Twenty-three years after Iran's banking sector was nationalized in the wake of the "Islamic" revolution, the first full-service private bank - Bank Karafarin - received its operating license from the Central Bank of the Islamic Republic of Iran on 26 December 2001 after months of anticipation.

Two other applications - Bank Eqtesade-e Novin, and Bank Parsian - have been approved, and are expected to qualify for licensing soon, once their minimum capital requirement of IR200bn ($25mn) is met. Some 44 other private entities have reportedly applied for licenses to operate as private banks. Not to fall behind, two state-owned banks - Bank Saderat and Bank Refah-e Kargaran - have volunteered to be denationalized, and allowed to compete with the new private banks. This near frenzy for private banking business is a reflection of the public frustration with the country's state-owned, tightly regulated, poorly managed, inadequately supervised, non-competing, and underdeveloped banking system. The increasingly evident shortcomings of the system, and the leadership's acknowledged concerns about its deficiencies, have made banking renovation and restructuring a top priority in President Khatami government's economic rehabilitation agenda.

Although the need for banking reform had been felt for many years and frequently stressed by domestic and foreign analysts, a number of constitutional and religious issues, and some interest-group politics, had postponed serious considerations of private banking until now.

Fast Forward To The Past Prior to the 1979 revolution, Iran enjoyed a modern, dynamic, and vibrant banking system where some 36 state, private, joint-venture, and foreign banks were in competition with each other at home and abroad. After the revolutionaries' victory, a hurried take-over of the banking sector was deemed necessary by the Provisional Government in order to prevent its imminent collapse.

Revolutionary turmoil, physical damage from looting and arsons by the mob, massive cash withdrawals from banks, and the exodus of many private bankers and bank managers from Iran were cited as reasons. A special decree by the Revolutionary Council in May 1979 nationalized, regrouped, and reorganized the existing institutions into six commercial and three specialized banks. The Council on Money and Credit later reduced the prevailing rates of interest on deposits and loans, and changed the term interest to "minimum guaranteed profit" paid to bank depositors, and "maximum service fees" charged to borrowers.

During the preparation of a new constitution, the "Islamic Marxists" among the triumphant revolutionaries and their supporting radical clerics, succeeded in turning the economic chapter of the final draft into a leftist, anti-capitalist, and anti-market manifesto. Thus, Article 44 of the l979 basic law explicitly placed the banking sector, inter alias, under a state monopoly. Not long after, with the speedy loss of power by the radical left in the revolutionary government, and the effective ascendancy of a tight-knit clerical oligarchy at the helm, a new move for the full Islamization of banking began to gain momentum. After a lengthy and tortuous legislative process, a Usury-Free Banking Act was finally ratified in August 1983 and went into effect on 20 March 1984.

The main objectives of the new law were: (a) proper issue of money and credit for the creation of a just, healthy and progressive economy;

(b) use of monetary tools to promote the national objectives of the Islamic Republic (including the elimination of poverty and attainment of national self-sufficiency); and

(c) preservation of the national currency's value and promotion of balance of payments equilibrium.

A number of "Islamic modes of financing" were inserted in the new law to direct banking transactions. Under these modes, no receipt or payment of a fixed or predetermined rate of interest was allowed. Interest was to be replaced by profit and loss sharing arrangements between the bank and its depositors and borrowers ac-cording to a pre-arranged formula. No party was to be a debtor or creditor, but only a "partner," in joint ventures. Curiously enough, the l983 law neither defined usury (reba), nor did it distinguish it from ordinary bank interest (bahreh).

The New Paradigm With the legal obligation to conduct business under the specific Islamic modes, but without prior practical experience or a guiding operational model, Iran's nationalized and Islamic banks gradually lost both their previous vibrancy and profitability: they became Islamic only in name, and banks only by designation. The most conspicuous change was in the nomenclature. Thus, the interest rate paid to bank depositors was now called "provisional rate of profit," and the interest charged to bank borrowers became "minimum expected rate of profit on granted facilities." Beyond this cosmetic change, what subsequently evolved in actual practice was the same old banking business carried out under an Islamic façade, and the banks operating as financial bureaus of the central government.

The Islamic charade has been amply evident. Under the new law in effect for the last 18 years, the ex-ante "profit" (interest) rates promised, and regularly paid to depositors, have been called interim or "provisional" with the final sum dependent on the outcome of the bank's profit or loss during the year. Yet, in no single year between l984 and 2001 has the ex-post "profit" differed from the ex-ante provisional one - regardless of the bank's profit or loss in that year. Nor has any depositor ever been asked to recoup the bank's losses by paying back part of the provisional "profits" received.

In all these years there has been only one exception by only one bank - Maskan (housing) - and only in one year (2002) where depositors have received a small bonus due to the bank's claimed "exceptional performance." All banks, regardless of size, geographic location, or individual efficiency, have promised and paid the same mandated "profit" rates. And no bank has ever had to justify the difference in the rates paid to depositors for short, medium, and long-term deposits.

Furthermore, "profit" rates have followed no relation to the recession or boom years in the economy. No accounting method has ever been announced or used to determine the profit's share of the bank and that of the account holders. Depositors, as interested parties in the banks' balance sheet, have not been given a clear profit and loss statement: they have had no control over banks' operations or lavish expenses.

With regard to borrowers, too, Islamic banking has been mostly contrived. Of the nine most often used "modes of finance" by commercial banks in recent years, about 60% on average has been under the "installment sale" category which is arguably the closest form to interest-bearing conventional banking. All other "Islamic modes" used - except for some small no interest loans - have been largely fictitious in nature, with banks trying to give ordinary transactions an Islamic cover.

Furthermore, banks, as presumed partners of their borrowing clients, have had no control or supervision on how the borrowed money is spent, and how much profit or loss is made. No loss resulting from poor investment of borrowed funds has ever been shared by the banks. In fact, non-payment by borrowers of principal and "minimum expected profit" has been subject to heavy fines. Interest paid to the banks is also considered business expense for tax purposes regardless of the entity's profits or losses.

Finally, profit or loss made by banks in their mandated investments in public projects (dams, roads, public transportation, and the like involving long-gestation periods or no financial returns) has never been even approximately ascertained.

State ownership of the banking system has had problems of its own. Commercial and specialized banks have been run by government-appointed boards and managers - selected mostly on the basis of ideological commitment rather than financial expertise. They have been mandated by the Majlis, in annual budgets, to offer specific amounts of credit to certain sectors, activities, or entities on demand. And they have been tightly regulated by the Central Bank's hands-on policy in their routine operations. As a result, they have been denied meaningful discretion, initiatives, or innovative opportunities. The Central Bank, instructed by the Council on Money and Credit, has prescribed: (i) "profit" (interest) rates paid to depositors for various duration of less than one year and up to five years; and (ii) "profit" (interest) rates demanded from borrowers in different activities (ie. agriculture, industry, construction, export, and trade).

In the last 10 years, the rates paid to depositors have ranged from 6% for one year or less, to 18.5% for 5-year deposits. The rates charged customers have ranged from the lowest 6% in agriculture to the highest 25% in trade and business. The ceilings for total lending during each year for each bank was also until recently determined by the Central Bank. In addition to their legal reserves requirements kept with the Central Bank, nationalized banks have also been obligated to share in financing the government's yearly budget deficits for a paltry return on their as-signed subscription.

While government ownership of the banking system has protected depositors against possible default or bankruptcy by periodically covering bank losses in the annual budgets, banking nationalization has involved a number of serious structural flaws. The banks as a group have remained significantly under-capitalized, interspersed in too many branches, over-staffed, and run by risk-averse inexperienced managers. Perennial budget deficits have left no room for capital injection except in the 2001-02 budget where for the first time some IR 5 trillion was allocated for this purpose.

Furthermore, the relatively small margin left between centrally-directed deposit and lending rates, coupled with non-remunerated high legal reserve requirements, high cost of operation, and high taxes on bank profits have financially handicapped the system. Still further, high-handed pressure on banks from above to accommodate large public-sector borrowers has often resulted in a single exposure that exceeded the entire bank capital.

Finally, banks have been given little or no incentives to improve their efficiency and profitability. Since capital and money markets were handled by same entities, efficiency has been compromised. Since deposit interests have been administratively fixed, banks have had no incentive or means for better mobilization of domestic savings.

Low or negative real interest rates on deposits, in turn, have led to capital flights, excessive land speculations, or investments in dollars and gold. Since lending interest rates have also been fixed, there has been no incentive for better credit allocation. Lending decisions have often been made under political pressure, friendship, cronyism, or other unsavory criteria. Many mandated credits have thus never been repaid, and a large part of the banking systems' assets has been reduced to non-performing loans.

Anxious to improve the bottom line, banks have subtly deviated from assigned credit ceilings for different sectors by neglecting agriculture (where the allowed interest has been as low as 6%), and diverted their loans to trade and business (where legal interest has been as high as 25%). They have also routinely favored large borrowers over the small fry. Another very lucrative source of money-making has also been found in gobbling up the risk-less and tax-free bonds (called "participation certificates") issued by government agencies - thus nullifying the Central Bank's intention to mop up excess private liquidity in the public's hands. This practice was finally banned in 2002.

The combination of nationalization and Islamization of the banking sector has consequently led to the creation of a dual financial system where an informal or underground network of money-lenders and speculative traders in the bazaar has competed with the formal and legitimate banks.

Thousands of registered credit cooperatives and interest-free Qarz-al Hasaneh funds (QHF) have also operated on the side. By some estimates the volume of money circulating in the bazaar (where interests paid to BOT depositors and borrowers exceeded the formal rates by some 20-25 percentage points or more) has been larger than the official money supply.

The vitality of this thriving informal network, in turn, has created ample opportunities for rent-seeking operatives within influential circles to borrow large sums from official banks and lend them in the bazaar at considerable profit. In this context, the operation of unsupervised QHFs have become particularly nettlesome since they have been engaged in raising zero-return funds from devout Muslims for on-lending to the needy on the same basis (ie. zero interest).

But in practice, they have often charged unreasonable" service fees" to desperate borrowers and/or demanded sizable collateral from them - using their funds for profit-making activities on their own accounts.

A Sobering Experience Iran's nationalized and Islamic banking system in the last two decades has had an unimpressive record. Far from achieving the three-fold objectives of the l983 Banking Act, namely, stimulating economic growth, promoting social justice, and protecting the national currency - the sector has been a drag on the economy and society. Plagued by slow growth, inefficient performance, narrow range of products and services, a large portfolio of low or non-performing assets, and a number of highly embarrassing embezzlement scandals, the banking sector has added to the country's major economic setbacks.

While the Iranian economy's unenviable post-revolution record of near stag-nation, double-digit inflation, high unemployment, falling per capita income, and widening income gaps cannot all be blamed on its banking architecture, the sector's responsibility in all of these shortfalls cannot be overlooked or underestimated.

With respect to failing broad national objectives, the record has been extensively aired out in Majlis debates, financial publications, and periodic banking seminars. According to these sources, instead of being an engine of growth, the banking sector has often fallen behind all others in annual expansion. During the Second Five-year Plan (1996-2000), for example, when non-oil gross domestic product grew at an average annual real rate of 3.8%, the financial sector's growth rate was only 1.6%.

Furthermore, instead of promoting public prosperity and social justice as intended, banks have served as instruments of income distribution in reverse.

With the annual official inflation rate in the 23-year period since the revolution averaging around 18%, and the average return on all bank deposits not exceeding 12% a year, helpless depositors have lost more than 6% of their assets' purchasing power each year. At the same time, with the cost of borrowing money throughout the period nearly always below the rate of real inflation, well-connected borrowers have gained hefty subsidies at the expense of depositors. Borrowers of foreign exchange at preferential rates below the free-market rates had even larger windfall gains at the expense of consumers and savers. And, finally, by financing almost all annual budget deficits of the public sector, the banking system has contributed to the cheap-ening of the national currency instead of protecting it.

The Rial which stood at $1=IR70 in 1979 has reached over $1=IR7,900 in 2002. In a word, the system has produced no profit for the stockholders (government); no modern services to depositors or customers; and instead of controlling inflation and creating investment and jobs, it has aggravated excess liquidity and hurt the job market by lowering capital costs vis-à-vis labor wages.

The Dawn Of A New Era?

In the early 1990s, after a full decade of experience with the state banks' sub-par performance and non-observance of both Islamic modes and Majlis mandates due to lax supervision, the need for reform and restructuring became ever more evident.

But since both the Constitution and the 1983 Banking Act permitted neither private nor conventional banking, an escape route was found by the Central Bank in the form of private "non-bank credit institutions." These entities were allowed to pay up to 4% higher interest rates than those paid by commercial banks, and to en-gage in a broad range of banking activities -with the exception of opening checking accounts and dealing in foreign exchange transactions.

The main intention was to create some organized and legitimate competitors to both the inefficient nationalized banks and the extra-legal bazaar credit network. Three such "non-bank banks" were authorized by the Central Bank since 1997 while one more, belonging to the politically powerful Bonyad Mostazafan charitable organization, was already active in the market without a legal permit. Concurrently, private domestic and foreign banks were also allowed to operate in Iran's Free Trade Zones in the Persian Gulf under less stringent regulations.

Once established and allowed to engage in some lucrative, albeit limited, financial transactions, the non-bank banks started to exert strong lobbying efforts within the Central Bank and the Majlis to become full-service banks. These efforts finally came to fruition when the conservative fifth Majlis in early 2000 took advantage of an escape clause in the Constitution, and approved the formation of private commercial banking in the mainland under certain safe-guards (including 100% Iranian ownership). Karafarin Bank and the other two credit institutions have been the out-come.

The re-establishment of private banking in Iran is doubtless a significant new chapter in the Islamic Republic's banking history. Some consider this chapter the epilogue to the nationalized banking system. Predictions are that once five or more private banks entered the scene, it would be just a matter of time for the state-owned banks to go out of business through bankruptcy, liquidation, and closure.

While such predictions may be wishful at this time and perhaps as long as the present clerical regime is in power, there is no question that significant reform and liberalization of the current system lies ahead.

Given a sufficiently hospitable climate, chances are that private banking may indeed revolutionize the existing banking practices in Iran.

Yet what remains certain is that after 26 December 2001, the future banking services in the Islamic Republic will never be the same.