One thousand years ago, and for several generations, Baghdad was the world’s richest city. Iraq’s capital city and commercial heart has a long road to travel to get back to anywhere near the global prominence it held in those dim, distant days – no small understatement intended – but even its current unpleasant notoriety has a feel of edgy excitement, of a place on the verge of a gold rush. It is intoxicating in an inexplicable way.

Despite a political stalemate that has dragged on since elections were held in March, with no new governmentyet to emerge, and despite continuing incidences of violence, Iraq is of considerable interest to investors and GDP growth is predicted to surpass 7% this year, powered by oil money.


“With FDI being a major factor affecting the growth of the Iraqi economy, it is safe to say that multinationals from different industries are beginning to take major interest in Iraq. Backed by massive oil fields and multinationals interested in developing oil services, infrastructure and construction projects, long-term potential could be massive,” says Abdel Hamid Shoman, executive chairman of Arab Bank, which has acquired a banking licence for Iraq.

Kyle Stelma, managing director of Dunia Frontier Consultants, says in the past six months his group has noticed a clear shift in investor attitudes towards Iraq and more private equity firms are beginning to take a serious look at the market. He expects “a massive uptick in FDI” as soon as the government forms, which most observers expect to happen in September or October.

But a mercantile infrastructure must be built, and quickly, for when the gold rush begins.

“Without real financial institutions and banking in Iraq nobody can work,” says Kais Kubba, chairman of Credit Bank of Iraq, a private bank that is majority-owned National Bank of Kuwait.

The signing of contracts with international oil companies and the entering of the market by these major firms – as well as the wave of follow-on investment their arrival portends – has put sudden pressure on a weak and unsophisticated banking sector, which will need to rapidly get up to speed.

Many of Iraq’s 30-odd banks are small, family-owned operations that function as little more than money shops. The landscape is dominated by state-owned banks: the three largest, Rafidain, Rasheed and TBI, account for anywhere from 85% to 95% of banking sector assets in terms of book value and roughly the same percentage of deposits.

There is very little true financial intermediation. Banks in Iraq offer a traditional range of deposit accounts and lending products including, relatively recently, debit and credit cards as well as exchange and transfer facilities. The vast majority of banking operations are confined to basic consumer transactions and banks derive most of their income from fee-based services such as money transfers.

“The problem of the banks in Iraq is there are a lot of small boutique banks with limited capital which are controlled by families and they’re using all the money and the banks for their own businesses. There is no cover and no security for certain banks – I am not talking about our bank or the HSBC bank in Iraq, because we have already got the relationships with the major banks – but the rest of the banks are facing a lot of troubles because they cannot open letters of credit from their banks to the world. They must go through Jordan or through Lebanon, which is costing a lot of money and fees. And the interest rate is too high in Iraq. Sometimes it’s 15% and sometimes it’s 20%,” says Mr Kubba.

Struggling to meet demand
As a market, Iraq is seriously under banked. Demand for banking services is outstripping existing capacity and penetration is low. Nearly every segment of banking is ripe for development and financing gaps are opening up all over the place. Project finance is in short supply, putting at risk the ambitious building projects as construction companies struggle to come up with the short-term financing required. There is obvious potential demand for Islamic finance products, given that 97% of the Iraqi population is Muslim. A handful of Islamic banks have registered in Iraq in an attempt to capture this market.

“What we’re seeing is appetite for medium tenor financing – five to seven years is available. But there is a major gap in the demand versus supply. We’re talking about a tens of billions of dollars requirement of financing from the private sector, public sector and multinationals,” says Hussain Ali Qaragholi, Iraq business head for Abu Dhabi Islamic Bank, which is planning to open its first branch in Iraq.

“There is certainly appetite for the market. The record speaks for itself – we’ve had announcements of European, American and Asian companies that have committed to coming into Iraq and with these deals there is finance that is involved.”

But Iraq is still a cash economy and many citizens distrust banks, preferring instead to keep their cash tucked away under the proverbial mattress – a throwback to the Saddam Hussein era, when the leader could confiscate deposits at will. There is no such thing as a credit information bureau in Iraq – or really any formal system of credit checks – and banking is very much a personal business. Technology is poor, and most state-owned banks do not even have core banking systems. Private banks are not always up to speed with basic banking products either. There is no proper rating criteria for banks (instead an oldfashioned ratings system called Camel is used) and there is a lack of expertise among managers, many of whom are nearing retirement age.

“People do not trust the banks – this goes back to the 1960s and 1970s. Equally, banking needs to prove itself as a qualified sector in dealing with people,” says Dr Salam Smeasim, a well-regarded Iraqi economist and a member of the Iraqi Securities Commission. “Many of the young staff are well computerised and open-minded, but sometimes the problem is the management, because you can have good human resources, but that doesn’t help if you don’t know how to manage them. This is a problem not just for banking but in all of Iraq.”

The same issues that make the general business environment difficult impede the proper functioning of the banking system: an overbearing public sector; inconsistent legal and regulatory frameworks; and humanresources issues including poor customer service and risk management cultures.

Business struggles
Corruption remains rife in Iraq, and the financial sector presents many opportunities for pocket-lining and favour-currying, and thus legal landmines for international investors. The Transparency International Global Corruption Report 2009 puts Iraq 178th out of 180 countries. The World Bank’s Doing Business 2010 report lists Iraq as among the worst countries in the world for starting a business, getting credit and enforcing contracts.

“I have seen companies innocently run afoul of the Iraqi banking and regulatory system - the system is nascent and there is confusion on all sides,” says David Jansen, leader of PricewaterhouseCoopers’ anti-corruption practice. “My advice to corporate executives is to obtain international crossborder financial and legal advisers who have professionals on the ground in Iraq experienced in working with officials in the finance or investment ministries. In addition to Iraqi regulations, laws in the UK, US and elsewhere require careful and robust due diligence.”

Iraq enacted legislation six years ago allowing foreign banks to operate freely in the country but while various foreign banks are circling around – camped out in Amman or other surrounding, safer areas – or are seeking out correspondent relationships with local banks, few have planted flags on the ground in Iraq. Regional banks have led the first wave in, with Lebanese and Iranian banks, as well as Bahraini, Kuwaiti and Turkish institutions, among others, active; their approach towards Iraq, on the whole, has been interested yet cautious.

For all its espoused bullishness on Iraq, Arab Bank has not yet utilised its licence due to lingering security concerns. “We used to have a presence in Iraq before being nationalised there. We obtained the licence due to our belief that there is potential in the country…but the financial crisis has inhibited many companies in expanding. Hopefully things will improve, and once they do, we will look into re-entering Iraq,” says Mr Shoman.

Speaking to local media, Mudhhir Mohammed Saleh, a member of the CBI’s board of advisers, attributed foreign banks’ temerity in Iraq to not only security concerns but also the lack of a favourable legal framework. The outgoing parliament failed to pass a new banking law, kicking the ball to the new legislature, whenever it should be seated.

Banks from outside the Middle East have been even more reluctant to go all-in. Of these, HSBC has been the pioneer, taking a majority stake in Dar Es Salaam Bank and dispatching an Irish executive to oversee the set-up as CEO for Iraq. James Hogan says the bank will have invested capital expenditure of $220min its Iraq business within the next few years and hopes eventually to expand from debtprovision services for its corporate clients to capital-raising. “In time we could see some of the advisory work we are doing in Dubai could be done onshore in Baghdad,” he says. “We will have fewer security people and more banking advisers on the ground here.”

HSBC will likely be alone among Western institutions actually based in Iraq for a while yet – a first-mover advantage it fully intends to exploit once the late-comers arrive – although Citibank, for one, looks ready to make a move: the CEO of the bank’s operations in Bahrain is reportedly being brought over to Jordan to run an Iraq-focused unit out of Amman.

Capital market option
Because the banking system is still so underdeveloped, capital markets are viewed as another important mechanism for expanding the economy and supporting business.

The Iraqi Stock Exchange (ISX) was launched in 2004, set up as an non-governmental organisation in order to be able to tap donor money; it is now doing automated trading and holds five sessions from Sunday to Thursday. Eighty-five companies have listed on the ISX, although 19 were recently suspended for late filings of financial statements. Results for 2009 were positive, with a 40% increase in trading volumes over 2008, and the first half of 2010 was strong as well, but investors have become nervous about the long delay in a government forming among other factors, says Taha A Abdulsalam, CEO of the exchange. Their chief worry is over the decisionby the Central Bank of Iraq (CBI) to force banks to raise their minimum capital to ID250bn ($211.5m). “This is a problem for investors so they want to sell their shares in banks,” he says.

Capital markets investors are not the only ones fretting about the new minimum capital requirements handed down by the CBI when it signed up to Basel II requirements in March. Understood as a way of forcing consolidation among banks, the requirements are bound to cause a shake-out. Most banks are currently only capitalised to the tune of about ID50bn to ID60bn, and were already struggling after the gravy train of 23% interest rates they had been living off of came to a halt when rates were lowered earlier this year to a leaner 6% to 8%.

The decision aims to strengthen the banks as the current lack of capital decreases the financing capability for economic development
purposes, a CBI adviser told local media in March. “Banks in general do not have a role in the investment field despite [the fact that] they enjoy a liquidity percentage which

reaches more than 60%, and we cannot pressure banks in this critical situation as the decision will make banks stronger and with more capital, which will increase their capabilities in lending,” Mathhar Mohammad Saleh told Aswat al-Iraq news agency. “The decision will contribute to increasing the financial resources to serve the economic development in the country as most of the Iraqi banks’ capital does not exceed $50m, which can’t do anything regarding the development projects.”

But some disgruntled bankers suggest a shake-down is in order as much as a shake-up. One of the largest private sector local banks, Warka, recently had to hand back sizeable government deposits upon demand and was ordered to close 87 of its 130 branches (a decision later reversed). Publicity surrounding these events caused depositors to do a run on the bank, which is still standing but says its would more than welcome a foreign investor or foreign bank that wanted to partner and take advantage of its extensive reach across Iraq, strong customer knowledge and comparative technical competence. “I don’t think any other bank would have survived,” says chairman Saad Al Bunia.

Asked if it would continue to survive, he replies: “We have to.”

Others will not. But Warka’s woes aside, consolidation, even if forced, is bound to be for the betterment of the sector by and large. “Based on the guidance and instructions issued by the executive authority in Iraq, which aims to stimulate the effectiveness of this sector, in the future there will be vital and active private banks,” says Kareem Noor Alyasir, vice-chairman of North Bank.

Kamil Gailana, former finance minister of Iraq who now works as a consultant, puts it more succinctly. “It’s better to have a few private banks working in a professional way than 29 that aren’t really doing anything,” he says.