## Rates of Profit on Bank Assets and Liabilities for 2011–12

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### I. Introduction and system overview
- Iran’s financial system: the largest Islamic financial system in the world.
- Recent transformations:
  - Significant deepening of bank intermediation in the past decade, spurred by licensing of private banks.
  - Private bank assets became the largest in the system following privatization of large public commercial banks in 2008-09.
  - Iran’s equity markets became viable channels of finance; mutual funds gained prominence since 2009.
  - The seven largest private banks are listed on the stock exchange and are among the most actively traded stocks.
- Public perception and policy effects:
  - Banks viewed as blue chip companies paying reliable dividends and benefiting from implicit government backing.
  - Government interventions (credit allocation, low lending rates on selected facilities) have contributed to relative weakening of bank soundness.

### II. Role of finance in Iran’s economic development strategy
- Financial sector objectives:
  - Support economic growth and job creation with low inflation under the 1983 Law on Usury (Interest) Free Banking.
  - Mobilize private capital via capital markets (TSE; OTC network; commodities exchange) and privatization in line with Principle 44.
  - 5th Five-Year Development Plan (2010–15) contains a chapter on strengthening and liberalizing the financial system.
- Depth and market structure indicators:
  - Banking system’s credit to GDP ratio: the second highest among seven comparator emerging market countries (Brazil, China, Egypt, India, Russia, Saudi Arabia, and Turkey).
  - Density of companies listed on local stock exchanges: the highest among comparators.
- Recent intermediation patterns:
  - Between 2001 and 2010, depth increased by 50 percentage points for credit/GDP and by 60 percentage points for credit/non-oil GDP.
  - Growth concentrated between 2001 and 2005 when private banks were re-licensed.
  - Intermediation spreads narrowed in 2006-10; narrower spreads in 2006-10 led to a pause in banking sector expansion.

### III. 5th Five-Year Development Plan (2010–15): Main financial system reforms (selected Articles)
- Article highlights (selected):
  - Article 82: MCC permits banks to borrow abroad to finance private sector and municipalities; such borrowing has no sovereign guarantee; MCC sets ceilings on foreign liabilities ratio.
  - Article 83: State-owned companies and municipalities can issue sukuk in foreign capital markets with prior approval of CBI and Ministry of Finance; no sovereign guarantee.
  - Article 86: CBI to ensure banks segregate charitable deposits (GAH) and use GAH for charity loans after deductions.
  - Article 87: Allows foreign investment in Iranian banks subject to CBI review; separate CBI regulations set share of foreign participation.
  - Article 90: Creates borrower identification system based on government civil registration; CBI mandated to operate a positive credit bureau.
  - Article 91: Banks required to develop internal credit rating systems per CBI instructions.
  - Article 92: MCC sets remuneration of term deposits to yield no less than the average of the previous year’s inflation and the CBI forecast for the current year.
  - Article 93: Public banks may retain after-tax profits into tier 1 capital upon government approval.
  - Article 94: Government-affiliated entities may keep deposits in banks instead of the central bank; conditions set for selecting banks.
  - Article 95: Establishes a deposit guarantee scheme funded by premia levied on credit institutions operating as banks.
  - Article 96: (i) CBI power to disqualify directors and senior officers; (ii) government appointees to public bank boards require CBI approval; (iii) CBI to inflation-adjust statutory fines every three years; (iv) CBI to regulate all nonbank credit institutions.
  - Article 97: Creates restricted investment accounts; MCC to align Iranian accounting standards with interest-free banking principles.
  - Article 98: Creates new sukuk structures: istitna; morabeheh; tanzeel (discounting of debts that finance real assets).
  - Article 99: All capital market securities must be registered with the Securities and Exchange Organization (SEO); trades outside SEO-regulated markets are null and void unless SEO approval; post-trade activities must be on SEO central depository; directors and senior officers of issuers must register with SEO and have transparent audit trail for trades.

### IV. Credit allocation, growth, and policy effects
- MCC 2010-11 sectoral credit allocation recommendation for deposit increases:
  - Banks allocate 80 percent of their increase in deposits to priority sectors:
    - 37 percent to manufacturing and mining
    - 25 percent to agriculture
    - 20 percent to construction and housing
    - 10 percent to trade
    - 8 percent to export
  - Remaining 20 percent of deposit increase could be used freely, subject to sub-limits on consumer durables or home improvement.
- Recent credit growth and policy-driven lending:
  - Rates on selected facilities became negative in real terms after 2007.
  - Credit growth accelerated from 16 percent in 2009 to 51 percent year-on-year by March 2011, mainly from the housing bank.
  - Private banks resumed credit expansion since the launch of subsidy reform in December 2010.
  - Government initiative: Maskan–mehr housing program aiming to increase usable dwellings by 15 percent between 2010 and 2014.
- Risks to soundness:
  - Controls on rates of return undermine bank profitability and capital.
  - Recent high credit growth could lead to new loan losses, pressuring profits and capital adequacy.
  - Regulatory forbearance could impact listed bank stocks and cause spillovers to listed firms in other market sectors.

### V. The role of Islamic finance in Iran’s system
- System characteristics:
  - Iran is the world’s largest market for Islamic finance; all banking activities must follow Shari’a principles under the 1983 law on usury (interest) free banking.
  - TSE planning for sukuk listings; sukuk market historically underdeveloped relative to Malaysia and GCC countries.
- Sukuk issuance developments:
  - Participation bonds (sukuk musharekat) existed since 1994 but were redeemable on demand and at face value, limiting secondary trading.
  - Issuance: less than 1 percent of GDP per year until 2009-10; increased to 4 percent of GDP in 2010-2011.
  - From April 2011, Islamic bonds to take the form of asset-based sukuk that are not redeemable and must be listed on the TSE.
- Deposit types under Iranian law:
  - Demand deposits: interest-free “loans” to the bank (0 percent rate for demand accounts).
  - Saving accounts: receive cash or in-kind prizes through random drawing (bank required to distribute 2.5 percent of GAH deposits per year via random drawing).
  - Term deposits / investment accounts: depositors share in general profits; provisional remuneration set by MCC and finalized after profits certified by external auditors (in 2011, one-year deposits yield a provisional 12.5 percent and five-year deposits 15 percent).
  - Special-purpose investment accounts (since 2011): investor restricts use of funds to designated projects in which bank is also equity partner.
  - Participation papers (bank CDs or participation bonds): function like term deposits but pay a maximum of one percentage point more than equivalent term deposits.
- Islamic credit contract forms:
  - Participatory facilities: banks share in profits and potentially in losses (e.g., mosharekat, mozarebeh).
  - Nonparticipatory facilities: similar to leasing or installment sales; bank remuneration is rental rate or mark-up.
  - Housing facilities: structured as multi-year installment sales.
  - Very short-term working capital: structured like commodity-backed swaps with repayment at higher future price; overdraft or credit card lending prohibited.
- MCC rate-setting for 2011:
  - Nonparticipatory facilities ceilings: 11–14 percent (depending on term).
  - Participatory facilities floor: 12 percent; ceilings introduced in 2011 of 14–17 percent depending on term, or a maximum 300bp above nonparticipatory facilities of equivalent tenors.
  - Provisional ceilings on rates of profits on bank liabilities; final rates on bank assets finalized a year later.

### VI. Rates of Profit on Bank Assets and Liabilities for 2011–12 (selected caps and items)
- Liabilities (resources):
  - CBI overdraft: 34 percent (ceiling).
  - Required reserves at CBI (in percent of deposit base): 16 percent average for banks; 10 percent for microfinance.
  - Demand accounts: 0 percent.
  - Saving accounts: cash or in-kind prizes through random drawing.
  - Term deposits: 6 to 15 percent as a function of maturity (6 months to 5 years).
  - Participation paper: +100bp over term deposits (ceiling).
- Assets (facilities):
  - Nonparticipatory (depending on term): 11–14 percent (ceiling).
  - Maskan-mehr construction facility: 11 percent (ceiling).
  - Maskan-mehr purchase facility: 12 percent (ceiling).
  - Participatory (e.g., mosharekat, mozarebeh): 14–17 percent (ceiling).

### VII. Surveillance, accounting, and provisioning issues for Islamic banking
- CBI surveillance:
  - Islamic banking does not pose particular issues to CBI surveillance, but Iran’s 100 percent Islamic banking structure complicates international comparisons and mapping to conventional banking standards.
- Interpretative issues:
  - Participatory contracts sharing losses among borrower, bank, and depositors have not been widely tested because high inflation eases borrowers’ debt burdens.
  - Provisioning for impaired assets:
    - Provisions are calculated using interest rates in conventional banking.
    - Islamic banks sometimes report lower provisions because facilities are backed by real assets, but market values of collateral can be hard to observe.
  - Accounting rules for equity-like exposures:
    - Under participatory facilities, losses are shared with depositors and assessed ex-post; only the installment in arrears is classified.
    - Conventional banking classifies 100 percent of a troubled loan and provisions expected losses upfront for the bank alone.
    - The 2007 regulation on classification and provisioning requires banks to classify 100 percent of an impaired facility (not just installments in arrears) if borrower financials and sector show diminished ability to pay.

### Loan classification and provisioning policy (regulatory classes and rates)
- Class 1 — Current: < 2 months — 1.5 percent (general reserve).
- Class 2 — Overdue: 2-6 months — 10 percent (specific reserves).
- Class 3 — Arrears: 6-18 months overdue — 20 percent (specific reserves).
- Class 4 — Doubtful: > 18 months overdue — 50 to 100 percent (specific reserves).
- Instalments in classes 2-4 require provisioning. The rest of the facility stays current unless the borrower‘s financials or sector show diminished ability to pay.
- Benchmark regulatory practices tend to require higher provision rates and prompter classification than in the case of Iran.

### Equity finance, capital markets, and market integrity
- Equity market developments:
  - Market capitalization doubled in dollar terms between 2006 and 2010.
  - Two trading venues: Stock TSE and an OTC exchange; together list some 500 companies.
  - 5th FYDP requires companies issued by public placements to be listed on the OTC exchange; another 1,500 companies expected to be listed by 2012.
- Iran Mercantile Exchange (IME):
  - Actively trades spot contracts of agricultural commodities, metals, gold and petrochemicals.
  - Plans to launch a crude oil contract and futures.
  - Nonresidents can trade contracts in the offshore center of Kish Island.
  - Government plans to use IME prices as benchmarks to adjust domestic prices after subsidy reform.
- Market integrity and disclosure:
  - Companies file quarterly statements within 30 days; mid-year and end-year statements must be audited.
  - Annual audited financials posted within 60 days of year-end; material developments must be immediately disclosed.
  - SEO requires registration and audit trail for insiders; SEO supervises audit profession and retains its own auditors.
  - Dedicated court with judges specialized in capital market issues exists.
- Mutual funds and retail participation:
  - Some 50 mutual funds marketed; open-ended mutual funds did not exist before 2009.
  - Direct retail accounts on the TSE: 4 million (2 million active).
  - Retail investors represent half of market turnover but hold 21 percent of market capitalization.
  - Remaining market capitalization composition:
    - closed-end investment companies: 25 percent
    - pension funds: 17 percent
    - government-affiliated investment companies: 16 percent
    - banks: 5 percent
    - “justice shares”: 16 percent
- Justice shares and privatization:
  - IPO distribution rule: 40 percent to justice shares, 40 percent to institutional investors, 20 percent free float to retail investors.
  - 40 million Iranians own justice shares; justice shares cannot be sold for ten years unless holders buy them from the government.

### Banking sector structure, balance sheet trends, and nonbank financial institutions
- Banking sector composition (26 institutions):
  - four public commercial banks;
  - four public specialized banks (agriculture, housing, export, mining, and industry);
  - sixteen relatively small private banks;
  - four large recently privatized public banks.
- Privatizations and market share:
  - Privatizations in 2008–09 boosted private banks’ market share from 13 percent in 2007 to 56 percent in 2011.
  - CBI issued eight new licenses between April 2010 and April 2011 and consolidated several hundred credit unions.
- Nonbank credit institutions (Box 3 highlights):
  - Some 7,000 registered nonbank credit institutions, 5,000 active (3,500 microfinance entities; 1,500 credit unions), total assets in 2010 of $60 billion (>15 percent of GDP).
  - Microfinance charities: six entities account for 90 percent of the sector’s assets of $40 billion; allowed to charge a 4 percent commission on lending.
  - Credit unions: six entities account for 90 percent of the sector’s assets of $20 billion; weak supervision led to failures affecting one million depositors in 2010.
  - 2007 law: deposits subject to CBI reserve requirement; lending restricted to interest-free loans.
  - CBI actions under 5th FYDP: closed 50 credit unions, merged remainder into six new entities; consolidation expected to result in 12 new banks and the Cooperative Bank of Iran.
  - Other nonbank institutions: 2 investment banks, 110 brokerages, 48 investment companies (SEO-regulated); 100 active leasing companies (CBI-regulated); 1,000-1,500 money transfer operations.

### Savings behavior and deposit composition
- Negative real deposit rates since 2007 have encouraged saving in real estate, stocks, gold, and foreign exchange.
- Deposit composition shifts:
  - Share of interest-free deposits dropped from 40 percent a decade ago to 20 percent currently.
  - Share of interest-free deposits in private banks stable at around 4 percent.
- Private banks rely on term deposits to fund term banking facilities.

### Aggregate capital adequacy, NPLs, and vulnerabilities
- Aggregate capital adequacy:
  - Aggregate capital adequacy ratio in March 2011: 7.5 percent of risk-weighted assets.
  - RWA methodology: Basel I weights; ratio of RWA/total assets in March 2011 ranged between 54 percent (specialized banks) and 63 percent (private banks).
  - Cross-country guidance: evidence suggests Iranian banks should target a capital ratio "well above 15 percent" given economy’s volatility; recent credit growth suggests a target on the order of at least 13 percent.
- Nonperforming loans and provision coverage:
  - Aggregate NPL ratio: 23 percent of the loan portfolio in early 2010; fell to 16 percent by February 2011.
  - Provision cover: 12 percent of NPLs in early 2010; rose to 32 percent by February 2011.
  - Comparator: Egypt’s NPL ratio comparable but impaired loans are fully covered by provisions.
  - Under-provisioning implies reported profits and capital may be overstated; shortfalls should be deducted from capital.
- Heterogeneity and private banks (Box 4 summary):
  - Reported capital adequacy ratio for private banks: 11 percent.
  - Private banks’ NPL ratio (February 2011): 23 percent.
  - Private banks’ provision cover (February 2011): 18 percent.
  - Under mild assumptions (assuming a provision cover of 50% of NPLs), private banks’ capital adjusted for under-provisioning would be 6 percent of RWA instead of the reported 11 percent.
  - Over April 2008 to March 2011, private banks’ capital adjusted for under-provisioning was on average 6.5 percentage points below their reported average capital of 9.1 percent.
  - Adjusted capital for private banks was negative between September 2009 and February 2010.
  - Sectoral composition: private banks’ NPLs concentrated in services, housing, and industry & mining; housing example — average private bank reported NPLs of 24 percent of outstanding credits versus 6 percent for the average bank.
  - NPLs on facilities extended to nongovernment public entities: 22 percent of such facilities, but their share in total lending is marginal.

### Policy actions and financial stability framework recommendations
- Strengthen capital, provisioning, and liquidity:
  - Raise minimum capital adequacy given Iran’s intrinsic volatility.
  - Implement a Basel-3-type capital conservation buffer above the minimum.
  - Increase provision cover.
  - Strengthen bank earnings by allowing banks to set rates of return on assets and liabilities freely and by reducing operating costs.
- NPL resolution and restructuring:
  - Conduct an accurate mapping of NPLs.
  - Establish an asset management company (AMC) to help banks focus on normal banking and coordinate financial restructuring.
  - Remove controls on credit allocation and rates of return to ensure proper incentives for considered risk-taking by banks.
- Early warning, monitoring, and contingency frameworks:
  - Centralized, real-time positive credit database launched in 2011 as a first step toward a comprehensive early warning system.
  - Early warning system should monitor riskier exposures, concentration of risks, dependence on large depositors, connectedness through interbank exposures, inter-enterprise arrears, restructured credits, corporate leverage, foreign borrowing of the private sector, and household indebtedness.
  - Design the planned deposit guarantee as part of a crisis management framework that includes:
    - A special insolvency regime ensuring swift CBI intervention in troubled banks.
    - A clear lender of last resort policy.
    - Minimum liquidity buffers to withstand protracted funding stress without central bank support.
- Supervisory powers and disclosure improvements:
  - 5th FYDP extends CBI’s regulatory reach and supervisory powers, including authority to disqualify directors and senior officers and to apply fit and proper tests to public bank officers.
  - FYDP authorizes government to allow public banks to retain after-tax profits into capital instead of accruing to the budget.
  - CBI revamping regulatory framework: increasing fines for noncompliance, introducing regulation on related party lending and large exposures, and mandatory disclosure of core financial soundness indicators.
  - CBI’s prompt enforcement powers (“cease-and-desist”) remain limited because violations are referred to a Bank Disciplinary Committee comprised of non-CBI members.
  - Improved disclosure: half of the banking system now discloses financial information to the Securities and Exchange Organization on a quarterly basis.
- International lessons on AMCs and restructuring:
  - AMCs suited to financial restructuring; operational restructuring often requires arm’s-length new investors.
  - Effective insolvency regime and fresh equity are critical.
  - Cutting connectedness between banks and large borrowers and enforcing supervisory discipline (classification, provisioning, exposure limits, capital adequacy) are essential to create incentives for upfront mark-downs.

*Italic: IMF staff report content unit — Rates of Profit on Bank Assets and Liabilities for 2011–12*

### 1.     Rates of Profit on Bank Assets and Liabilities for 2011–12 ....................................................7

### Rates of Profit on Bank Assets and Liabilities for 2011–12

### I. Introduction and system overview
- Iran’s financial system is described as the largest Islamic financial system in the world.
- Major recent transformations:
  - Significant deepening of bank intermediation in the past decade, spurred by licensing of private banks.
  - Private bank assets became the largest in the system following privatization of large public commercial banks in 2008-09.
  - Iran’s equity markets have become viable channels of finance; mutual funds gained prominence since 2009.
  - The seven largest private banks are listed on the stock exchange and are among the most actively traded stocks.
- Public perception supporting banking stocks: banks are viewed as blue chip companies that pay reliable dividends and benefit from implicit government backing.
- Government interventions to support the economy (credit allocation, low lending rates on selected facilities) have contributed to relative weakening of bank soundness.

### II. Role of finance in Iran’s economic development strategy
- Financial sector objectives:
  - Support economic growth and job creation with low inflation under the 1983 Law on Usury (Interest) Free Banking.
  - Mobilize private capital via capital markets (TSE; OTC network; commodities exchange) and privatization in line with Principle 44.
  - 5th Five-Year Development Plan (2010–15) contains a chapter on strengthening and liberalizing the financial system.
- Indicators of depth and market structure:
  - The banking system’s credit to GDP ratio is the second highest among seven comparator emerging market countries considered in the study (comparator countries: Brazil, China, Egypt, India, Russia, Saudi Arabia, and Turkey).
  - Iran’s density of companies listed on local stock exchanges is the highest among comparators.
- Recent patterns in bank intermediation:
  - Between 2001 and 2010, depth increased by 50 percentage points for the ratio of credit to GDP and by 60 percentage points for the credit to non-oil GDP ratio.
  - Growth occurred largely between 2001 and 2005 when private banks were licensed for the first time since 1979.
  - Intermediation spreads narrowed in the second half of the decade; narrower spreads in 2006-10 led to a pause in banking sector expansion.

### III. 5th Five-Year Development Plan (2010–15): Main financial system reforms (Box 1)
- Selected Articles and reforms:
  - Article 82: MCC permits banks to borrow abroad to finance private sector and municipalities; such borrowing has no sovereign guarantee; MCC sets ceilings on foreign liabilities ratio.
  - Article 83: State-owned companies and municipalities can issue sukuk in foreign capital markets with prior approval of CBI and Ministry of Finance; no sovereign guarantee.
  - Article 86: CBI to ensure banks segregate charitable deposits (GAH) and use GAH for charity loans after deductions.
  - Article 87: Allows foreign investment in Iranian banks subject to CBI review; separate CBI regulations set share of foreign participation.
  - Article 90: Creates borrower identification system based on government civil registration; CBI mandated to operate a positive credit bureau.
  - Article 91: Banks required to develop internal credit rating systems per CBI instructions.
  - Article 92: MCC sets remuneration of term deposits to yield no less than the average of the previous year’s inflation and the CBI forecast for the current year.
  - Article 93: Public banks may retain after-tax profits into tier 1 capital upon government approval (previously had to remit to budget).
  - Article 94: Government-affiliated entities may keep deposits in banks instead of the central bank; conditions set for selecting banks.
  - Article 95: Establishes a deposit guarantee scheme funded by premia levied on credit institutions operating as banks.
  - Article 96: (i) CBI power to disqualify directors and senior officers; (ii) government appointees to public bank boards require CBI approval; (iii) CBI to inflation-adjust statutory fines every three years; (iv) CBI to regulate all nonbank credit institutions.
  - Article 97: Creates restricted investment accounts; MCC to align Iranian accounting standards with interest-free banking principles.
  - Article 98: Creates new sukuk structures: istitna; morabeheh; tanzeel (discounting of debts that finance real assets).
  - Article 99: All capital market securities must be registered with the Securities and Exchange Organization (SEO); trades outside SEO-regulated markets are null and void unless SEO approval; post-trade activities must be on SEO central depository; directors and senior officers of issuers must register with SEO and have transparent audit trail for trades.

### IV. Credit allocation, growth, and policy effects
- MCC sectoral credit allocation recommendation for 2010-11:
  - Banks allocate 80 percent of their increase in deposits to priority sectors:
    - 37 percent to manufacturing and mining
    - 25 percent to agriculture
    - 20 percent to construction and housing
    - 10 percent to trade
    - 8 percent to export
  - Remaining 20 percent of deposit increase could be used freely, subject to sub-limits on consumer durables or home improvement.
- Recent credit growth and policy-driven lending:
  - Rates on selected facilities became negative in real terms after 2007.
  - Strong credit expansion in the past 18 months (relative to March 2011): credit growth accelerated from 16 percent in 2009 to 51 percent year-on-year by March 2011, mainly from the housing bank.
  - Private banks resumed credit expansion since the launch of subsidy reform in December 2010.
  - Government initiatives include the Maskan–mehr housing program aiming to increase usable dwellings by 15 percent between 2010 and 2014.
- Risks and soundness:
  - Controls on rates of return undermine bank profitability and capital.
  - Recent high credit growth could lead to new loan losses, pressuring profits and capital adequacy.
  - Regulatory forbearance could impact listed bank stocks and cause spillovers to listed firms in other market sectors.

### V. The role of Islamic finance in Iran’s system
- Iran’s Islamic banking context:
  - Iran is the world’s largest market for Islamic finance.
  - All banking activities must follow Shari’a principles; Islamic banking is regulated by law (1983 law on usury (interest) free banking).
  - TSE is developing plans for listing sukuk; sukuk market had been underdeveloped relative to Malaysia and GCC countries.
- Sukuk issuance and market developments:
  - Participation bonds (sukuk musharekat) existed since 1994 but were redeemable on demand and at face value and thus not suitable for secondary trading.
  - Issuance was small (less than 1 percent of GDP per year) until 2009-10; in 2010-2011 issuance increased to 4 percent of GDP.
  - From April 2011 onward, Islamic bonds will also take the form of asset-based sukuk that are not redeemable and must be listed on the TSE.
- Deposit types under Iran’s legal framework (four types):
  - Demand deposits: interest-free “loans” to the bank (0 percent rate for demand accounts).
  - Saving accounts: receive cash or in-kind prizes through random drawing (bank required to distribute 2.5 percent of GAH deposits per year via random drawing).
  - Term deposits / investment accounts: depositors share in general profits; provisional remuneration set by MCC and finalized after profits certified by external auditors (in 2011, one-year deposits yield a provisional 12.5 percent and five-year deposits 15 percent).
  - Special-purpose investment accounts (since 2011): investor restricts use of funds to designated projects in which bank is also equity partner (generally used by specialized banks).
  - Participation papers (bank CDs or participation bonds) function like term deposits but pay a maximum of one percentage point more than equivalent term deposits.
- Islamic credit contract forms:
  - Participatory facilities: banks share in profits and potentially in losses (e.g., mosharekat, mozarebeh).
  - Nonparticipatory facilities: similar to leasing or installment sales; bank remuneration is rental rate or mark-up.
  - Housing facilities are structured as multi-year installment sales.
  - Very short-term working capital: structured like commodity-backed swaps with repayment at higher future price; overdraft or credit card lending prohibited.
- MCC rate-setting for 2011:
  - For nonparticipatory facilities, MCC specified ceilings of 11–14 percent in 2011 (depending on term).
  - Participatory facilities subject to a floor of 12 percent; in 2011 MCC introduced ceilings on participatory facilities ranging from 14–17 percent depending on term, or a maximum 300bp above nonparticipatory facilities of equivalent tenors.
  - Provisional ceilings on rates of profits on bank liabilities; final rates on bank assets finalized a year later.

### VI. Rates of Profit on Bank Assets and Liabilities for 2011–12 (selected items and caps)
- Resources (liabilities):
  - CBI overdraft: 34 percent (ceiling).
  - Required reserves at CBI (in percent of deposit base): 16 percent average for banks; 10 percent for microfinance.
  - Demand accounts: 0 percent.
  - Saving accounts: cash or in-kind prizes through random drawing.
  - Term deposits: 6 to 15 percent as a function of maturity (6 months to 5 years).
  - Participation paper: +100bp over term deposits (ceiling).
- Facilities (assets):
  - Nonparticipatory (depending on term): 11–14 percent (ceiling).
  - Maskan-mehr construction facility: 11 percent (ceiling).
  - Maskan-mehr purchase facility: 12 percent (ceiling).
  - Participatory (e.g., mosharekat, mozarebeh): 14–17 percent (ceiling).

### VII. Surveillance, accounting, and provisioning issues for Islamic banking
- CBI surveillance and international-standard mapping:
  - Islamic banking does not pose particular issues to CBI surveillance, but Iran’s 100 percent Islamic banking structure complicates international comparisons and mapping of conventional banking standards.
- Specific interpretative issues:
  - Participatory contracts requiring sharing losses among borrower, bank, and depositors have not been tested on a large scale because high inflation eases borrowers’ debt burdens.
  - Provisioning for impaired assets:
    - Provisions are calculated using interest rates in conventional banking.
    - Islamic banks sometimes report lower provisions because facilities are backed by real assets, but market values of collateral can be hard to observe.
  - Accounting rules for equity-like exposures:
    - Under participatory facilities, losses are shared with depositors and assessed ex-post; only the installment in arrears is classified.
    - In conventional banking, troubled loans are 100 percent classified and expected losses are provisioned upfront for the bank alone.
    - The 2007 regulation on classification and provisioning requires banks to classify 100 percent of an impaired facility (not just installments in arrears) if borrower financials and sector show diminished ability to pay.

*Italic: IMF staff report content unit — Rates of Profit on Bank Assets and Liabilities for 2011–12*

### 1. Current  < 2 months 1.5 percent (general reserve)

### 1. Current  < 2 months 1.5 percent (general reserve)

### Loan classification and provisioning policy
- Class 1 — Current: < 2 months — 1.5 percent (general reserve).
- Class 2 — Overdue: 2-6 months — 10 percent (specific reserves).
- Class 3 — Arrears: 6-18 months overdue — 20 percent (specific reserves).
- Class 4 — Doubtful: > 18 months overdue — 50 to 100 percent (specific reserves).
- Instalments in classes 2-4 require provisioning. The rest of the facility stays current unless the borrower‘s financials or sector of operation show diminished ability to pay.
- Benchmark regulatory practices tend to require higher provision rates and prompter classification than in the case of Iran, as well as on total exposure.

### Equity finance and capital markets: overview
- Banking remains the backbone of the financial system, but Iran’s equity markets have become viable, though still small, channels of finance for the real economy.
- Market capitalization doubled in dollar terms between 2006 and 2010, driven by more listings, significant IPOs under the government’s privatization plans, and sharp price increases in 2009-10.
- Two venues for listing and trading shares: the Stock TSE, and an OTC exchange for small and medium-sized enterprises; together they list some 500 companies.
- The TSE hosts a main board for more liquid and stronger companies, and a secondary board for less liquid shares. The OTC exchange lists companies with less of a track record.
- The 5th FYDP provides that companies which have issued shares under public placements must be listed on the OTC exchange, regardless of their performance; as a result, another 1,500 companies will be listed by 2012 and therefore comply with minimum requirements of transparency and governance.

### Iran Mercantile Exchange (IME)
- The IME actively trades spot contracts of agricultural commodities, metals, gold and petrochemicals.
- IME plans to launch a crude oil contract, as well as futures.
- Nonresidents can trade contracts in the offshore center of Kish Island in the Persian Gulf.
- Government plans to use IME prices as benchmarks to adjust domestic prices when the subsidy reform is completed.
- IME prices are considered more suitable for domestic pricing because the specifications of the underlying commodities match the Iranian market more closely than international prices, thus avoiding basis risk.

### Market integrity, disclosure, and enforcement
- Capital market regulator has developed a comprehensive approach to market integrity emphasizing transparency and enforcement.
- Companies file and disclose quarterly statements within 30 days of quarter end; mid-year and end-year statements must be audited.
- Companies must post annual audited financials within 60 days of year-end and provide quarterly earnings guidance.
- Material developments of a financial or corporate control nature must be immediately disclosed to the market.
- The Securities and Exchange Organization (SEO) requires all company insiders (directors and senior officers) to be registered and their trades individually traceable (audit trail) on its central depository system, which handles all post-trade requirements.
- The SEO supervises the audit profession and retains its own auditors to verify that financial statements fairly represent management’s current knowledge.
- Iran has a dedicated court with judges specialized in capital market issues to prosecute market abuse and manipulation.

### Mutual funds, retail participation, and ownership structure
- Mutual funds were recently licensed; open-ended mutual funds did not exist before 2009. Some 50 funds are currently marketed by asset managers, brokerages, or investment banks.
- Direct retail accounts on the TSE number 4 million, of which 2 million are active.
- Retail investors represent half of market turnover but hold 21 percent of market capitalization.
- Remaining market capitalization locked up in:
  - closed-end investment companies: 25 percent
  - pension funds: 17 percent
  - government-affiliated investment companies: 16 percent
  - banks: 5 percent
  - “justice shares”: 16 percent

### Justice shares and privatization distribution rules
- Government distribution under privatization: IPOs of state companies must allocate 40 percent of the offering to the justice shares scheme, 40 percent to institutional investors, and 20 percent as free float to retail investors.
- Justice shares scheme: 40 million Iranians own justice shares in state-controlled investment vehicles (one per province) that hold and service a uniform portfolio of underlying company stocks.
- Justice shares cannot be sold for ten years, unless holders buy them from the government.
- Developing a shareholding culture depends partly on the investment vehicles paying dividends on justice shares; as a result, some companies may not retain sufficient earnings to contain leverage.

### Recent equity price surge assessment (Box 2 summary)
- By April 2011, the Tehran Stock Exchange (TSE) all-share index (TEPIX) had increased 200 percent from its April 2009 low.
- The TEPIX growth was broad-based across sectors and coincided with numerous IPOs.
- Iran’s mass privatization program allows for 80 percent of state assets to be sold: 40 percent via distribution to low-income households; 40 percent via IPOs.
- Cross-country context: China, Egypt, and Saudi Arabia have had price surges up to twice as large as Iran during this period.
- TSE post-Lehman trough-to-peak and one-year gains/losses: the TSE surge between early 2009 and April 2011 was the largest in any 2-year window over its past ten years, but historical corrections have been smaller (27 percent) than comparator countries (China’s 70 percent).
- In real terms (CPI-adjusted), real stock prices in April 2011 were still 30 percent below their 2004 peak.
- Real prices were up to 18 percent above trend in the recent past, below threshold values of 40-50 percent that help predict financial crises at one- to two-year horizons.
- Valuations: TSE price/earnings (P/E) ratios between 2007 and 2010 ranged between 25 and 44 percent of the median of other markets.
- Sectoral effects: sanctions may have boosted earnings of diversified industrials and motor vehicles and parts through import substitution; basic metals, mining, and petrochemicals benefited from global commodity price surges. Under-pricing of large government IPOs (Iran Telecom, banks) also supported prices.

### Banks listed on the TSE and investor perceptions
- The seven largest private banks are listed on the TSE and are among the most actively traded stocks.
- At end-2010, the TSE sub-sector “Monetary Intermediation” had the largest capitalization among the TSE’s 39 sectors (18 percent of the market), with four banks in the top ten listings by market cap.
- The monetary intermediation sector accounts for more than half of total market turnover due to higher free float.
- Central Bank of Iran (CBI) regulations encourage wide holding of bank shares: a 2007 regulation prohibits an individual from holding more than 5 percent of a private bank’s equity and 10 percent for a legal entity, assessed on an ultimate beneficiary basis. These limits do not apply to foreign investors (CBI has discretion).
- Public perception: banks are seen as blue-chip companies that pay reliable dividends and are assumed to have implicit government support; no bank has ever failed and government has a record of supporting banks in trouble.
- CBI intends to standardize bank public reporting by introducing minimum requirements to disclose core financial soundness indicators and qualitative information on bank governance (not yet included in SEO disclosure requirements).

### Banking sector structure and nonbank financial institutions
- Banking sector composition: 26 institutions in four segments:
  - (i) four public commercial banks;
  - (ii) four public specialized banks (agriculture, housing, export, mining, and industry);
  - (iii) sixteen relatively small private banks;
  - (iv) four large recently privatized public banks.
- Private banks were allowed since 2000; six licenses initially and ten more since then.
- Several hundred credit unions and microfinance institutions exist; credit union sector undergoing intense restructuring following abuses.

Box 3 highlights nonbank credit institutions:
- Iran has some 7,000 registered nonbank credit institutions, of which 5,000 are active (3,500 microfinance entities; 1,500 credit unions), with total assets in 2010 of $60 billion (>15 percent of GDP).
- Microfinance charities: six entities account for 90 percent of the sector’s assets of $40 billion; allowed to charge a 4 percent commission on lending; 4 percent often insufficient to cover operating costs during higher inflation, leading to risk-taking and losses; 2003 run on a microfinance charity in Isfahan revealed systemic risks.
- 2007 “law on the regulation of nonbank money markets”: deposits became subject to CBI reserve requirement; lending restricted to interest-free loans.
- Credit unions: six entities account for 90 percent of the sector’s total assets of $20 billion; weak supervision led some to engage in regular banking and promise deposit remuneration above CBI-regulated rates; in 2010, one million depositors were affected by the bankruptcy of two medium-sized credit unions; the run stopped when the CBI provided a credit line to a bank that absorbed the failed institutions.
- New CBI remit under the 5th FYDP of 2010 (article 96): CBI solely responsible for licensing and supervising nonbank credit institutions. Since then, 900 credit unions have applied for a CBI bank license; CBI closed 50 credit unions and merged the remainder into six new entities. Consolidation expected to result in 12 new banks and the Cooperative Bank of Iran.
- Other nonbank financial institutions include:
  - 2 investment banks, 110 brokerages, and 48 investment companies regulated by the Security and Exchange Organization
  - 100 active leasing companies regulated by the CBI
  - 1,000-1,500 money transfer operations

### Banking sector trends, balance sheet structure, and credit allocation
- Private bank assets became the largest in the system following privatizations in 2008–09. The four privatizations boosted private banks’ market share from 13 percent in 2007 to 56 percent in 2011.
- CBI issued eight new licenses between April 2010 and April 2011 and brought several hundred credit unions under supervision.
- Some original private banks are financial arms of broader commercial/industrial groups. CBI aims to reduce cross-shareholdings; clearer separation delayed by international sanctions.
- Bank funding is straightforward: domestic deposit-type liabilities and some Islamic bank bonds (except four specialized banks).
- Public commercial banks previously had excess liquidity in deposits at the central bank, largely disappeared by end-2010.
- Four specialized banks depend on central bank refinancing due to large directed credit programs (e.g., Maskan-mehr National Housing Program). At end-2010, the CBI lent out to specialized banks about half of the deposits of private banks at the CBI.
- Interbank borrowing is still underdeveloped.
- Asset side dominated by credit to nongovernment entities. Three-fourth of credit to the nonpublic sector goes to services, housing, and industry and mining.
- Some credit facilities benefit from government guarantees, including national credit programs and ad-hoc injunctions (e.g., imports of essential goods, packages to cushion subsidy reforms). Guarantees are concentrated in public banks and used to comply with large exposure limits for borrowers benefiting from national credit programs.
- Private banks have concentrated lending on participatory facilities; original private banks account for less than 3 percent of systemwide nonparticipatory facilities. Banks charge higher rates for participatory facilities to compensate for greater market risk due to profit-sharing features.
- Private banks have experienced significantly higher NPLs than privatized banks or public commercial banks.

### Savings behavior and deposit composition
- Negative real deposit rates since 2007 have spurred other forms of savings: real estate, stock market, gold, and foreign exchange.
- It is generally believed that retail deposits in Islamic systems have limited sensitivity to remuneration, but:
  - The share of interest-free deposits dropped from 40 percent a decade ago to 20 percent currently.
  - The share of interest-free deposits in private banks has been stable at around 4 percent.
- Private banks’ business model focuses on term deposits to fund term banking facilities.

*Italic: IMF staff report content as provided in the source PDF.*

### 30.      The banking system’s aggregate capital adequacy ratio is low. In March 2011, the

### _cr11242 - 30.      The banking system’s aggregate capital adequacy ratio is low. In March 2011, the

### Aggregate capital adequacy and appropriate targets
- Aggregate capital adequacy ratio in March 2011: 7.5 percent of risk-weighted assets.
- Cross-country comparison and volatility:
  - China’s banks operate with capital adequacy comparable to that of Iranian banks (in the aggregate), although China’s economy is 40 percent less volatile than Iran’s.
  - Cross-country evidence suggests Iranian banks should target a capital ratio "well above 15 percent" given the economy’s volatility.
- Recent credit growth implication:
  - Iran’s 2009 capital adequacy ratio was much below other countries given credit growth.
  - The recent credit growth suggests a target for the capital ratio on the order of at least 13 percent.
- Risk-weighted assets (RWA) methodology note:
  - RWA are calculated under the Basel I set of weights.
  - In March 2011, the ratio of RWA/total assets ranged between 54 percent (specialized banks) and 63 percent (private banks).

### Nonperforming loans (NPLs), provisioning, and implications
- Aggregate NPL ratio and provision cover:
  - Aggregate NPL ratio reached 23 percent of the loan portfolio in early 2010.
  - Provision cover in early 2010: 12 percent of nonperforming loans.
  - By February 2011, NPL ratio fell to 16 percent and provision cover rose to 32 percent.
- Comparator country example:
  - Egypt’s NPL ratio is comparable to Iran’s, but impaired loans are fully covered by provisions.
- Under-provisioning consequences:
  - Under-provisioning implies reported profits and capital could be overstated, especially for banks with below-average provision cover.
  - Shortfalls from under-provisioning should be deducted from capital to better reflect bank soundness.
  - Under-provisioning reflects weak earnings relative to risk taken and pressure to distribute dividends.

### Heterogeneity across bank types (summary of Box 4)
- Reported vs adjusted capital for private banks:
  - Reported capital adequacy ratio for private banks: 11 percent.
  - Private banks’ NPL ratio (February 2011): 23 percent.
  - Private banks’ provision cover (February 2011): 18 percent.
  - Under mild assumptions (assuming a provision cover of 50% of NPLs), private banks’ capital adjusted for under-provisioning would be 6 percent of RWA instead of the reported 11 percent.
  - Over April 2008 to March 2011, private banks’ capital adjusted for under-provisioning was on average 6.5 percentage points below their reported average capital of 9.1 percent.
  - Adjusted capital for private banks was actually negative between September 2009 and February 2010.
- Sectoral and borrower composition of private banks’ NPLs:
  - Private banks’ NPLs originate from private borrowers in the service, housing, and industry & mining sectors.
  - Example: in the housing sector, the average private bank reported NPLs of 24 percent of outstanding credits, compared to 6 percent for the average bank.
  - NPLs on facilities extended to nongovernment public entities stand at 22 percent, but the share of such credits in total lending is marginal.

### Drivers enabling low capital operation and reporting environment
- Limited market discipline and connectedness:
  - Iranian banks do not rely on foreign funding and do not need international ratings.
  - Iranian banks borrow little from each other.
  - Sanctions constrain the supervisor, justifying more forbearance than would be the case without sanctions.
- Reporting and supervisory framework:
  - How and what banks report is determined by the state accounting and auditing body, though efforts aim to keep local standards aligned with evolving international standards.
  - Restoring capital through fresh equity or consolidation would require strong measures to restore bank profitability.
- Ratings coverage:
  - Capital Intelligence rates three out of 26 Iranian banks: one private, one specialized and one privatized.

### Policy actions and financial stability framework recommendations
- Strengthen capital, provisioning, and liquidity:
  - Raise minimum capital adequacy given Iran’s intrinsic volatility.
  - Implement a Basel-3-type capital conservation buffer above the minimum.
  - Increase provision cover.
  - Strengthen bank earnings by allowing banks to set rates of return on assets and liabilities freely and by reducing operating costs.
- Nonperforming loan resolution and restructuring:
  - Conduct an accurate mapping of NPLs.
  - Establish an asset management company (AMC) to help banks focus on normal banking and coordinate financial restructuring.
  - Remove controls on credit allocation and rates of return to ensure proper incentives for considered risk-taking by banks.
- Early warning, monitoring, and contingency frameworks:
  - Launched a centralized, real-time database with positive credit data in 2011 as a first step toward a comprehensive early warning system.
  - Early warning system should anticipate vulnerabilities, monitor riskier exposures, concentration of risks, dependence on large depositors, and connectedness through interbank exposures.
  - Track inter-enterprise arrears, restructured credits, corporate leverage, foreign borrowing of the private sector, and household indebtedness.
  - Design the planned deposit guarantee as an integral part of a crisis management framework that includes:
    - A special insolvency regime ensuring swift CBI intervention in troubled banks.
    - A clear lender of last resort policy.
    - Minimum liquidity buffers to withstand protracted funding stress without central bank support.
- Supervisory powers and disclosure improvements:
  - 5th FYDP extends the CBI’s regulatory reach and supervisory powers, especially over public banks, including authority to disqualify directors and senior officers and extend fit and proper tests to public bank officers.
  - FYDP authorizes government to allow public banks to retain after-tax profits into capital instead of accruing to the budget.
  - CBI revamping regulatory framework to align with international practices: increasing fines for noncompliance, introducing regulation on related party lending, large exposures, and mandatory disclosure of core financial soundness indicators.
  - CBI’s prompt enforcement powers (“cease-and-desist”) remain limited, as violations are referred to a high-level Bank Disciplinary Committee comprised of non-CBI members.
  - Improved disclosure: half of the banking system now discloses financial information to the Securities and Exchange Organization on a quarterly basis.

### International lessons on AMCs and corporate restructuring (Box 5 condensed)
- AMCs are more suited to financial than operational restructuring; operational restructuring often requires arm’s-length new investors free from political pressures.
- Key lessons and requirements:
  - An effective insolvency regime is critical; bankruptcy must be a credible threat.
  - Banks need fresh equity to absorb losses from systemic insolvencies; continuing earnings alone are insufficient.
  - Connectedness between banks and large borrowers through ownership links or connected lending must be cut back.
  - Supervisory discipline (loan classification and provisioning, exposure limits, capital adequacy) is essential to create incentives for upfront mark-downs of claims.
  - Overcoming supervisory forbearance is a widespread challenge.

*Italic: IMF staff estimates and analysis as presented in the source content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11242.pdf_