Total rebuild: Reconstructing Iraq's banking system starts from scratch

Global Finance, Nov 2003 by Platt, Gordon

BANKING

Before Iraq's economy can even begin to recover from the war, its banking system must be rebuilt. * By Gordon Platt

The ruins in Baghdad of the Central Bank of Iraq, its marble-clad walls collapsed, are symbolic of the condition of the entire Iraqi banking sector. A majority of the country's banks were bombed, torched and looted during the war. Six months after the United States declared an end to major combat operations, only a few banks are open for business.

Late in 2002, even before war in Iraq was certain, high-level US treasury officials began drawing up plans for financial reconstruction. They knew that reopening the banks after the fall of Saddam Hussein's regime would be essential to get the country running again.

They were right. And the widespread devastation left economic planners with a clean slate on which to design a new banking and financial system. What has emerged is a radical proposal to transform a centrally planned economy based on Eastern European communism into a free-market model for the Arab world.

The occupation government of Iraq has decreed a sweeping liberalization that would privatize most staterun industries except oil and gas, roll out the red carpet for foreign investors and put much of the banking system in foreign hands. It is a plan that many analysts and economists say is bound to fail in a country that lacks basic institutions and laws vital to the functioning of a free-market economy.

"You can't take a Bundesbank and plunk it down in Baghdad and expect it to work," says Steve H. Hanke, professor of applied economics at Johns Hopkins University in Baltimore, Maryland, and a senior fellow at the Cato Institute, a Washington, DC-based public-policy research foundation. "All of this liberalization talk is just 'Washington-speak.' It's stuff grabbed out of the air," he says. "We don't know how the dust will settle. These are just decrees that could be overturned by an elected government."

Banks Must be Recapitalized

Without a functioning money market, it will be impossible for the central bank to operate using monetary-policy instruments such as repurchase agreements, Hanke says. The central bank and all of the commercial banks are insolvent, since their balance sheets are dominated by claims on the now-defunct Hussein government. Hanke says the banking sector will have to be recapitalized and restructured to operate in a market economy.

The existing banking system centers on two large state-owned banks, Al Rasheed and Rafidain, as well as the central bank, which Saddam treated as his personal bank account. The former Iraqi leader sent his younger son Qusai to take nearly $1 billion from the central bank in the middle of the night shortly before the US began bombing Baghdad.

"Simply restoring the economy to what it was before Saddam will be a tremendous improvement in the well-being of the Iraqi people," according to John B. Taylor, US undersecretary of the treasury for international affairs. In 1979 Iraq's gross domestic product was $128 billion, but by 2001 it had declined to $40 billion. "Strengthening and modernizing the banking sector is central to achieving overall economic progress in Iraq," Taylor told a US Senate committee following the fall of the Hussein regime.

Under Saddam, Iraqi banks were oriented much more toward the fulfillment of Baath Party political objectives than toward financial intermediation, Taylor said. Banks under the former regime were not permitted to make loans based on commercial viability and a borrower's ability to repay. The country, therefore, lacks a commercial banking culture and technical skills.

The US-led Coalition Provisional Authority issued a Request for Information in August to get ideas about how to restructure Rasheed and Rafidain banks to operate successfully in a market economy. According to the CPA, these two banks are likely to play key roles in Iraq's economic reconstruction due to their longstanding presence in Iraq, their substantial shares of assets and deposits and their extensive customer base and branch networks.

Meanwhile, the CPA named a 13-bank consortium led by JPMorgan Chase to operate the newly created Trade Bank of Iraq, which will support Iraqi imports of equipment and commodities funded through the Development Fund for Iraq. The CPA-administered fund receives most of the proceeds from Iraqi oil exports. JPMorgan Chase was selected over five competitors, including groups led by Bank of America, Bank One, Citigroup and Wachovia, as well as UK-based HSBC, which applied as a single bank.

The trade bank is scheduled to operate for 12 months, with the option to remain open for an additional two years, after which the job of issuing and confirming letters of credit will be turned over to local banks. Members of the consortium are being urged to transfer trade-finance and other international banking skills to Iraqi institutions.

US Banks May Hold Back

The national origins of the members of the trade-bank consortium closely mirror that of the coalition. However, this does not necessarily mean that American and other Western banks will dominate the Iraqi banking system in the future, says Richard Stewart, counsel in the London office of lawyers Bryan Cave. The US-based firm maintains offices in Kuwait, Riyadh, Dubai and Abu Dhabi.