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Cablegate: Banking System Impedes Investment in Kurdistan

VZCZCXRO9977
RR RUEHBC RUEHDA RUEHDE RUEHIHL RUEHKUK
DE RUEHGB #2844/01 2371236
ZNR UUUUU ZZH
R 251236Z AUG 07
FM AMEMBASSY BAGHDAD
TO RUEHC/SECSTATE WASHDC 2996
INFO RUCNRAQ/IRAQ COLLECTIVE
RUEATRS/DEPT OF TREASURY WASHDC

UNCLAS SECTION 01 OF 02 BAGHDAD 002844

SIPDIS

SENSITIVE
SIPDIS

E.O. 12958: N/A
TAGS: ECON EFIN IZ
SUBJECT: BANKING SYSTEM IMPEDES INVESTMENT IN KURDISTAN
REGION

REF: BAGHDAD 1239

1. This is a Kurdistan Regional Reconstruction Team (RRT)
cable.

2. (SBU) Begin Summary: Private sector leaders and senior
government officials recently told PRTOff that the Dohuk
Governorate's primitive banking system remains the single
largest impediment to the province's economic development.
The province's eight banks have limited technological
capabilities, and the banks are unable to conduct electronic
transfer of funds to each other. This perpetuates an
inefficient, unsecured, and opaque (from a record-keeping
perspective) cash-based payment system for goods and
services. The implementation of capital investment projects
-- initiated both locally and from abroad -- suffers from
transaction inefficiencies, security issues, and the
heightened overall business risk premium associated with
frequently transporting and deploying large amounts of cash.
In addition to the debilitating effects of their primitive
technological capabilities, banks throughout the Kurdistan
region suffer under the Iraq-wide systemic impediments
identified in the March 2007, USAID-funded, Izdihar project
report on the country's banking system. These include Center
Bank of Iraq (CBI) disincentives to lending, poorly qualified
and trained management and workers and insufficient internal
and external auditing. Absent significant investments in
training and technology, as well as implementation of the CBI
reforms recommended in the Izdihar report, the Kurdistan
region's dysfunctional banking system will continue to impose
substantial opportunity costs on capital investment and GDP
growth. End Summary.

----------
Background
----------

3. (SBU) Senior representatives from the Dohuk Governorate,
the Dohuk City chamber of commerce, Rafidain Bank (State
owned; Iraq's largest bank; largest bank operating in Dohuk),
and the Iraq Middle Market Development Foundation (IMMDF)
told PRTOff on August 16 that the province's undeveloped
banking system must be improved, in order for Dohuk and the
rest of the Kurdistan region to attract significant foreign
investment -- especially from countries other than Turkey.
Western businessman have repeatedly cited the lack of a
properly functioning banking system as a major factor in
their foreign direct investment decision-making process.

4. (U) Most of the problems identified with the Dohuk banking
system are endemic within the Kurdistan region's other two
governorates of Erbil and Sulaimaniyah. While non-bank
lenders such as the IMMDF and micro lender Al Thiqqa have
stepped into the market and experienced high demands for
loans, their activities remain dwarfed by those in the formal
banking sector.

---------------------------------------
Technological Limitations: Cash is King
---------------------------------------

5. (SBU) Eight banks currently operate in Dohuk Governorate,
five of which are state-owned. Each bank operates as an
electronic island unto itself. No system exists to handle
inter-bank transfers of funds. As bank customers are unable
to initiate an electronic funds transfer from their own bank
to a business or individual holding an account at another
bank, even large business to business transactions are
conducted on a cash basis. Jameel Mohammed Diab, the head of
Rafidain Bank's operations in Dohuk City, told PRTOff
recently, "It's a largely cash economy here." He explained
that non-Turkish foreign investors have shied away from
investment in Dohuk, in large part due to the inefficiencies,
physical risks, and record-keeping challenges posed by
enacting business transactions in cash. Jameel's comments
were confirmed by the Chairman of Dohuk City's Chamber of
Commerce, Ayad Abdulhalim, who stated, "Our bad banking
system is our number one economic problem. It prevents us
from attracting more foreign direct investment." Jameel's
comments mirror those of the Chairman of the Sulaimaniyah
Chamber of Commerce, who spoke with us in April 2007 (reftel).

--------------------------------------
CBI Impedes Development of Bank Sector
--------------------------------------

6. (U) In addition to surmounting their primitive
technological capabilities, Dohuk banks face systemic
development impediments emanating from CBI practices and
policies. According to a March 2007 analysis of Iraq's

BAGHDAD 00002844 002 OF 002


banking system by the USAID-funded Izdihar project, the CBI
pays banks an annual interest rate of 20 percent on the
banks' 30-day deposits with the CBI. This is risk free income
for the banks and poses a significant disincentive to bank
lending. Comment: Why would banks choose to lend their funds
to customers, who may or may not repay the loan, when the
banks can earn more by investing their funds risk free with
the CBI? End Comment. Indeed, under such circumstances,
Iraq's banks exhibit very low levels of lending volume,
relative to international norms.

7. (U) According to the Izdihar report, over half of Iraqi
private bank assets were in cash or deposits with the CBI in
2005 (latest statistics available). In comparison, Western
commercial banks typically hold less than five percent of
their assets in liquid form as the potential for higher
earnings exists in lending to the private sector. Among its
other recommendations, the Izdihar report stated that the CBI
should either reduce the rate it pays on funds deposited with
the CBI by Iraqi banks, or limit the amount of such deposits.

8. (SBU) Other systemic problems hamper the development of
the region's banks. Jameel stated that Rafidain Bank's loans
are always collateralized by real estate or other hard
assets, and the interest rate charged on loans is
standardized for all borrowers. In his opinion, this obviates
the need for a risk assessment of the borrower. As a result
of such institutionalized practices, the five
government-owned banks in Dohuk Governorate lack sufficient
risk management capabilities at both the tactical (i.e.
individual loans) and strategic (loan portfolio) levels.

9. (SBU) Coupled with the CBI's cursory auditing of banks'
operations and the CBI's limited requirements for the
production of meaningful financial statements and statistics,
these impediments make the true credit risk embedded in any
bank's portfolio is difficult to determine. The Dean of Dohuk
University's College of Economics, Khalil Ghazi Besfki, told
PRTOff on August 16, "The banks will do OK as long as land
prices continue to rise, but we don't know what will happen
if they fall." To help bolster oversight of lending
portfolios at both the CBI and individual bank levels, the
March 2007 Izdihar banking report recommended that the CBI
require annual assessments of all existing commercial credit
facilities, rather than the currently required biennial
reviews.

-------
Comment
-------

10. (SBU) Kurdish regional banks have been largely
ineffective. They have not fulfilled their primary economic
role of attracting deposits and lending money to qualified
borrowers at a rate commensurate with the assumed credit
risk. The absence of these primary banking services has
resulted from a lack of market-based improvements of the
banking sector in the Kurdistan region and across Iraq, both
prior to and after the 2003 U.S.-led invasion. Even with its
relatively secure environment and its July 2006 investment
law that allows a foreigner to own a bank (as opposed to the
national investment law which prohibits foreign ownership of
banks), few foreigners have considered establishing banking
operations in the Kurdistan region. The Kurdistan region is
not a nation, and its banking system remains subject to
oversight and control from the CBI. Absent implementation of
the CBI reforms recommended in the Izdihar report, as well as
significant investments in training and technology, the
region's banking system will remain dysfunctional and largely
bereft of foreign direct investment. Problems in the banking
sector -- and the cash-based economy resulting from them --
will continue to restrain capital investment and GDP growth
across virtually all other economic sectors in the Kurdistan
region. End Comment.
CROCKER

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