting system for smaller payments regulations. orders were implemented in 2006. An electronic clearing system for checks is expected to be Politically supported, robust, concerted efforts operational at the end of 2011 and the must be made to prevent abuse and authorities are working with donors to further undermining of the financial system through strengthen the retail payment system, including corruption, money laundering and the potential through a universal switch for bank cards. financing of terrorism. Nevertheless, the use of cash remains high. Capital Markets: The capital market in Iraq is Supervision of Banks: The system of banking concentrated on the Iraq Stock Exchange (ISX). laws and regulations provides a workable The stock exchange is small and under- framework for the exercise of banking developed but has significant potential. It is supervision, provided rules are implemented currently at a crucial stage of its development. and enforced vigorously. A full expert-assisted Activating the privatization program to place at self-assessment of the supervisory system, least a proportion of the shares of currently based on the Basel Core Principles and the 2006 state owned companies into the hands of Iraqi assessment methodology, is required to further citizens and institutional and foreign portfolio align the system to international standards. investors could, over several years, see ISX rival However, there are three prerequisites for the its regional peers in size and depth. CBI to be able to fully deploy effective It is probable that there is (unsatisfied) demand supervision: (i) ensuring the political will to let from life insurance companies and pension the CBI perform its tasks without interference, funds for medium/long term debt securities in (ii) assuring that state owned banks are order to match long term liabilities with long effectively supervised by the CBI in full term assets. There appears to be no issuance of accordance with the 2006 Memoranda of such securities currently by either the Understanding (MOU) between the CBI and government or the private sector. The absence the Minister of Finance, (iii) ensuring that the of government debt beyond one year inhibits CBI has the resources, financial and human, to effectively supervise these large institutions 2 with their many branches. An international bank-rating system where bank supervisory authorities rate institutions according to six For optimal effectiveness of current rules and factors represented by the acronym "CAMELS." This refers to Capital adequacy, Asset quality, Management quality regulations, enforcement needs to be Earnings, Liquidity, and Sensitivity to Market Risk strengthened, and banks rated three under the September 2011 · Number 44 · 3 the latter as there is no “risk free� yield curve to whether these small companies are active. The use to price corporate bond issues. Capital participants in the insurance sector feel a strong market development requires improvements in need for strengthening of the supervision of the all the necessary underpinnings of a market in insurance sector. which issuers and investors can have confidence. These include laws on contract The government has taken some measures to enforcement, shareholder and creditors rights, improve the legal and supervisory framework efficient and fair judicial processes, corporate for the insurance sector. A new insurance law, governance and accounting and auditing the Insurance Business Regulation Act from standards which (at least) match regional 2005 has been passed and a supervisor has been benchmarks. established. The next steps should be to make the supervisor operational so that its role is It also requires an effective, fair and efficient made known to market participants and it regulatory framework within which to operate. commences the supervisory activities the This should have as its objectives the protection present legislation allows. The current of investors, ensuring that the market is fair, legislation on insurance should be strengthened efficient and transparent and the reduction of and brought in compliance with the systemic risk. international best practice. It is particularly important that the new legislation provides the Legislative changes: Legislative reforms to supervisor with the power to conduct on-site achieve these ends have been discussed since inspections at the insurers’ place of business. 2008 and steps should now be taken to The long-term goal should be to establish a implement these. The larger report sets out modern legal framework and proper amendments which would enhance the current supervision of the insurance sector. draft Securities Law. They would also provide a stronger foundation on which the permanent The pension sector in Iraq is going through a Iraq Securities Commission (ISC) could draft transition period with a new law to merge older and enforce its regulations. Currently little is pension schemes into a single pension fund known about the interim ISC’s capacity, with the help of the Bank’s PRISTA project3. At competencies or goals as it did not take part in present pension funds have weak supervision the review process. It appears however that the requirements and it is critical that these are current legislative and regulatory framework incorporated now, since it will be very difficult under which the ISC operates is weak and to put these into place after the new fund has underdeveloped. The current Companies Law, been established. although amended in 2004, was written in 1997 and also needs further updating to better achieve good corporate governance in joint stock companies and to secure improved Contact MNA K&L: shareholders rights. Laura Tuck, Director, Strategy and Operations. MENA Region, The World Bank Insurance and Pensions Sectors: The insurance sector in Iraq is dominated by state owned Regional Quick Notes Team: insurance companies that benefit from being Omer Karasapan, , Roby Fields, and Hafed Al- Ghwell the sole provider of insurance services to the Tel #: (202) 473 8177 government. The law requires the government The MNA Quick Notes are intended to summarize to make use of a public tender process when lessons learned from MNA and other Bank purchasing insurance services. However, even Knowledge and Learning activities. The Notes do not though the public process is used there is little necessarily reflect the views of the World Bank, its trust in the market in its fairness, because it is board or its member countries. always the state owned insurance companies that are awarded the contracts. There are a number of private sector insurance companies 3 For more see: but the number is uncertain because some of http://siteresources.worldbank.org/IRFFI/Resources/Pen them are very small and sometimes it is unclear sionReformSep2010.pdf September 2011 · Number 44 · 4 September 2011 · Number 44 · 5