PRIMITIVE BANKING

The existing financial system comprises the Central Bank of Iraq (CBI), six state-owned 'monolithic' banks and 19 small private banks — formed during the early 1990s. The CBI and state banks — notably Rafidain and Al Rasheed — were merely fiscal instruments for the Baathist party, or more specifically, they acted as Saddam Hussein's personal bankers and as such were responsible for massive 'flight capital' from pre-conflict Iraq.

According to the US Treasury Department, total assets are now estimated at about $2bn, equivalent to 10% of gross domestic product, while the aggregate equity of Iraq's 25 banks is reported at a mere $42m. The sectors capital-assets ratio of 2.1% is extremely low by international comparison.

Most, if not all of Iraq's banks are 'technically insolvent', possessing negligible capitalisation, while the true value of assets falls well short of liabilities to depositors and other creditors, including foreign banks and western export credit agencies.

Moreover, the bad debts of these 'typical' Iraqi banks exceed their own paid-up capital, while reserves are far too small to cover loan losses. Inadequate accounting systems and poor regulations enabled banks to conceal non-performing loans (NPLs) in their accounts by constantly rescheduling principals and capitalising interest arrears in order to maintain the status quo.

The main reasons for NPLs are excessive directed lending for the financing of ballooning budget deficits, funding operations of public enterprises and large, uneconomical projects during the past three decades. Other irregular practices such as inside lending to former ruling elites/cronies have also resulted in huge bad debts.

The 'Old Iraq' lacked a commercial banking culture, with lending based on cronyism, not credit quality.

To date, effective competition remains weak, and therefore concentration in the banking sector is extremely high. The two big banks, Rafidain and Al Rasheed, control 85%-90% of total banking assets. During the 1980s, Rafidain (founded in 1941) was the largest Middle Eastern bank with assets of $47bn, but today it owes some $24bn to western and regional Arab banks, as well as Paris Club countries.

Rafidain Bank also carries the old regime's [unpaid] sovereign debts and letters of credit. Until the issue of Sl27bn-plus external debt is settled, international trade-finance business is closed to state-owned banks. The Trade Bank of Iraq, a consortium of 13 international banks led by JP Morgan Chase (US), was established in December 2003 to handle all trade documentation, covering Iraqi exports/imports and is solely responsible for issuing and confirming letters of credit.

The distressed banks are unable to provide services and products largely taken for granted elsewhere in the world, including corporate financing, structured trade finance, cash management/treasury services, mortgages, insurance, leasing, credit cards, and cash machines (ATMs).

Iraq remains a predominantly 'cash-based' economy, where banking is confined to deposit taking and a few short-term loans. It is estimated that only one-third of the total money supply in circulation is inside the banking sector. Apparently, most Iraqis elect to keep their savings "under the bed".

Meanwhile, the domestic payments system is almost primitive — money transfers between two banks, or even between branches of the same bank, can take over a week. Due to the absence of electronic links and a depleted telecommunications infrastructure, the system is largely 'manually-based', with banks processing checks via messengers. This has often led to long delays and high levels of credit float.

Substantial investment in IT systems is urgently needed. Neither SWIFT (Society For Worldwide Interbank Financial Telecommunications) — a messaging system that facilitates global funds transfers — nor MICR (Magnetic Ink Character Recognition) — a secure, high-speed method of scanning and processing information used by banks — are available in Iraq.

The CBI has raised minimum capital requirements for private banks to help promote consolidation and restore solvency ratios. The move should encourage mergers and acquisitions within the sector. By April 2005, core capital (shareholders' funds) must reach $5m. Among the large private institutions are the Bank of Baghdad, Iraqi Middle East Investment Bank, Commercial Bank of Iraq, Investment Bank of Iraq and Credit Bank of Iraq. The clientele group frequently includes family members or business associates of the owners. A recent Citigroup report shows that the total deposits of private banks were mostly invested in treasury bills and affiliated companies.