Iran: Finally making the right move?

The US is out. Europe wants to stay in. Iran is determined on staying afloat. US President Donald Trump’s decision to quit his predecessor’s hard-fought landmark 2015 Iran nuclear deal to strong-arm the Islamic Republic into yielding to a “better deal” by threatening adverse economic repercussions has sent politicians and investors — institutional and retail — scrambling. President Hassan Rouhani, however, is resolved to not let his US counterpart get what he wants — and has been putting up scaffoldings to prevent a banking and economic collapse. But Hassan’s reforms, as VINEETA TAN and MARC ROUSSOT find out, could exacerbate rather than ameliorate the hardships faced by financial institutions, in the short run at least.

Rage against the machine
For months, ordinary Iranians nationwide took to the streets protesting the banking system they believe is corrupt and broken. These protestors were investors of the bankrupted Caspian Credit Institute, a licensed financial institution with alleged links to Supreme Leader Ayatollah Ali Khamenei’s office. Not only has Caspian Credit Institute failed to pay its depositors the promised profit rates since July 2017; also, depositors have not been able to withdraw their savings.

Hurling insults at the Republic’s president with some throwing tomatoes and eggs at Caspian Credit Institute’s premises, the protestors projected their anger toward the entire banking system, calling banks thieves and calling the supporting machinery behind banks corrupt. At the time of writing, victims of Caspian Credit Institute have yet to be compensated.

Broken system
These demonstrations are a manifestation of swelling resentment and loss of confidence in the Iranian banking system plagued by negative earnings and bad assets. Iranians were removing their money from the banking system long before Trump pulled the plug on the nuclear deal: Mohammad Reza Pourebrahimi, the head of parliament’s economic committee, in March reportedly said that capital outflows had been US$30 billion in recent months.

The flee of capital seems to suggest that Hassan’s promise to overhaul the fragile banking sector back in 2017 did little to inspire market confidence.

Sentiments at that point were mixed: Hassan managed to retain his electoral seat but the victory came amid signals that the Joint Comprehensive Plan of Action was threatened by the then newly-elected Trump who vowed to undo what he has repeatedly called “the worst deal ever”. Foreign companies which rushed to set up shop in the Republic, lured by the prospect of benefiting from the once isolated economy worth almost US$440 billion, were unsettled by the capricious Trump.

Also at stake is the future of 45 banking institutions and a financial system, the only one in the world (except Sudan) to fully abide by Shariah laws, many would describe as opaque, inefficient and toxic.

Deaf ears
In an attempt to assuage public unrest, facilitate its international ‘comeback’ and rehabilitate its ailing banking system, Iranian lawmakers over the last year have put forth major reform proposals addressing banks’ ownership structure, disclosure requirements, bankruptcy and dissolutions of financial institutions, transparency and accountability, supervision and accountability as well as a more robust and faithful usury-free banking system — all these amid a collapsing rial and an increasing distrust for the banking system against the backdrop of heightened political uncertainties.

In recent months, the parliament has agreed to restructure banks in the name of transparency and corporate governance — banks are only allowed to operate as public joint companies/corporations and acquisition of stakes above 10% would require central bank approval. Banks are also required to comply with International Financial Reporting Standards (IFRS).

But these are easier said than done.

More than a dozen banks have refused to follow IFRS, claiming that the Iranian version of the standards are flawed; analysts on the other hand view this reluctance as a move to cover unfavorable activities. None of the banks contacted by IFN, including some of the largest financiers in the countries, are willing to comment on the matter.

Not only banking
Resistance to reforms and the lack of enforceability are not issues unique to the banking sector. Apart from the Central Bank of Iran, the Securities and Exchange Organization of Iran (SEO) has also revamped its regulations. Most recently, the SEO imposed ceilings to the size of all investment funds, a measure taken to deepen Iran’s fledgling capital markets, but also more importantly, to reduce its exposure to the banking sector, particularly fixed deposits (See sidebar). This is one of the most significant reforms in over a decade.

Yet, despite coming into effect in mid-April, IFN understands that few are following the new requirements; and investment managers are not being held accountable for breaking the new rules, which apply to both new and existing funds.

“We have not seen much action until now but if the regulator decides to introduce penalties we will surely see things moving. However, the regulator knows that implementing such regulations cannot be achieved overnight,” says Edris Feyz, the head of international business development at Lotus Investment Bank, which manages one of the largest fixed income funds in the country, the IRR157.61 trillion (US$3.72 billion) Lotus Parsian Fund, in addition to nine other large funds. The regulator has not specified a time frame for market participants to adapt to the new rules.

Separating banking from capital markets
Market participants believe the SEO’s latest drastic move is an attempt to deepen the capital markets which have atrophied by a lack of investments as a large majority — 60-70%, according to analysts — of funds invest in fixed deposits offered by banks and credit institutions. With a 15-20% annual return, fixed deposit accounts are particularly appealing as they offer an equally, if not more, competitive return relative to Sukuk, equities and derivatives, but at lower risk levels.

This means that the young US$130 billion non-banking capital market of Iran is only able to absorb a fraction of these funds, with the large chunk being disbursed into the banking system. As at the end of February 2018, the AuM of investment funds stood at IRR1.55 quadrillion (US$36.77 billion), according to latest SEO data. This is excluding the numerous funds offered by unlicensed credit institutions, which observers note run into the thousands.

On the other hand, the two local stock exchanges — Tehran Stock Exchange (TSE) and Iran Fara Bourse (IFB) — as tracked by the SEO had a market capitalization of IRR3.82 quadrillion (US$88.94 billion) and IRR1.47 quadrillion (US$34.72 billion) as at the end of March 2018 respectively.

Regulating the size of investment funds to be proportional to the size of the capital markets (available instruments) would be vital in creating a sustainable financial market.

Insufficient capacity
Regulating the size of investment funds, and the number of such funds in the market, is not the regulator’s first try at reducing investors’ dependence on fixed deposits. Last September, the SEO mandated funds to reduce their fixed income portfolio in bank deposits to 50%, but to little success.

“The depth of the capital market is a key issue here as there are not enough Sukuk issued or companies listed to absorb all this liquidity,” explains Edris. The number of unlisted companies on the IFB are almost double those listed at 160 vs 95 (the TSE has 326 listed entities); outstanding Sukuk in Iran reached IRR717.62 trillion (US$17 billion) as at the 31st March 2018. There are also not enough market facilitators with the capacity to absorb funds: out of the 45 banks, only nine are investment banks, out of which, only three are actively managing investment portfolios on a stand-alone basis rather than for their parent/sister banks.

In other words, for investors to move away from banking deposits and into capital market instruments, the products must first be available. The Iranian government has been proactively attempting to broaden the investment universe: in January 2018, the government began issuing Islamic treasury bills. More corporates are also tapping the Sukuk market.

Ride out the change
The picture painted here looks ostensibly dire: market players are not faithfully following the rules (and are getting away with it), the banking system continues to shoulder excess bad debts, investment managers are caught in between a rock and a hard place with few available asset classes to diversify their portfolio leaving the low-risk lucrative fixed deposit accounts the preferred choice, thereby assuming high risks associated with the less-than-healthy banking sector. And the elephant in the room, the revival of sanctions by the US, is and will continue to adversely impact how cross-border businesses are done.

But market participants are hopeful.

Despite the US walking back on its agreement, foreign powers including the likes of Germany, China and Russia still want to keep bilateral ties open, although admittedly, it would be trickier to do so. There are some tough negotiations with the EU ahead.

On the domestic level, while industry players would not deny that the financial architecture is less-than-sophisticated and the markets are less-than-desirable, but they acknowledge that regulators are taking critical concrete steps to untangle the mess. Because the reality is, even if sanctions were waived, Iranian financial institutions would still find it difficult to do business with foreign banks because their risk management practices are not at par with international standards.

But the financial market is heading in the right direction: the SEO, for example, was admitted as an associate member of the International Organization of Securities Commissions, a global standard-setter. The first phase of turning over a new leaf nonetheless would be marked with hiccups and pain points. Local banks are turning to mergers and acquisitions to leverage on the strengths of others and to better manage weaknesses: Bank Ansar is expected to acquire Mehr Eqtesad Bank and Samen Financial Institute, and Qavamin Kowsar and Hekmat Iranian Bank are also undergoing negotiations to merge. Investment banks would see their bottom line suffer as they scale back tremendously under the new fund rules but in the long-run, the financial markets would emerge stronger and more sustainable.

“It will be difficult: there will be gainers and losers — but in the long term the financial market will be the winner,” one Iranian investment banker aptly observed.

SEO implements new caps

Effective the 18th April 2018, all investment funds (equity, balanced and fixed income) are only allowed to manage up to IRR5 trillion (US$118.48 million) in assets a year, with the possibility of doubling their assets under management (AuM) limit after 12 months, subject to approval from the High Council of the Capital Market Authority. Over the lifespan of these funds, they are not allowed to manage more than IRR100 trillion (US$2.37 billion) in assets.“Previously, there were no such controlling mechanism, and companies managing funds were more or less free to issue as many units as they wanted,” Majid Pireh, an Islamic finance supervisory expert at the SEO, explained to IFN. Majid believes that the regulations would help the SEO better manage systemic risk.

The new fund size constraint is expected to impact investment banks more than private management companies as the former typically manage large funds, according to Mohsen Motmaen, deputy CEO of Aseman Portfolio Management Company. “For example, the biggest size of [a] fixed income fund managed by a private management company is about IRR4 trillion [US$94.74 million] while there is a fund with IRR300 trillion [US$7.11 billion] of AuM being managed by an investment bank,” shared Mohsen.

Although technically, there is nothing stopping fund managers from breaking down their existing funds into multiple smaller funds to meet the new requirements, it is understood that the significantly more stringent application and approval process for new funds would likely control the number of funds being launched. For example, the High Council of the Capital Market Authority, whose approval is needed for fund expansion, only meets at most once every quarter, thereby inadvertently making requests for a fund upsize and new approvals a lengthy and tedious process.

This article first appeared in IFN Volume 15 Issue 22 on the 30th of May 2018

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