Iran’s Pivotal Moment

Euromoney, September 2014

Iran is at a pivotal moment. The year ahead will determine which path it takes: a resource-rich, rejuvenated success story, returned to the international fold and relied upon by western states as a stable force in an increasingly troubled region; or a recession-hit, bad loan-addled failure still barred from western trade and getting steadily, inexorably worse. The view in Tehran is that it really could go either way.

The fascinating thing about Iran is the way that geopolitics, the most unpredictable of forces, are slowly shifting in its favour, largely for reasons that actually having nothing to do with Iran.

One would never have imagined it a few years ago, but Iran is suddenly a natural ally to the US, which badly needs a stable government in a region in which ISIS (which, being Sunni in its ideology, is never going to be a friend of Shi’ite Iran) is gaining worrying traction, particularly in neighbouring Iraq. The aligning of the stars, with a leader in Hassan Rouhani who wants to reach out to the west at the same time as an American President who wants to make peace and who badly needs a foreign policy success, feels like a once-in-a-generation opportunity.

And at the same time, Europe has good reason to want better relations with Iran as its own relationship with Russia deteriorates. European reliance on Russian energy, chiefly gas, is clearly problematic; Iran has vast fields of the stuff and pipelines which already reach the Caucuses.

All of these things are bargaining chips for Iran as it tries to negotiate an end to nuclear sanctions in Geneva, and they raise the prospect of a sanction-free Iran ready to resume global trade and to make the most of its many advantages. “I know that there are a lot of foreign entities – companies, contractors, investors – who are scrutinizing the situation,” says Mohammad Amir Davoud, general director of international affairs at Bank Pasargad, one of the biggest and strongest private banks in Iran. “They are waiting to see the results of the negotiations between Iran and 5+1 [the five UN Security Council states plus Germany, with whom Iran is in negotiation around its nuclear programme, the initial cause of the sanctions] so they can rush back to Iran for further investment. History shows the Iranian market has always been a secure and positive haven for investors.” Indeed, Euromoney hears frequently of European businesses and banks that have informally visited Iran lately, assessing opportunities for when the right moment arises.

So what will they find when they get there? A mixed picture indeed: vast resource wealth, not just in hydrocarbons but minerals; a highly educated population keen to work hard in renewed international commerce; and a reformist government. But also a bloated banking sector that is riddled with bad debt, odd accounting and a shortage of deployable capital, and an economy within which your business partner might well turn out to be the Revolutionary Guard. Nothing is simple in Iran.

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First, the positive view.

Demographically, Iran has a lot going for it. Its population of 78 million is well-educated, it holds 9% of the world’s oil reserves alongside a broad-based manufacturing sector, and has a stock market capitalization that stood at $170 billion earlier this year, similar to Poland’s and with a free float bigger than Kuwait or Nigeria. It has a reformist president, Hassan Rouhani, who wants to engage with the rest of the world.

“We have a lot of competitive advantages,” says Hojatollah Saydi, managing director of Kharazmi Investment Co, one of the vast investment conglomerates that dominate the Iranian stock markets and economy. “Firstly there’s the population: not only its size, but its youth. Secondly, there is our geopolitical position,” between Europe, the Persian Gulf and the growing resource-rich markets of central Asia. “Then there is the level of education, very different from other countries in the region.” A huge source of pride: they say locally that the engineering graduates from Tehran’s Sharif University of Technology are right up there with the best of MIT. “And there is the potential: not just the oil and gas reserves, but our reserves of minerals.” He lists a long and bounteous inventory: copper, gold, nickel, zinc, cobalt, phosphate, gypsum, limestone (he doesn’t mention the uranium, but that’s another story.) “For a young population, if some doors open for us, we can do many things.”

It’s not only the locals who feel this way. “Tehran feels like Ankara did in 2004,” says Charles Robertson, global chief economist at Renaissance Capital, who launched a benchmark report on Iran in March following a visit to Tehran. “This looks to us like a potential re-rating play that could – in an investable scenario – attract those investors who have recently invested in Saudi Arabia, like those who invested in Turkey after 2001 and Russia since the 1990s.”

“No other country,” he says, “is as large or as untapped.”

It’s untapped, of course, because of the sanctions, and that’s the problem: none of that potential can be realized in anything other than a domestic sense so long as western enterprises are forbidden from trading with Iran in most sectors, and foreign banks from funding their trade. “Now the world is flat,” says Saydi, “and no company can grow without international cooperation.”

But – and here we get to the bad news – sanctions are only part of the problem.

Iran’s economy is in a perilous state, experiencing a deep recession of -5% last year at the same time as high inflation, with a devaluing currency, rampant unemployment, a banking sector addled by non-performing loans and a manufacturing base throttled by imports of cheaper goods from places like China. At the moment, one can argue that it’s getting modestly better: according to the central bank, inflation stood at 45% last year, is now down to 35%, and is projected to drop to 20-25% by March 2015, the end of the Iranian year. But it’s impossible to do this at the same time as growing an economy. “We have to squeeze liquidity to fight inflation, but we must also inject liquidity to let the economy grow,” says one senior policy official in Iran. “And you cannot really do both.”

It’s a common misconception that Iran’s economic woes are a function of sanctions. Sanctions certainly haven’t helped. But Iran’s economic problems are largely self-inflicted, under the administration of Mahmoud Ahmadinejad, who ruled from 2005 to 2013. It is said that under his eight year tenure more was earned from oil – at a period of high prices and largely before sanctions kicked in – than in all previous administrations, but if that’s true, the money doesn’t seem to have gone to the right places.

“We did not suffer from sanctions so much as we suffered from mismanagement,” says one banker. “We could have had a stable economy with low inflation.” He raises his hands with a wry smile. “But we do not.”

A word about sanctions. They apply at three levels – European Union, UN and US – but the American sanctions are by far the most influential, partly because they go a lot further than the others (they cover almost the entire banking sector, for example – see box for the one exception, Middle East Bank), partly because they don’t just preclude trade with the US but anything in US dollars no matter where it is conducted, and partly because America’s vociferousness in pursuing sanction breaches has scared off many companies and banks from conducting even legitimate businesses. The almost $9 billion fine levied against BNP by US regulators in July has had quite an impact on the attitude of potential correspondent banks.

Sanctions do not cover a particularly broad range of industries – particularly since concessions in July removed the automotive and part of the petrochemical industry from the list – and humanitarian sectors such as food and beverages, medicine and medical devices have always been exempt. It is a surprise to many visitors to Tehran to find many household names of western commerce, such as Nestle, Vodafone and Carrefour, operating successfully (and perfectly legally) in Iran. But because financial services is still blacklisted, very little trade can be financed. Also, it means there’s no scope for hedging, although in truth the central bank has never had a mechanism for it to take place anyway.

So the key sanction is financial services, because so long as it stays on the sanction list, everything else might as well be too. There are labyrinthine methods through which European companies in non-sanction areas can legally trade with Iran, but they involve, for example, setting up accounts in Japan and transacting through there. That might make economic sense for a big grain shipment, but it won’t be economically viable for a supply of a relatively small amount for a particular medicine, even though pharmaceuticals are not on the sanction list.

“The practical result of sanctions,” says the principal of Magellan Capital, a London-based boutique advisory specialising in emerging and frontier markets, “is that a man who needs a cancer pill from Pfizer can’t get it.”

Indeed, as is common in sanctioned nations, there is widespread local resentment, a feeling that a political issue has yielded a punishment on ordinary people instead of politicians. Euromoney’s visit to Tehran coincided with a fatal air crash there, and even as news broke over the city’s radios, taxi drivers were blaming it on sanctions. Why? Because until very recently, spare parts for aircraft were on the sanctions list, meaning the local airlines – upon which Iranian politicians surely never fly – have been unable to repair their fleet without going through the black market. And although aircraft parts were recently relieved from sanctions, still nobody’s selling them because of the stigma that now attaches itself to Iranian trade.

So the point about sanction relief is not so much when it happens as in what order. Clearly, for example, nobody is going to be allowed to ship arms to Iran in the near future, which doesn’t bother ordinary people (or the economy) in the slightest. But if, as seems likely, the next step is a few more removals from the sanctions list, the clincher is whether financial services is included.

“If banks cannot have active communication with the international world and other banks, it’s like a one-way street: you’re just going down one side and cannot come back the other way,” says Jalal Rasoulof, CEO of Ayandeh Bank. “If they open to the banks it would be very fruitful for the people.”

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Iran’s banking sector is complicated. There are a handful of major state-owned banks, then around 20 others that call themselves private. This latter group varies between largely state-backed enterprises that sold some stock on the Tehran Stock Exchange during a privatization process during the last decade, to others that have no government ownership and in some cases have surprisingly diversified private shareholder bases. Beyond them are other financial institutions, credit cooperatives and several very large investment companies, some of which have their own banks within their holding company structure.

When sanctions start to lift from financial services, they are likely to do so in phases. Bank Sepah, which is owned by the armed forces (Sepah means army in Persian), should probably not hold its breath waiting to be permitted to do business with the west. But most of the private banks are already off the European and UN sanctions lists, and would expect to be among the first to come off the US one too.

And that’s the crucial point. The impact of American sanctions is so pervasive that it often doesn’t make any difference if a bank is free of EU constraints. “Even though humanitarian items are exempted from sanctions, there are still fears of future punishment by the United States against them,” says Davoud at Bank Pasargad. “So as a cautious gesture, they have decided not to work with the Iranian market at all. They are watching until all the sanctions are removed.”

Sanctions consequently do have a number of knock-on effects, perhaps broader than their intentions. Consider London-based Persia International Bank, a largely autonomous institution in London which is owned by two of the largest state owned banks, Mellat and Tejarat (Mellat successfully got itself removed from EU sanctions by the European courts, but Tejarat is still on the list, and consequently Persia Bank itself is also barred). There is a staff of 21 in a grand Georgian building on Lothbury just across the road from the Bank of England, doing pretty much nothing; the bank cannot even cash in its VAT refunds from HM Treasury – payments that have been clearly marked as legal by the British state itself – since no London bank will touch it for fear of being accused of improper behaviour.

It is a common lament that the BNP fine was not chiefly about indiscretions in Iran, but Sudan; likewise HSBC’s $1.9 billion money laundering fine was mainly about Mexico, with Iran something of an afterthought. “But when it says Iran first…” says one banker. “All foreign banks are scared and conservative. They avoid us even in areas that are perfectly legal.”

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When sanctions do lift, there will be a flurry of Iranian banks reaching out for correspondent relationships with western counterparts, and westerners leaning in to do the same. It’s not exactly ancient history: a great many big western banks were represented here before sanctions, from Chase to HSBC to ABN Amro. In one meeting, Euromoney spots one of those Merrill Lynch bull sculptures on an office shelf, sitting there like a museum artifact.

So when the westerners come back, in what state will they find Iran’s banking sector? It faces two considerable challenges: one about past lending, one about funding for the future.

Iran is blighted by bad loans, for sundry reasons. One is the collapse in Iran’s exchange rate earlier this year from just over 10,000 rials to the dollar to almost 30,000, which caused many clients to be unable to meet payments to banks. Another is the decline in competitiveness of Iranian manufacturing – particularly the automotive sector – in the face of cheap Chinese imports dating from the Ahmadinejad administration. There have also clearly been problems with credit assessment.

Most bankers talk about a system-wide NPL level of about 15%, but none of them believe it. It might well be double that. “You tell me a bank that has less than 15% non-performing loans,” says one banker, “and I’ll tell you which bad debt he’s not showing in his books.”

One bank that has had a particular challenge in NPLs is the otherwise impressive Saman Bank, which found itself a victim in one of the worst business scandals ever to hit Iran. In 2011, it became clear that almost US$3 billion worth of letters of credit had been fraudulent, affecting seven state and private banks, most notably the state-owned Bank Saderat. Forged letters of credit were used to acquire assets – including major state-owned or privatized assets such as the Khuzestan Steel Company – and it took four months for the fraud to become clear. When it did, at least 20 people were arrested, and four – including Mahafarid Amir Khosravi, judged to be the mastermind – were sentenced to death, with Khosravi hanged in May 2014. The former managing director of Bank Melli, Mahomud-Reza Khavari, resigned after the bank was implicated and his whereabouts today are unknown.

Saman found itself on the sharp end of this. “Basically, we had discounted LCs of Bank Saderat, and they defaulted on making the payments,” explains Vali Zarrabieh, Chairman. The two banks have been in the courts ever since, and Saman has won every single case, but while it waits to get the money back its balance sheet has been crippled. “At the time almost $600 million of deposits [based on a US$/IRR rate of 10,000, as it was at the time] were locked up into those assets that are not performing,” he says. Still, the story also demonstrates a certain level of equanimity and sense that one might not have expected to see. “How we managed it was nearly a miracle. Very hard work, micromanaging everything, and daily meetings of the asset-liability management committee – not monthly or weekly. Also, one or two banks that tapped into the interbank market helped us greatly, and I’m always grateful for their help.”

Not everyone, though. “We never received any help from the central bank, and it was a pity,” he says. “I believe it was their responsibility to help as a bank of last resort, but they never did, and we never borrowed from them. The private banks had the decency to understand that what we had done was nothing out of the ordinary – and they knew if we went into trouble, there would have been a domino effect in the market.”

Once remaining LCs are repaid (there’s about US$100 million outstanding now), Zarrabieh says Saman’s NPL ratio will fall to below 11%, “which is basically normal in this market,” Zarrabieh says. “This rather high NPL is all because of macroeconomic issues that need to be addressed collectively.” Most NPLs, he says, are collateralized mainly with properties and listed shares, “which take longer than expected to liquidate in order to circulate the cash into operation.”

Others have different challenges. Parsian Bank has as its major shareholder the Iranian car manufacturer Iran Khodro, which at some times has been a great benefit to the bank in funding the automotive sector, but is likely to have led to bad loan problems in recent years when the sector, battered by imports, has been running at as low as 40% capacity. Asked about this, Parsian responds: “We cannot say bad loans, because they are our main shareholders. If we have given a facility to them, their facilities are secured and safe.” In Parsian’s case, it probably won’t matter because the automotive industry is improving – Khodro has doubled production, it says – so that anything non-performing on the books has the potential to be revived, but it does speak to the difficulty in seeing just what’s happening inside a bank.

One problem that has to end is an accounting practice of banks raising their level of capitalization not by actually raising capital or attracting deposits, but by repeatedly revaluing their own property portfolios, which are often vast: some banks have as many as 3,000 branches, and they tend to own them outright. Tehran has a preposterous surplus of branches; there is a particular streetside location from which it is possible to see 13 without moving.

Zarrabieh believes the only solution is for the government or central bank to create a ‘bad bank’ structure to shift all the troubled assets in to. “To my opinion, this is the most feasible solution to address this issue efficiently,” he says. “But having had many meetings and discussed this many times they have not yet come to a single solid solution.”

Others have similar ideas. Parviz Aghili is founder and CEO of Middle East Bank (see box). He has put forth a proposal for the restructuring of the banking system and improving the quality of financial statements, properly audited. “Their records should represent the actual facts,” he says. He then wants their capital adequacy tested under Basel 3, with the results listed. “Those who are below 5% should be closed down. Between 5 and 8, give them time to raise good cash. I don’t mean some of the stupid arrangements many of the banks do, reappraising the value of properties they own to increase the capital. That’s ridiculous. What I’m talking about is clean cash coming in in the form of equity.”

The situation may not be quite as bad as it seems, he says, because of the level of security banks hold in real estate, which has at least benefited because of inflation. “Under normal circumstances when you have such bad loans you should be in deep trouble, but they may not be if we have a good bank-bad bank model to separate the bad loans.”

But he believes beyond that, a change in attitude is necessary. “It is not understood that a bank has to operate as a bank. A bank cannot be an investor in a project like the chaebols did in Korea. Banking is an intermediary: you receive deposits, you provide loans and facilities, and that’s it.”

Aside from bad loans, there is a common lament in Iran: that there is just not enough money available for corporates to grow. Although there are a large number of banks – arguably too many – several of the private sector ones are modestly capitalized, and in no position to advance the funds Iranian businesses need.  The government is understood to be planning a restructuring of the balance sheets of state-owned banks to put them on a better foundation and make them better able to fund the troubled manufacturing sector of the economy, but that is scarcely underway and the bad loans have to be digested for that to happen. “There are insufficient funds for companies that are trying to complete projects,” says Mansour Tafazoli, vice president, international at Parsian Bank. “They are facing problems raising the money they need.”

And what else can borrowers do? They can’t raise funds in a local bond market, because there isn’t one, or at least not one that any issuer elsewhere in the world would recognize; there are something like retail bonds, issued and guaranteed by banks, but they are not tradable, and are instead generally sold back to the bank eventually at par (creating a further encumbrance for already-troubled bank balance sheets). These are known locally as participation papers or PPs, and the central bank acknowledges that they would be more useful if there was a secondary market for them. The central bank, in fact, is not ill-equipped: it has a scripless securities trading system in place, ready and waiting. But it isn’t used, because nobody wants to use it. Probably new rules and regulations would help, but there are bigger issues too. “You have to change the mood of the people,” says one Iranian policymaker. “They are used to PPs. They see them as like banknotes.”

Aghili has proposed a method of helping capital market development through murabaha, by providing a sort of subsidy based on future tax credits. “If they go to the market right now they won’t be able to raise funds below 25%, but half of it could be subsidized by tax credits and future earnings, to get the economy moving. That way we can get markets to provide a substitute for bank debt, to provide working capital and assist our private sector firms. We could take the pressure off the central bank. Then we don’t have to increase liquidity as we did in the past.”

There is a modest sukuk market in Iran too, and at the time of writing the Sina Financial Services holding company, part of the enormous Mostazafan Foundation (see box), was preparing an issue for a steel company within the group that should raise the equivalent of $80 million. But issues are still reasonably rare.

There’s also a big and vibrant stock market, but it lacks proper market makers and since there is only one class of share – a voting one – companies think twice about using the exchange to raise funds and issue new stock. “Shareholders cannot easily make a decision on raising capital because they will be diluted and lose control,” says Zarrabieh.

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Despite their challenges – and perhaps because of them – banks are preparing themselves for brighter days when sanctions are lifted. Bank Mellat, for example, which styles itself as the largest private bank since a privatization five years ago but is still state-backed, is several years into an overhaul of business practices that among other things wants to get everything ready for when the foreign banks and investors come calling again. Pasargad has a series of action plans in place – one for worst case, one for an end to sanctions – and plans to increase its capital base from $1.5 billion to $2 billion within the next three years in order to have a base to grow from.

International business hasn’t gone away completely. Trade today is chiefly with five or six countries – especially China, India, Korea, Turkey and to an extent Japan – which can accept oil exports from Iran; Iran must then try to source all its import needs from the same country, though even then, payment and settlement is very difficult.

Still, there’s business to be had: Parsian, for example, still derives 20-25% of its profits from international banking, and has correspondent bank relationships with UCO Bank in India, Konlon Bank in China, Woori in Korea, Megabank in Taiwan and Halk in Turkey. “After sanctions are lifted we hope to start helping customers to hedge their obligations and contracts faster,” says Tafazoli.

And there are some successful businesses that have focused on the sectors that have never been covered by sanctions. “We focused on food and pharma, because we saw this would be a door that stays open,” says Zarrabieh at Saman, an institution that would have sold more than 40% of its shares to a Middle Eastern bank in 2005 had it not been for the arrival of sanctions. “Today, we do about $6 billion of trade finance per year with a focus on food and pharma. We handle about 20% of the market share in food commodities and 50% of total pharmaceuticals.” But clearly, the potential is far greater, in terms of the obvious quick gains like trade finance, but also in areas such as private banking, asset management and offshore capital raising.

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When the doors open, what should we expect from capital flows? Renaissance Capital expects significant interest in Iran’s stock market, arguing that its rehabilitation into the west will create a re-rating play almost by definition. “We believe the reform drive might justify an overweight stance for EM strategists – If Iran was tradeable,” Robertson says.

The Tehran Stock Exchange is a surprisingly big and diversified market, with a market cap of over $100 billion even taking into account the currency’s devaluation, and 490 listed companies covering most of the sectors one would expect to find on a mature bourse. There is a futures market here, and Hassan Ghalibaf Asl, CEO and President, tells Euromoney an options market is under development, though shorting is not permitted at this stage. Online trading accounts for 15% of volume, Asl says, and there are several exchange-traded funds. Euromoney is aware of an online educational share trading program under development to help individual investors – of whom some seven million are licensed – to gain a better understanding of how markets work. A visit to the Tehran Stock Exchange, its dismal downtown building notwithstanding, is interesting: downstairs in the lobby, where stock prices flash on screens, there is an eager audience of grey-haired men in their 60s or older, watching their shares move, looking for tips, and generally enjoying the social side of it all.

Retail is, in fact, the biggest part of exchange turnover. Institutional investment come from the banks, from a reasonably development mutual fund industry, from insurers and the big investment company behemoths one finds in Iran (see box).

Then there’s FDI. Zarrabieh at Saman says “without any doubt” there will be funds wanting to come into Iran in one form or another. “This country can absorb everything now with respect to investment,” he says, “from mining to oil, trade finance up to project finance. In my opinion, the best way would be for strategic investors to come and buy into the insurance and banking industry, because that would be a doorway to invest into other sectors through them.”

Iran’s currency has devalued heavily in recent years, but one can make a positive case for this, both in terms of competitiveness of exports, and the allure to foreign investors who will get more for their money. “I believe that since the change in the exchange rates, prices are much more real in this country,” says Davoud at Bank Pasargad. “For investors who wish to bring in foreign currency, it’s much better now, and a much more secure environment for the conversion of riyal back to foreign currency again. They can feel much more confident that such a change in the exchange rate will not occur again.”

That said, the foreign investor on the FDI side will face a number of uncertainties and challenges. The accepted way in, much like China’s early days of openness, will be through partnership and joint venture, and that raises the question (also like China) of whom exactly one is dealing with.

“It can be quite difficult in Iran to know if the entity you are looking at is linked to the Revolutionary Guards or not,” says Henry Smith, senior analyst at consultants Control Risks. Since the early 2000s, he says, the Guards – who started out as the militia for the Ayatollah after the Iranian revolution – have taken a more overt role in business and the economy, and in many cases gained stakes in companies during the opaque privatization process through that decade. “There are implications for a company considering Iran, given that the Revolutionary Guards are in some sense enemy number one for the US. Anyone dealing with them automatically poses legal and regulatory risks for themselves.” Corporate records, he says, will only help to an extent, because often the principal of a company is a front for a retired general or his family members.

For capital moving in the other direction, the truth is that the real individual wealth has probably already found its way out of Iran through Dubai, Switzerland or London. But still, private banking operations are being developed, partly with the hope of assisting that capital overseas should it wish to go there. “Private banking is in its infancy,” says Zarrabieh. “What we offer now is primarily higher quality of current banking services: personalised services such as chequebook delivery to the client’s doorstep, better and more flexible interest rates, and more flexible deposit terms.” Saman does offer structured products, such as portfolio management and custodian services, “but not many clients are keen because of the relationship they have historically built up with stock brokers in the market. The services that are most attractive to them now are our concierge service, which basically offers booking tickets for movies or flight tickets at a discounted price, rather than a proper product we can earn fees out of.”

Nevertheless, the middle ground of premier banking has been the most successful area for Saman; premier and private services now encompass more than 60% of the bank’s deposit base. A private client, in Saman’s definition, is one with about $1 million of disposable assets, but it’s not a very large pool. “Many clients with more than a million either have a safe haven abroad, and just maintain working capital here,” he says, “Or are the so-called ‘new money generation’ who want to own 10 chequebooks from 10 different banks.”

So when banks find their way back in and once again navigate the immigration lines of Tehran Imam Khomeini Airport, and the everyday madness of the traffic, they will find opportunity for sure, but also the scars of an economy whose isolation and past mismanagement have left it brittle. Buyer beware.

BOX: MIDDLE EAST BANK

“What I’m trying to do,” says Parviz Aghili, “is to set up a bank that is accustomed with what is going on around the world.”

That institution is Middle East Bank, the newest in Iran and the only one not on any sanction list, and Aghili’s role models are international rather than Iranian. “I’ve set up proper corporate governance here, risk management, corporate compliance, risk management. And I’ve mostly hired youngsters who have had no background in state-owned banks. The average age here is 27 and we’re bringing them up in the way things are done in banking outside of Iran.”

Aghili is no fan of the way things are done in Iran, and is in a strong position to judge, having worked in the Iranian banking sector for many years. He fondly recalls the old days when he would rub shoulders with Chase, Bank of America, Citi, ABN Amro and many other foreigners who held offices in Tehran, many of them staffed by Iranians who had been educated overseas. “The banking system was really up to the level of international banking then.” He takes the view that when the foreigners left, and the state began a lengthy process of mergers, the people who ended up running the system were out of their depth. “The third tier of management who then started running the banking system had essentially no knowledge of how banking was run outside Iran.”

Fourteen years ago he set up Bank Karafarin, which he ran along what he believed to be international lines with a focus on international business for many years – it would have secured an IFC facility to set up a joint venture leasing company with Kuwait’s NBK had it not been for President Ahmadinejad’s arrival scaring off the IFC – before becoming disillusioned following the arrival of new shareholders trying to impose what he saw as old-school ideas, chiefly an obsession with the number of branches.  “Their mentality was: a bank means branches,” he says.

Not liking what was happening, he quit in 2010, and was swiftly told by the central bank that if he wanted to apply to start a whole new bank “I will give you a permit in 48 hours.” Nothing is simple in Iran – “Instead of 48 hours it took two and a half years” – but when Middle East Bank finally did appear, it was under a shareholding structure that stopped people bringing in family members or other affiliates as fellow shareholders, and which limited individuals to 5% holdings. Nevertheless, to get started the bank raised $400 million “in a matter of less than 10 days”, all of it in small amounts, with 30 individual investors contributing about 1% apiece.

Launching a new bank in an overbanked and sanction-blighted country is not an obvious step, but Aghili was hopeful of avoiding sanctions. Immediately he hired a law firm in Washington – Patton Boggs, since merged to become Squire Patton Boggs – to represent the firm to the Office of Foreign Assets Control, the arm of the US Treasury that sets sanctions. Aghili as an individual represented quite a compelling case: he studied in Wisconsin, and has American children who had settled in the country. But more importantly, the case he pitched to American regulators and Congressmen was that the business model would be based exclusively on the so-called humanitarian sectors that have consistently been exempt from sanctions. “That way, nobody could question us about what international business we were involved in.”

Staying true to this promise has sometimes involved some arcane distinctions – he has declined to import tetrapak containers that hold juice and milk, because it’s not clear if the packaging of drinks are off the sanctions list, or just the drinks themselves – but he insists the bank’s whole business premise is based on it being scrupulously clean. “Every time I have been asked to do something I am not comfortable with, I say: please, there are twentysomething other banks here, use any one of them. Allow one bank to stay clean from an international point of view for a rainy day. Then, if everything else is shut down, we can still import food and medicine when we need it Leave us alone.”

Despite this, Aghili has often found international banks to be wary of him and his bank. “Some Iranian banks have learned beautifully how to go around these rules and regulations and sanctions, and so international banks don’t want to risk it. They don’t believe there could be a bank here that is strictly following the rules and regulations.” Consequently, Middle East Bank’s monopoly in being free of US sanctions has not been the free kick one might expect. Aghili understands the problem. “After the BNP fine, I’d be scared too.”

If sanctions lifted, Aghili’s priorities would be to establish correspondent relationships with big international banks, to send his staff overseas for experience, and perhaps to invite foreign investment into his bank, provided it was a minority stake from a regional bank with a big international network. Trade finance would obviously expand and the cost of transactions would come down dramatically. However big it got, he’d still keep branches down to 20 or 25.

Aghili has bold visions for his country’s future: he paints a picture in which Iran could be completely independent of oil wealth, bolstering its petrochemical exports and other key products to the point that the oil revenue could be kept for a sovereign wealth fund. “A lot of Iranians have learned that you don’t have to produce everything domestically,” he says. “You can produce a few things that are very good, have proper international trade and play a good role in the region. There are something like half a billion people in Iran and neighbouring countries. That is a huge market.”

BOX: Ayandeh and bank mergers

Few bank mergers anywhere in the world have been more ambitious than the one that created Bank Ayandeh in Iran in 2013. It combined two financial institutions, a bank and 10 credit cooperatives into one, and did so in a country that has absolutely no regulatory guidance for how to do it and where staff layoffs are all but taboo because of vast national unemployment.

The man responsible for bringing it all together was Jalal Rasoulof, who has been immersed in Iranian banking and policy for more than 20 years. It’s easy to see why he was chosen for the task: a former deputy minister in the Ministry of Agriculture in the 1990s, he was given the task of winding down the insolvent Agricultural Bank and turned it from an agricultural fund into one of the better government commercial banks. He then ran two other private banks before taking on Ayandeh.

An immaculately presented man, he nevertheless exudes a certain fatigue from the effort involved. Asked what challenges the merger involved, his answer runs to 31 minutes. “I have 35 years of management experience, but when I compare this to my previous experiences it was most complex and difficult one,” he says. “But I’m sure it was the best and maybe the first big merger in the financial sector from the beginning of banking bureaucracy in Iran, which is more than 120 years.”

Problem number one: banks, financial institutions and credit cooperatives all operate under different regulations and supervisory environments. Two, naturally, each institution has its own culture, and they are all different. Three, there are no consultants or advisors you can go to in Iran to help with a merger, and there was no blueprint for how to go about it: while the state has forced banks together in the past, there has never been a private sector merger like this, or possibly at all. “We started by ourselves and we did everything by ourselves. From A to Z, it was planned by us.”

Next, Iran’s laws just don’t say anything about mergers. There is nothing in Iran’s commerce and trade law about it; there are resolutions that cover things like corporate governance, but they don’t touch upon M&A. In any event, the regulations about trade are very old and they considerably pre-date the revolution and the movement of the Iranian economy to a system that is, bank interest notwithstanding, wholly Islamic. Then there’s accountancy: Iranian banking accounting systems involve titles and sub-titles, and there are 6,500 of them in the regulations around banking, and just a handful for credit cooperatives. Each bank and institution brought its own accounting and technology systems, none of them technically compatible, and then there was the transfer of information to combine the books and exposures of 13 different institutions.

But perhaps the biggest problem was consolidation, both physical and human. He says he was forced to decrease the number of bank branches by three quarters, from 641 to 165, in the space of six months: 80 closures per month. But in Iran one cannot simply lay off all the staff, partly because of labour law, and partly because it just can’t be done. “It would have needed to dismiss at least 1600 people during this process,” he says. “Surely if we did this we would have had a bad social image against the bank. The attitude of the people would have been bad, and that of the parliament, which supports the people.”

He did institute an evaluation of the staff and get rid of those who couldn’t make the grade, but beyond that, he tried to find a way to keep everyone in employment. Many of the surviving branches have been upgraded to what he calls mega-branches, which allowed for bringing staff from closed branches into the bigger ones; this, he says, was popular too, since it gave a greater opportunity for broader experience and career advancement. Also, there is an affiliate business handling the electronic side of banking activity, and he was able to place many of them there, and in other linked businesses. “The important thing was not the size of the difficulty in closing the branches” – though he says this involved 9,000 discrete processes – “but how to reduce the staff in a country where you have a high rate of unemployment. Most people were young people who relied on the bank, and are married. It is very difficult: it is not the fault of the people that work in the branch that it is going to be closed.” Keeping so many, he says, was “kind of a miracle in the bureaucratic process.” It would no doubt be seen as weakness in the west, a failure to streamline and adapt, but processes and public perception are very different in Iran.

Next came training: 280,000 man hours of education to bring the knowledge and practices of 13 merged institutions’ employees into line.

Having succeeded in the merger, Ayandeh has well over 1.8 million customers, a strong capital base, and the heft to compete. Rasoulof is compiling accounts of the merger and a guide for other people who might attempt them, which he plans to give to the central bank – and there is no doubt in his mind that they will need it, since further mergers are necessary. “The most important thing for the health and soundness of a bank is capital,” he says, “and of all the banks just three or four of them have strong capital. Many others are small and cannot compete, particularly if the doors to the country are opened to foreign banks. On the other side, some banks have more than 2,000 branches, which can increase costs and are not to the benefit of customers. The country needs to merge some banks if it cannot solve the problem of bank capital.”

The interesting thing is, though, that not everybody agrees with this. One person within Iran’s state notes that, while Iran used to force mergers to happen, it is exceptionally difficult to do so, and that the laws and regulations are simply insufficient to allow it to happen smoothly. He does say, though, that the country’s many credit institutions, which operate without central bank licences and largely do what they want, could be ripe for mergers.

Besides, less banks are not the desirable certainty one might think. “The problem is not the number of banks, it’s the capacity of the banks,” says one executive at a major state-backed lender. “In fact, there’s not enough banks, or not enough with a big enough capital base. The shortage of available capital in Iran is very obvious.”

BOX: After the revolution – the Moszatazafan Foundation and Iranian investment companies.

After the Iranian Revolution overthrew the Shah in 1979 and the Grand Ayatollah Ruhollah Khomeini launched the Islamic Republic that exists today, there were a lot of assets the Shah and his followers had left behind as they fled Iran. These assets, and those of his followers, were gathered together as a bonyad, or charitable foundation, originally called the Bonyad Mostazafan and now called the Mostazafan Foundation of Islamic Revolution. It was to be invested in a range of economic sectors with a proportion of profits set aside “for the miserable people: that’s what Mostazafan means,” says Behzad Golkar, CEO at Sina Financial & Investment, one of the holding companies within the Foundation. He’s very specific about the word miserable, as opposed to poor: it has a focus on providing for the disabled and oppressed.

It is an enormous enterprise. Golkar says the foundation is made up of 200 individual companies split across 19 holding companies; Sina is just one of those holding companies yet includes a bank, two brokerages, mutual funds, an insurer and a leasing business, with plans to build an investment bank well underway. The other 18 cover pretty much every imaginable area of the economy, and between them the foundation companies employ 27,000 people directly and thousands more indirectly. It’s hard to speak of an asset base – under Iranian accounting, assets are booked at their original value, which in some cases have since been invested for 35 years – but group turnover in 2012-13 was the equivalent of US$5 billion. Assuming an asset base seven to 10 times that size, it could be a $50 billion enterprise.

The thing is, that might not even be the biggest institution in Iran. Iran’s Social Security Fund, and the SHASTI investment arm, is almost certainly bigger, and there are many other conglomerate or holding company-styled institutions, among them Kharazmi Investment Co, Ghadir Investment Company and the Armed Forces Pension Fund. Many of these, including Kharazmi and Ghadir, are listed, and appeal to retail investors because they can gain exposure to a broad range of economic sectors through a single investor.

Even the Revolutionary Guards, the feared second army that has reported directly to the country’s Supreme Leader ever since 1979, is a significant investor. “They have always had a key role in securing the Islamic republic and through the eight years war with Iran, and that brought them significant practical and political influence,” says Henry Smith at Control Risks. Adam Szubin, director of the OFAC arm of the US Treasury that sets sanctions, told Congress last year the Guards were “Iran’s most powerful economic actor,” dominating energy, construction and banking. Over the years, and particularly during Iran’s privatization process, the Guards became quite the corporate behemoth, with tentacles spreading into every area of Iranian life and economy activity. It is, by some accounts, the second or third largest chunk of institutional wealth in the country.