Iraqi banking system grapples with trust deficit, US sanctions

Shafaq News/ Despite the efforts of the government, Iraq's banking system efforts to lift itself again continues to face a lack of trust among citizens, which ultimately hinders efforts to promote financial inclusion and undermines the overall health of the financial sector. Several factors, however, contribute to this trust deficit, according to economic experts.

Omar Al-Halbousi, an economic analyst, cites the collapse of several longstanding banks as a primary concern. These failures left depositors without their money, despite attempts to seek compensation through the Central Bank and Iraqi judiciary.

In an interview with Shafaq News Agency, Al-Halbousi argued that the CBI's "inadequacy in effectively overseeing and regulating banking operations" pushes citizens towards keeping their cash at home instead of depositing it in banks. Additionally, the ownership structure of some private banks raises red flags. Entities implicated in corruption or foreign ownership with unclear motives deter potential depositors.

Further complicating the situation are recent US sanctions imposed on a subset of Iraqi private banks. These sanctions exacerbate the existing anxieties of the potential depositers.

Citizens worry about the potential freezing or instability of funds held in sanctioned banks, particularly since many Iraqi banks rely heavily on the US dollar for their operations. The lack of a diversified investment portfolio within the banking sector further amplifies these concerns.

"The citizens' reluctance to deposit their funds in banks increases alongside the rise in sanctions imposed on banks," Al-Halbousi said.

The US Treasury Department has sanctioned 32 out of the 72 private banks operating in Iraq. According to Al-Halbousi, these sanctions fall into two categories. The first category restricts sanctioned banks from conducting transactions in US dollars, although they can still operate in other currencies.

The second category involves more severe sanctions imposed by the Treasury Department's Office of Foreign Assets Control (OFAC). These sanctions target banks involved in serious financial crimes, including money laundering, terrorist financing, evasion of US sanctions, dollar smuggling, and the use of counterfeit commercial bills. A recent example is Al-Huda Islamic Bank, which faces a complete ban on dollar transactions and is isolated from foreign banks due to these contraventions.

Al-Halbousi argued that the CBI's failure to adequately supervise banks and address illicit activities led to the US imposing sanctions. He warned that the list of sanctioned entities is likely to grow, with additional banks at risk for involvement in financial crimes. Companies and individuals acting as fronts for terrorist organizations could also face sanctions.

Official data from the Central Bank paints a concerning picture. As of December 2023, the total amount of cash issued by the CBI stands at 102 trillion Iraqi dinars. However, only 60 trillion dinars are deposited in government banks, with a meager 13 trillion dinars deposited in private banks. This leaves a staggering 93 trillion dinars circulating outside the formal banking system.

Ahmed Eid, a researcher specializing in economic affairs, emphasizes the negative impact of this imbalance on Iraq's financial inclusion goals and overall economic development. For this situation, he blames mismanagement, politically motivated decisions, and a lack of robust governance and control mechanisms within the banking sector.

Eid points to the slow adoption of modern technologies for financial transactions and the inadequate implementation of electronic payment systems as additional factors hindering trust. These shortcomings and a lack of attractive incentives for using digital financial tools discourage citizens from utilizing formal banking services.

The researcher confirmed a widespread preference among Iraqis to keep their money at home rather than deposit it in banks. This stems primarily from a lack of trust in many banks, often perceived as affiliated with influential parties and susceptible to potential bankruptcy. Additionally, government banks often fail to offer competitive interest rates or attractive facilities to incentivize deposits.

Dollars or Dinars?

Deposits in the Iraqi banking system can be made in US dollars or Iraqi dinars. According to economist Abdul Rahman Al-Sheikhli, deposits in Iraqi dinars are not directly affected by US sanctions and function without significant disruptions.

"When a citizen deposits funds in a bank for a current account or an interest-bearing account, the money remains within the internal banking channels of that specific bank," he said. "This means that withdrawals are also processed in the same currency."

However, Al-Sheikhli acknowledged potential delays in accessing deposited funds. "Previously, citizens could approach the CBI directly to withdraw dollars in case of delays by their banks. However, current regulations restrict dollar withdrawals from the Central Bank."

"There are potential consequences to these limitations, he added. "Banks could face penalties or even license revocation if they fail to fulfill their obligations to depositors."

Liquidity Concerns and Efforts to Restore Confidence

"The emergence of ISIS in 2014 significantly impacted Iraqi banks' liquidity. Many banks held letters of guarantee from companies that ultimately defaulted on their obligations," he said. "The resulting confiscation of these guaranteed amounts significantly strained the liquidity of some institutions. While larger banks with substantial reserves weathered the storm, smaller banks faced setbacks."

The Central Bank does hold a portion of banks' capital as reserves, which it can utilize for compensation in certain situations. Furthermore, a deposit guarantee company established by the CBI approximately four years ago aims to mitigate potential shortfalls experienced by banks. However, this mechanism is primarily designed to address scenarios like the bankruptcy of Basra International Bank, which is currently undergoing efforts to revive its operations.

Al-Sheikhli points to a recent development that could impact dollar-denominated transactions.

"For the first time, the CBI, rather than the US administration, restricted eight banks from accessing the dollar auction window. While one of these banks, Al-Huda Islamic Bank, was singled out by the US Treasury Department due to alleged ties with the Iranian Revolutionary Guards, the remaining seven banks were subjected to a temporary audit and oversight process by the CBI."

This move, along with the planned phasing out of the currency sale window and electronic platform throughout 2024, aims to reduce reliance on the US dollar and diversify the Iraqi currency basket. As Al-Sheikhli explained, private banks abroad have opened accounts with reputable foreign banks, enabling them to conduct a broader range of banking activities, excluding dollar transactions.

Central Bank Oversight and International Standards

The Central Bank of Iraq is responsible for overseeing banking operations in the country. This mandate is established by Law No. 56 of 2004 and reinforced by Law No. 39 of 2015 concerning Money Laundering and Financing of Terrorism, which came into effect in 2016.

Following these regulations, the CBI has implemented global compliance standards. Banks are now required to appoint dedicated directors tasked with monitoring all financial transactions to ensure adherence to international benchmarks.

Economist Abdul Rahman Al-Mashhadani emphasized the importance of this shift towards international compliance.

However, Al-Mashhadani acknowledged the challenges of achieving full compliance. Many Iraqi banks, particularly those without significant US counterparts, struggle to meet the required standards. Even for banks with US connections, convincing American authorities that their activities solely focus on trade financing and are not involved in illicit activities remains difficult.

A significant factor contributing to this difficulty is Iraq's heavy reliance on imports from Iran, estimated at $25-30 million daily. The lack of reciprocal trade with Iran necessitates these imports, yet Iraqi exports to Iran remain negligible. This creates a situation where Iraqi businesses involved in Iranian imports require access to financial resources, raising concerns from US authorities.

To address these concerns, the CBI recently instructed banks to enlist the services of reputable international auditing firms to review their operations and programs over the past three years. These independent audits, conducted by firms recommended by the US itself, aim to provide credible assessments of Iraqi banks' financial activities.

"A further step towards international legitimacy involves bank classification by internationally recognized rating agencies like S&P Global Ratings and Moody's. Reports generated by these institutions carry significant weight and can help build trust with US authorities."