REPUBLIC OF IRAQ FINANCIAL SECTOR REVIEW

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1 REFERENCES 219

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3 EXECUTIVE SUMMARY REPUBLIC OF IRAQ FINANCIAL SECTOR REVIEW

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5 EXECUTIVE SUMMARY iii Middle East and North African Region REPUBLIC OF IRAQ FINANCIAL SECTOR REVIEW A Study Led By SAHAR NASR

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7 EXECUTIVE SUMMARY v Contents FOREWORD PREFACE ACKNOWLEDGEMENTS EXECUTIVE SUMMARY I. INTRODUCTION II. MACROECONOMIC ENVIRONMENT AND RISKS III. FINANCIAL SECTOR OVERVIEW IV. THE BANKING SECTOR A. State-owned Banks B. Private Commercial Banks C. Islamic Banks D. Access to Finance E. Payments System V. BANKING SUPERVISION AND REGULATION A. Assessment of the Effectiveness of Banking Supervision B. Supervisory Rules and Practices C. Risk Management D. Legal Framework for Islamic Banking VI. CAPITAL MARKETS A. Capital Market: the Current Position B. Preconditions for Developing the Capital Market C. Capital Market Regulations D. Issuers and Infrastructure E. Developing the Capital Market Investors VII. THE INSURANCE AND PENSION SECTOR A. The Insurance Sector B. The Pension Sector VIII. CONCLUSIONS AND POLICY RECOMMENDATIONS A. Banking Sector B. Banking Supervision C. Capital Market D. Insurance and Pension E. Overall Recommendations to Enhance the Financial Sector in Iraq REFERENCES ix xi xiii xv

8 vi ANNEXES Annex 1: Restructuring of Rafidain Bank Action Plan Annex 2: Restructuring of Rasheed Bank Action Plan Annex 3: Joint CBI MOF Memorandum of Understanding Restructuring of Rafidain Bank Annex 4: Joint CBI MOF Memorandum of Understanding Restructuring of Rasheed Bank Annex 5: Framework for Institutional and Operational Restructuring of State-owned Banks Annex 6: Banking Supervision Acton Plan Annex 7: Informal Assessment of Banking Supervision in the Republic of Iraq Annex 8: IOSCO Objectives and Principles of Securities Regulation: Informal Assessment Annex 9: An Example of Minimum Disclosure Requirements for a Prospectus Annex 10: Informal Assessment of the IAIS Core Principles for Effective Insurance Supervision Annex 11: Consolidated Statement of Banks Annex 12: Consolidated Statement of State-owned Banks Annex 13: Consolidated Statements of Commercial Banks Annex 14: Consolidated Statements of Commercial Banks (without Islamic Banks) Annex 15: Consolidated Statements of Islamic Banks Annex 16: Banking Ratios Annex 17: Banking Indicators Annex 18: Financial Sector Reform Action Plan TABLES Table 2.1: Economic Activities as a Share to GDP Table 2.2: Iraq Annual Inflation Rates ( ) Table 4.1: Illustrative Adjusted Balance Sheet Items ( ) Table 4.2: Iraq Structure of Banks Adjusted Balance Sheet (2010) Table 4.3: Iraq Breakdown of Credits (2009) Table 4.4: Iraq Household Borrowing (2007) Table 6.1: Market Capitalization Major MENA Equity Markets + ISX Table 6.2: Average Daily Market Value Traded Major Mena Markets + ISX FIGURES Figure 2.1: GDP by Economic Activity Figure 2.2: Financial Sector as a Share to GDP Figure 2.3: Daily Average Exchange Rate Figure 2.4: Central Bank Reserves Figure 4.1: Structure of Oversight Committees Figure 6.1: Broker s Proprietary Index BOXES Box 4.1: Rafidain Bank and Rasheed Bank Box 5.1: Supervision and Restructuring of Rafidain Bank and Rasheed Bank

9 EXECUTIVE SUMMARY vii LIST OF ABBREVIATIONS AND ACRONYMS AGM ALM Annual Meeting of the General Assembly Asset and Liability Management INI IOPS Iraq National Insurance Co. International Organization of Pension Supervisors AML BCP BRU BSA CBI CFT CIS COM CPA DFI E&Y FATF FRP FSVC GSRS HRD IAIS ICBG Anti-money laundering Basel Core Principles for Effective Banking Supervision Bank Reconciliation Unit Board of Supreme Audit Central Bank of Iraq Combating the Financing of Terrorism Collective Investment Schemes Council of Ministers Coalition Provisional Authority Development Fund for Iraq Ernst and Young Financial Action Task Force Financial Restructuring Plan Financial Services Volunteer Corps Government Securities Registration System Human Resources Development International Association of Insurance Supervisors Iraqi Company for Bank Guarantees IOSCO ISA ISC ISX METAC MLRO MOU NBP NPL ORP PCB PCR PMU PRISTA ROC ROSC RTGS SBA International Organization of Securities Commissions International Standards on Auditing Iraq Securities Commission Iraq Stock Exchange Middle East Regional Technical Assistance Center Money Laundering Reporting Office Memorandum of Understanding National Board of Pensions Non Performing Loan Operational Restructuring Plan Private Credit Bureaus Public credit reporting systems Project Management Unit Pension Reform Implementation Support Technical Assistance Restructuring Oversight Committee Report on the Observance of Standards and Codes Real Time Gross Settlement Stand-By Arrangement ICF Iraqi Company for Financing SMEs SME Small and Medium Enterprise ICP ID IDC IFAC IFRS IFSB ILO IMF Insurance Core Principles Iraqi Dinars Iraq Depository Center International Federation of Accountants International Financial Reporting Standards Islamic Financial Services Board International Labor Organization International Monetary Fund SORP SPF TBI UCITS US SEC XBRL Strategic and Operational Restructuring Plan State Pension Fund Trade Bank of Iraq Undertakings for Collective Investment in Transferable Securities United States Securities and Exchange Commission Extensible Business Reporting Language

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11 EXECUTIVE SUMMARY ix FOREWORD This report was initiated at the request of the Iraqi government to get a better understanding of the overall financial sector in Iraq. The main objective of the report was to develop a comprehensive assessment of the financial sector. The report assessed the impact of recent reforms introduced by the Iraqi government and the Central Bank of Iraq on the performance and soundness of the financial sector, as well as the sector s contribution to enhancing Iraq s economic growth. It followed a forward-looking developmental approach, identifying key challenges and priority areas of reform moving forward. This review came at a very opportune time in light of the need to respond to the potential impact on the Iraqi financial sector of the global financial challenges, and the need to ensure that the momentum behind reform efforts does not slow down. Furthermore, with the current political situation in Iraq, there is a need for additional policy guidance to identify new reform priorities, especially now that the first phase of the reform program is coming to closure. Key findings of the report are as follows: (i) Iraq s financial sector is dominated by the banking system, with most assets held by state-owned banks; (ii) many private banks are in the process of developing modern banking practices, but still need further strengthening and consolidation; (ii) other financial markets are concentrated at the Iraqi Stock Exchange but capitalization is low, and few instruments are traded; (iii) the insurance sector is small, dominated by state-

12 x owned enterprises, and is not supervised; (iv) weak financial infrastructure is a clear impediment to access to finance; and (v) SME and microfinance is not well developed. While work should commence on a broad range of issues, some key decisions need to be taken immediately, while others may be implemented over the medium term. Key issues to be addressed up front are the role of state banks and the creation of a level playing field for all banks. This will need to be followed by the early adoption of the proposed permanent Securities Law and steps to turn the insurance Diwan into an effective supervisor. Supporting ongoing efforts will be needed to address financial sector infrastructure, including supervision, credit registry, collateral framework, judicial systems, and accounting and auditing frameworks. A number of the issues raised in this report are already being addressed by the Banking Sector Reform Strategy initiated by the government in Loïc Chiquier Sector Director Finance and Private Sector Development Middle East and North Africa Region The World Bank Hedi Larbi Country Director for Iraq Middle East and North Africa Region The World Bank

13 EXECUTIVE SUMMARY xi PREFACE The Government of Iraq in February 2009 embarked on a comprehensive two-phase Banking Sector Reform Strategy ( ), endorsed at the highest political level, with the objective of modernizing its banking system. The strategy has received the support of the World Bank and other international partners. Financial sector work in Iraq has thus far focused on strengthening the two state-owned banks and on improving the overall regulatory framework. The Iraqi government, the Ministry of Finance, and the Central Bank of Iraq have been keen on the effective implementation of this strategy, and significant progress has already been made, evident in continued work on the financial and operational restructuring of the state-owned banks. In an effort to strengthen the financial sector infrastructure, a set of prudential regulations applicable to all commercial banks was published in January Efforts have been undertaken to strengthen supervisory and regulatory authority, and several measures to improve the banks governance have been taken. Also, improvements have been made in the regulations regarding risk management, and the basic elements for banking supervision are in place. On the non-bank front, the Iraq Stock Exchange provides a good foundation for capital market development, and more attention would be given to the insurance and pension sectors. The progress and pace of the reforms, viewed against a difficult security and political situation, have been commended by donors and the international

14 xii community. However, we are aware that we still have some way to go to fully reform the sector and address its main challenges. The Government of Iraq will continue to foster efforts on enhancing the financial system, and ensuring economic growth. We hope that the findings and recommendations of this report would assist in the ongoing endeavors to meet this challenge. Dr. Sinan Al Shabibi Governor Central Bank of Iraq The Republic of Iraq Dr. Rafie El Essawi Minister of Finance Ministry of Finance The Republic of Iraq

15 EXECUTIVE SUMMARY xiii ACKNOWLEDGEMENTS The Iraq Financial Sector Review was prepared by a core International Bank for Reconstruction and Development (IBRD) team led by Sahar Nasr, Task Team Leader and Lead Financial Economist; and comprised of Arne Petersen, Banking Sector Consultant; Jan Van der Vossen, Basel Core Principle Consultant; Nabil Hashad, Banking Supervision Consultant; Richard Britton, Capital Market Consultant; Sibel Kulaksiz, Senior Economist; Erik Huitfeld, Insurance Sector Expert; and Laila Abdelkader, Finance and Private Sector Development Analyst. Basant Abdelmonsef, Research Assistant; Marwan Ezz Al Arab, Research Assistant; Amira Zaky, Program Assistant; May Ibrahim, Program Assistant and Rola Assi, Team Assistant provided extensive support. Special gratitude is also due to Hedi Larbi, Country Director (MNCO2); and Mr. Loïc Chiquier, Sector Director (MNSFP) for their guidance. Thanks are also due to Mr. Simon Bell, Sector Manager (MNSFP). Special thanks to Dale Lautenbach, Communications Advisor (MNAEX), for ensuring the report s effective dissemination and outreach. The authors are grateful to the peer reviewers, Ms. Zsofia Arvai, Senior Economist (IMF); and Mr. Åke Lönnberg, Senior Financial Sector Expert, Monetary and Capital Markets Department (IMF). The team would also like to thank in particular Mr. Ziad Badr, Senior Country Officer (IFC), for his cooperation. The World Bank Group greatly appreciates the close collaboration with the Government of Iraq. Special gratitude and appreciation goes to H.E. Dr.

16 xiv Rafie El Essawi, Minister of Finance; H.E. Dr. Sinan Al Shabibi, Governor, Central Bank of Iraq (CBI); H.E. Dr. Abdul Razzak Al Saadi, Chairman, Iraq Securities Commission (ISC). Thanks are also due to Dr. Ahmed Al-Juboori, Deputy Governor, CBI; Dr. Shaker Salman Fayad, Economic Advisor to the Minister of Finance Mr. Waleed Eidy, Director General of Banking Supervision Department, CBI; Mr. Abdel Abbas Khalaf Sultan, Chairman, Board of Supreme Audit (BSA); Mr. Faeq Kassab, Chairman, the Iraq Stock Exchange (ISX); Mr. Taha Abdulsalam, Managing Director, ISX and Dr. Huda Hadi, Advisor to the Minister of Finance and Head of Bank Reconciliation Unit. The team also wishes to thank Mr. Kadhim Nashoor, General Manager of Rasheed Bank; Mr. Muhsin Abd Hassan, Deputy Manager of Rafidain Bank. The authors are grateful to the guidance provided by the various stakeholders and private banks, especially Dr. Abdul Aziz Hassoun, Director General, Iraq Private Banks League; Mr. James Hogan, Chief Executive Officer, HSBC Dar El Salam, Iraq; Mr. Sadik Fadhil Ullaiwy, Director General, National Insurance Company. The team would also like to thank Dr. Majid Al Souri, Director, Iraq Banking Sector Reform Project Management Unit (PMU); Ms. Leena Khider, Procurement Officer, PMU; and Ms. Lamees Tobia, Financial Officer, PMU. The authors would also like to acknowledge the countless other individuals from the banking, insurance and capital markets sectors who have contributed to the preparation process. This report was prepared in close collaboration with partners in development, specially the International Monetary Fund and the US Treasury. Special thanks goes to Mr. Ron Van Rooden, Mission Chief for Iraq, Middle East and Central Asia Department, IMF as well as colleagues from the US Treasury, Mr. Michael Ruffner, Director, Office of Technical Assistance; Mr. Paul Leonovich, Associate Director for Banking and Financial Services; Mr. Khalid Simaan, Banking Advisor; and Mr. Thomas Howell, Expert. Earlier versions of this report have been presented and discussed at workshops in Baghdad and at a High Level Forum in Istanbul in which different stakeholders participated, including bank and non-bank financial institutions both public and private, private sector, civil society, academia, government officials, and the supervisory and regulatory bodies. We would like to take this opportunity to thank all the people in government, financial donor, and academic communities who have provided their time, thoughts and contributions to the team and to the study.

17 EXECUTIVE SUMMARY xv EXECUTIVE SUMMARY The link between sound and well-developed financial systems and economic growth is a fundamental one. Empirical evidence, both in developing and advanced economies, has shown that countries with developed financial systems grow at faster rates. Efficient and prudent allocations of resources by the financial system is crucial for increasing productivity, boosting economic development, enhancing equality of opportunity, and reducing poverty. Getting the financial systems of developing countries to function more effectively in providing the full range of financial services is thus a task that will be well rewarded with economic growth. This report takes a first look at the overall financial system of Iraq with a forward looking approach. At the outset it was agreed with Iraqi authorities that the focus of this review should be forward looking and constructive. Overall the financial sector in Iraq is underdeveloped, and is playing a limited role in financial intermediation. The banking system is still by far the most important part of the Iraqi financial system, accounting for more than 75 percent of the assets and dominated by state ownership. Non-bank financial institutions and markets are small and under-developed but have the potential to provide access to sources of finance. Access to finance is impeded by weak financial infrastructure, which needs to be strengthened over time in all areas, including credit registry, the collateral framework, judicial systems, and accounting and auditing skills. When looking at Iraq s financial system it is important to keep the general political economy in

18 xvi mind. The difficult security situation imposes costs and constraints, the complex political situation impedes decisive policy action, governance issues linger, and the legacy of prevailing state intervention has not been fully addressed. Banking System The banking system is still by far the most important part of the financial system, accounting for more than 75 percent of the assets. Seven state banks dominate the banking system (in particular, Rafidain Bank, Trade Bank of Iraq (TBI), and Rasheed Bank). Private banks are generally quite small and many have been established relatively recently. Seven of the 36 private banks have foreign participation and eight operate according to Islamic principles. Official figures vastly overstate assets of Rafidain Bank and Rasheed Bank (because of carryover of valuation losses equivalent to the double of GDP); staff estimates indicate that state banks account for 86 percent of bank assets and 69 percent of credits. The banking system is small, with an adjusted asset to GDP ratio of 73 percent compared to 130 percent for the Middle East and North Africa (MENA) region. Although growing rapidly in 2010 credits to the economy only amount to 10 percent of GDP compared to 55 percent for the MENA region. As a corollary, banks are very liquid; foreign assets and deposits at the Central Bank of Iraq (CBI) amount to 63 percent of assets. The operations of Rafidain Bank and Rasheed Bank (the two large state banks with country wide branch network) are inefficient and the two banks suffer from the legacy of past losses as well as from carrying out of quasi fiscal operations. Reform of the two banks has been significantly delayed from what was envisaged in a 2006 Memorandum of Understanding (MOU) between the CBI and the Ministry of Finance. Several committees have been working but little progress has yet been achieved, including in the technical area of cleaning up the two banks balance sheets. A World Bank project has been supporting the reform process since The reform process for Rafidain Bank and Rasheed Bank needs to be accelerated, including through the carving out of disputed items from their balance sheets and their transfer to a new asset/liability management company. More fundamentally, the authorities need to consider the relative roles they wish to assign to state banks and private banks, including the role to be assigned to the TBI. The TBI was set up as a specialized trade bank, but now operates as a general commercial bank and has become an important player in the financial system. As part of this overall strategy, state banks must become subject to normal supervision by the CBI. Private banks operate on an uneven playing field. State banks benefit from the perception of a de facto deposit guarantee and from restrictions imposed on the operations of the private banks. Government, government agencies, and state

19 EXECUTIVE SUMMARY xvii owned enterprises are not allowed to place deposits with private banks. Nor can state-owned enterprises receive loans from private banks. Moreover, payments to the government (taxes and other payments) cannot be effected by check drawn on a private bank. Discussions are under way among private banks to set up a self-funded deposit guarantee fund, but these are at an early stage. The strength and business expertise of the 36 small private banks appears to be improving. Several of them are offering a full range of products, including consumer loans. However, staff skills are often weak, the range of services provided by many banks is still limited, and loans are mainly short term loans related to wholesale and retail trade. Because of their small size, private banks are not yet able to finance large projects, as syndication is not yet used. Some observers and CBI officials question the professionalism of private banks and are concerned that they are not yet able to effectively support rapid economic growth. Foreign banks have shown increasing interest in conducting business in Iraq. While initially some of the foreign banks are mainly oriented towards foreign companies doing business in oil and related activities, over time they should help improve the overall banking climate and help stimulate the development of the financial sector. Profitability of banks is in general good, but a decline in profits for private banks in 2010 needs watching. State banks are de facto exempted from meeting prudential requirements, and some of them would otherwise fail because of low capital. Prudential indicators for most private banks are strong, except for three banks. Prudential and performance indicators for Islamic and conventional private banks are broadly similar, but Islamic banks fund themselves more from capital and give a larger share of long term loans. There is concern among some market participants and observers that banks may be weaker than they appear as accounting and auditing standards are lax and banking supervision is not in all cases fully effective. Nevertheless, most banks appear to be well capitalized, and with a continuous strengthening of banking supervision and financial infrastructure and a leveling of the playing field, the majority of private banks should be able to continue to grow and improve and gradually provide the financial underpinning of stronger non-oil growth. The planned gradual increase in minimum capital requirements will help promote consolidation and further strengthen the private banks. State banks will also need to increase capital to help level the playing field. The banking system does not appear to give rise to significant macro-prudential risk at present. Private banks are small, highly liquid, and have strong prudential indicators. While Rafidain Bank and Rasheed Bank clearly require recapitalization, they are still highly liquid, with cash, deposits at the CBI, and foreign assets covering 97 percent of private deposits. Bringing the capital level of all state banks up to the new minimum level by June 2013 could require a

20 xviii capital injection equivalent to 1.4 percent of GDP, if a risky assumption is made as to the actual level of capital in Rafidain Bank and Rasheed Bank. As noted above, bank credit is relatively low and access to other forms of finance also needs improvement. A USAID project team has estimated that less than 5 percent of SME s in the formal sector have ever received a bank loan. The authorities and donors have only recently started to focus on micro-finance. There are no good estimates for unsatisfied credit demand. As a simple yardstick, to bring the credit to GDP ratio from 10 percent to GDP to the average level for MENA countries of 55 percent will require an increase in credit of ID 45 trillion. The planned increase in bank capital levels will be sufficient to support such a lending level. However, depending on whether credit growth does not outpace banks risk management skills, nor the capacity of the CBI to supervise banks rapid growth, such an increase in credit within a short time typically bears the risk that asset quality deteriorates. Weak financial infrastructure is a clear impediment to access to finance in Iraq. Actions are needed in all areas, including credit registry, the collateral framework, judicial systems, and accounting and auditing skills. Improving the accounting and auditing skills, and over time moving to international standards, are particularly important, both to help ensure the transparency of banks and to allow banks to identify creditworthy clients. More reliable accounts are also key for better quality share issuance prospectuses, and for the development of reliable financial media. Iraq was last among Arab countries in the survey of Doing Business in the Arab World 2011 and the authorities must undertake a concerted effort to improve the business environment and to strengthen the real economy through revitalization and privatization of the state-owned enterprises. The Iraqi payments system is relatively well developed, representing in part significant technical support from foreign donors. A real time gross settlement (RTGS) system and an electronic netting system for smaller payments orders were implemented in An electronic clearing system for checks is expected to be operational at the end of 2011 and the authorities are working with donors to further strengthen the retail payment system, including through a universal switch for bank cards. Nevertheless, the use of cash remains high. Banking Supervision The Iraqi system of banking laws and regulations provides a workable framework for the exercise of banking supervision, provided the rules are implemented and enforced vigorously. A full expert-assisted self-assessment of the supervisory system, based on the Basel Core Principles and the 2006 assessment methodology, is required to help further align the system to international standards.

21 EXECUTIVE SUMMARY xix However, for the CBI to be able to fully deploy effective supervision, three main conditions need to be met: (i) the political will to let the CBI perform its tasks without interference also with regard to state owned banks, using the laws, regulations and its professional judgment, (ii) assurance that the state owned banks which hold by far the majority of banking system assets, are effectively supervised by the CBI in full accordance with the 2006 Memoranda of Understanding (MOU) between the CBI and the Minister of Finance, (iii) the CBI has the necessary resources in terms of quantity and quality -to take on the supervision of these large institutions with their many branches. For optimal effectiveness of the current set of rules and regulations, enforcement needs to be strengthened, and banks rated three under the CAMELS system need to be carefully monitored to prevent further slippage in safety and soundness in the current environment in Iraq. Banks financial and prudential information needs to become more reliable and more rapidly accessible, through introduction of fully International Financial Reporting Standards (IFRS)-compliant accounting standards, internationally acceptable auditing standards, and a chart of accounts to assure consistency across the system in compiling figures needed for IFRS compliant accounts. Obligations to publish timely audited financial statements must be enforced more forcefully. Islamic banks must be brought under the purview of regular CBI regulations and supervision through rapid adoption of the draft Islamic banking law, and the associated regulations. Politically supported, strong concerted efforts must be made to prevent abuse and undermining of the financial system through corruption, money laundering and the potential financing of terrorism. Capital Markets The capital market in Iraq is concentrated on the Iraq Stock Exchange (ISX). The stock exchange is small and under-developed but has potential to provide issuers with access to sources of permanent and long term capital via the issuance of equity and corporate bonds to institutional and retail investors, domestic and foreign. It is currently at a crucial stage of its development. Activating the privatization program in a way which would place at least a proportion of the shares of currently state owned companies into the hands of Iraqi citizens and institutional and foreign portfolio investors could, over several years, see ISX rival its regional peers in size and depth. It is probable that there is (unsatisfied) demand from life insurance companies and pension funds for medium/long term debt securities in order to match long term liabilities with long term assets. There appears to be no issuance of such securities currently by either the government or the private sector. The absence of government debt beyond one year inhibits the latter as there is no risk free yield curve off which to price corporate bond issues.

22 xx Capital market development requires improvements in all of the necessary underpinnings of a market in which issuers and investors can have confidence. These include the laws on contract enforcement, shareholder and creditors rights, efficient and fair judicial processes, corporate governance and accounting and auditing standards which (at least) match regional benchmarks. It also requires an effective, fair and efficient regulatory framework within which to operate. This should have as its objectives the protection of investors, ensuring that the market is fair, efficient and transparent and the reduction of systemic risk. Legislative change to achieve these ends had been discussed since 2008 and steps should now be taken to implement it. This report sets out some amendments which would provide enhancements to the current draft permanent Securities Law. They would also provide a stronger foundation on which the permanent Iraq Securities Commission (ISC) could draft and enforce its regulations. Currently little is known about the interim ISC s capacity, competences or goals as it did not take part in the review process. It appears however that the current legislative and regulatory framework under which the ISC operates is weak and underdeveloped. The current Company Law, although amended in 2004, was written in 1997 and also needs further updating to better achieve good corporate governance in joint stock companies and to secure improved shareholders rights. This report sets out and prioritizes thirteen recommendations for change. They include legislative and regulatory improvements, changes to market infrastructure, the development of new capital market based products to attract investors and measure to expand the size and depth of the capital market. Insurance and Pensions Sectors The insurance sector in Iraq is dominated by the state owned insurance companies that benefit from being the sole provider of insurance services to the government. The law requires the government to make use of a public tender process when purchasing insurance services, but even though the public process is used there is little trust in the market in its fairness, because it is always the state owned insurance companies that are awarded the contracts. There are a number of private sector insurance companies but the number is uncertain because some of them are very small and sometimes it is unclear whether these small companies are active. The participants in the insurance sector feel a strong need for strengthening of the supervision of the insurance sector. The government has taken some measures to improve the legal and supervisory framework for the insurance sector. A new insurance law The Insurance Business Regulation Act from 2005 has been passed and a supervisor has been established. The next steps now should be for to make the supervisor operational so that its existence is made known to the market participants and it commences the supervisory activity the present legislation allows it to conduct.

23 EXECUTIVE SUMMARY xxi The present insurance legislation should also be strengthened so it is brought in compliance with the international best practice standards. It is particularly important that the new legislation provides the supervisor with the needed power to conduct on-site inspections at the insurers place of business. The long-term goal should be to establish a modern legal framework and proper supervision of the insurance sector. The pension sector in Iraq is presently going through a transition period with the combination of the existing pension system into one unified pension fund. A law was passed to allow for this unification into one pension fund. The World Bank is helping out through the PRISTA project to make this unified pension fund operational. The present organization of the pension funds does not provide proper protection of the participants fund and does not include requirements to supervision of the pension fund. It is very important that these elements are incorporated now, because it will be very difficult to establish these protections once the new fund has been established. Summary of Key Recommendations While work should commence on a broad range of issues, some key decisions need to be taken immediately, while others may be implemented over the medium term. Key issues to be addressed up front are the role of state banks and the creation of a level playing field for all banks. This will need to be followed by the early adoption of the proposed permanent Securities Law and steps to turn the insurance Diwan into an effective supervisor. Supporting ongoing efforts will be needed to address financial sector infrastructure, including supervision, credit registry, collateral framework, judicial systems, and accounting and auditing frameworks. A crucial step, also to signal seriousness of intent, is to clean up the balance sheet of Rafidain Bank and Rasheed Bank, which has been under discussion since Since more time may be required to clarify some of the disputed items on the balance sheet, the best approach will be to transfer disputed assets and liabilities of the two banks to a newly created asset/liability management company to permit the slimmed down Rafidain Bank and Rasheed Bank to focus on moving forward with their operational restructuring. The latter process is well formulated in the 2006 memorandum of understanding between the Ministry of Finance and the Central Bank of Iraq and should be carried out over the next two years. Once the balance sheet is cleaned up, the capital of the two banks should gradually be brought up to the level prevailing for private banks by June Once the reform of Rafidain Bank and Rasheed Bank is well under way, the authorities should consider more generally the role of state banks in the economy, including that of ITB and the four smaller sectoral banks, with a view to eventual liberalization. As noted above, private banks operate on an uneven playing field. An immediate priority should be to announce the removal of all impediments for private banks

24 xxii in doing business with the government and state owned enterprises. Given some concerns over the strength of private banks, some elements, such as the size of letters of credits, could be phased in over a period of two years (but preannounced) to permit enhancement of the effectiveness of banking supervision to take hold as well as some consolidation of the banking system following the increase in minimum capital levels. It is clear that this potential expansion of private banks business opportunities entails keen vigilance on the part of the banking supervision department of the CBI to ensure the safety and soundness of the private banks. A permanent Securities Law has been under discussion for several years. The government need to urgently conclude these discussions, after also considering the recommendations contained in this report. The Law should then be presented to Parliament for speedy passage. Early passage of the Law is required to allow the ISC to enhance its role in developing capital markets. The insurance market is at an early stage of development. Nevertheless it is urgent that the Insurance Diwan be given the human resources to allow it to take on its assigned role of regulating the insurance market. As noted in the report, the insurance law will need to be amended to allow the introduction of internationally recognized principles of supervision. Carrying out the review has posed a number of unique challenges. Access to key officials and market participants within Iraq was severely limited because of the security conditions and the team therefore had limited possibilities to assess first hand actual implementation and enforcement of rules and regulations. Moreover, due to the recent introduction of many of the prudential regulations, there is little track record of compliance and enforcement. Nevertheless, in spite of these caveats, this assessment point clearly to a number of key issues that need to be addressed to underpin the development of Iraq s financial system. The report comes up with key recommendations some of which are short term, in the sense that they should be initiated immediately. Others will be ongoing and may only be fully realized in the medium term. All these aim at enhancing the performance and soundness of the financial sector in Iraq, and ensuring that it plays a key role in financial intermediation and overall economic growth.

25 INTRODUCTION I. INTRODUCTION A well-developed financial market comprises a broad spectrum of well functioning banks and non-bank financial institutions. Banks provide deposit and payments services, allocate resources, and monitor operations of firms. Securities markets provide financial leverage and ensure efficient allocation of resources. Well-developed capital markets force banks to pay more attention to smaller firms and households. Active domestic bond markets provide firms with long-term domestic currency finance and ease credit crunch pressures during periods of bank stress. Housing finance is important for households and provides an important asset for entrepreneurs. Successful leasing, factoring, and venture capital markets provide financing and enhance an economy s productivity. At the outset it was agreed with Iraqi authorities that the focus of this review should be forward looking and constructive; it should analyze the current situation with regard to the banking system, financial markets, infrastructure and regulation and make recommendations, with an emphasis on what is: (i) essential and (ii) realistically achievable given limitations on resources in Iraq. Carrying out the review has posed a number of unique challenges. A conventional project of this nature would normally be based upon at least ten days on the ground in the jurisdiction seeking the views and experiences

26 of a range of stakeholders such as bankers, borrowers, trade associations, current and potential issuers of shares to the public, brokers and dealers, institutional fund managers, banks, lawyers and accountants as well as operational staff at the banking supervision department, the securities commission, the stock exchange and the clearing, settlement and custody entities, and the insurance supervisor. In all sectors, the authorities would have been expected to have prepared self assessments which would have formed the basis of several days of technical discussion. In this case, selfassessments were non-existent or very partial and data requests could in many cases not be met because of physical destruction of data series. Access to key officials and market participants was restricted by the conduct of most of the discussions outside Iraq and interviews in the field were severely limited because of the security conditions. Therefore the mission had very limited possibilities to assess first hand actual implementation and enforcement of rules and regulations. Moreover, due to the recent introduction of many of the prudential regulations, only a limited track record of compliance and enforcement had been built at the time of the assessment. Nevertheless, in spite of these caveats, this assessment point clearly to a number of key issues that need to be addressed to underpin the development of Iraq s financial system. This report is organized as follows: After reviewing the macroeconomic framework in Chapter II, a brief overview of the financial sector is given in Chapter III, which points clearly to the fact that the banking sector is still by far the dominant part of the financial system. Chapter IV then contains an assessment of the banking sector in Iraq. When looking at the banking system it is important to keep the general political/economic environment in mind. The difficult security situation imposes certain costs on banks (security, transport, and communication). Moreover the legacy of prevailing state intervention has not yet been fully addressed. Full transition to a market oriented system is still a long way off, requiring liberalization of large parts of the real sector from state control. Both of these factors impacts on the ability of banks to find creditworthy clients. Given the importance of access to finance for creating growth, a separate section on access to finance is included under the chapter on banking. A separate section on the development of the payments system is also included. Effective banking supervision is crucial to maintain the financial soundness of the banking system and Chapter V contains a comprehensive assessment of the banking supervision function. The assessment is based on a study of relevant laws and prudential regulations and on interviews in February and March 2011 with officials of the banking supervision department of the Central bank of Iraq

27 INTRODUCTION (CBI), the Association of Private Banks, representatives of the Supreme Audit Council, the Steering Committee for the Restructuring of Rafidain Bank and Rasheed Bank, Representatives of Rafidain Bank and Rasheed Bank, the Iraq based World Bank Project Management Unit, representatives of the Islamic banking community, and officials of the Ministry of Finance. The assessor liaised with the World Bank Project Management Unit, the IMF, USAID, US Treasury, and the Financial Services Volunteer Corps. This review does not provide compliance ratings against the formal BCP criteria, and does not represent a ROSC. The 25 Basel Core Principles for Effective Banking Supervision (BCP) and the 2006 assessment methodology were used as an organizing framework for this review. Chapter VI describes capital markets and their regulation. While the review is based on IOSCO s detailed Methodology 1 for assessing the level of implementation in a jurisdiction, it was agreed that the review would not conduct a formal assessment. Rather, an informal assessment based on readily available information would form the basis of a series of recommendations for improvements in regulation and market infrastructure necessary if the capital market is going to play a greater role in economic development in Iraq. The informal assessment can be found at Annex [8] to this report. Effective regulation of capital markets must have at its foundation a comprehensive and robust legal framework which sets out the powers and duties of the regulators over markets and market participants and resolves issues of independence, accountability and resources. This framework also needs to be supported by a broad, and equally robust, set of preconditions in the areas of law and professional standards, such as laws on bankruptcy and contract finality, judicial, accounting and auditing standards and corporate governance. It was expected, and, on the basis of admittedly limited discussions, it proved to be the case, that in all these areas there are substantial weaknesses which impact negatively on the level of confidence with which investors, domestic and particularly foreign, will consider investment in corporate equity and debt. Chapter VII gives an overview of the insurance and pension funds sector and presents the findings of an informal assessment of the insurance sector in Iraq based on the methodology Insurance Core Principles (ICP) developed by the International Association of Insurance Supervisors (IAIS) dated October 2003 and modified in The assessment reviews the effectiveness of Iraq s insurance legislation (including supporting regulation and rules) as well as the effectiveness of the supervisory body for the insurance sector. Finally, Chapter VIII contains a listing of key time-bound recommendations for strengthening the Iraqi financial system. 1. The Principles were updated in 2010 and the Methodology in 2011.

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29 MACROECONOMIC ENVIRONMENT AND RISKS II. MACROECONOMIC ENVIRONMENT AND RISKS Iraq s economic and financial performance depends to a significant extent on the performance of the oil sector. Revenues from oil account for about two-thirds of Iraq s GDP and for almost all export and fiscal revenues. Government oil revenues accounted for 60 percent of GDP in 2009, and the share of crude export revenues in total revenues was 87 percent. As a result, overall GDP growth is vulnerable to oil price and volume shocks. Financial sector deepening is required to support growth of the non-oil sector. Iraq s economic growth performance has deteriorated since 2008, but is expected to recover in The real GDP growth rate fell from around 9.5 percent in 2008 to 4.2 percent in 2009 due to the slump in international oil prices and stagnating petroleum output. This has been the most significant if indirect impact of the global financial crisis on Iraq s economy. Driven by the oil sector, economic growth rates declined further in 2010 due to serious oil infrastructure bottlenecks, but are expected to pick up in 2011, driven mostly by the oil sector. The financial sector s contribution to economic growth is very low in Iraq. Figure 1 below shows that Iraq s economy is highly dependent on the oil sector and the correlation between oil sector growth and GDP growth is very high. Although the financial sector has been growing since 2004 (in nominal terms), this growth mainly reflects increasing trend in ownership of dwellings as opposed to banking and insurance sector.

30 Figure 2.1: GDP by Economic Activity Source: COSIT (2010). The table below shows that the share of the banking and insurance sectors in GDP declined from 5.6 percent in 1980s to an average level of 1.3 percent between 1990 and 2003, and further to percent 0.7 in Although the share of the banking and insurance sectors started to increase in 2007 and accounted for 1.7 percent of GDP in 2009 and during the first half of 2010, the sectoral contribution to economic growth is still very low. 2 Table 2.1: Economic Activities as a share to GDP Source: COSIT (2010). 2. GDP figures for 2009 and 2010 are based on preliminary COSIT figures.

31 MACROECONOMIC ENVIRONMENT AND RISKS The graph below shows historical trends in the contribution of the financial sector to GDP starting from The time series show that rising share of financial services in recent years can be explained by the increasing level of ownership of dwellings. The banking and insurance sectors share in GDP, however, is still very low. Figure 2.2: Financial Sector as a Share to GDP Source: COSIT (2010). The nominal exchange rate continues to be the main tool for conducting monetary policy and maintaining price stability, given the very low level of financial intermediation. A nominal appreciation of the exchange rate from November 2006 to January 2009 helped bring inflation down from 65 percent in 2006 to low single digits. In 2010, the inflation rate was low at 3.3 percent, and the exchange rate has remained stable. As of April 1, 2010, the CBI lowered the policy interest rate from 7 percent to 6 percent and reserve requirements from 25 percent to 20 percent, after which it declined to 15 percent on September 1, This development is expected to encourage more lending to private sector companies. To enhance mobilization of domestic financing, limitations on stateowned banks use of government deposits for investing in Treasury bills have been reduced, while the pension fund has also been allowed to invest in Treasury bills and to participate in auctions directly. Figure 2.3: Daily Average Exchange Rate (Iraqi Dinar per US Dollar) Source: Central Bank of Iraq (2011).

32 Table 2.2: Iraq: Annual Inflation Rates ( ) (percentage change; end of period) Consumer price inflation (percentage change; end of period) Core price inflation (percentage change; end of period) Est. Est. Est. Est. Proj. Proj Source: International Monetary Fund. Iraq s international reserves have played a critical role in helping ensure macroeconomic stability. The accumulation of foreign exchange reserves at the CBI allowed Iraq to stabilize the Dinar, reverse the dollarization process, and contain inflation. Gross international reserves of the CBI increased from US$ 44.3 billion at end-2009 to US$ 50.6 billion at end The authorities remain committed to ensuring the independence of the CBI. A ruling by Iraq s Federal Supreme Court also noted that while the CBI is part of the country s executive apparatus, it is by law independent in its decisions and operations. Figure 2.4: Central Bank Reserves (US$ millions) Source: Central Bank of Iraq (2011). Although Iraq s economic growth prospects are favorable, risks remain high. In addition to Iraq s vulnerability to oil price shocks, main risks include political factors, security issues, technical capability and institutional capacity issues to implement reforms. A deterioration in the political environment in the region might have a negative impact on implementation of programs. If the security situation deteriorates in Iraq, this would create a large source of risk for all operations. Capacity risks are also critical. Poor technical capability among key Government agencies and low institutional capacity increase the risk of mismanagement of reforms and programs.

33 FINANCIAL SECTOR OVERVIEW III. FINANCIAL SECTOR OVERVIEW The Iraqi financial system is dominated by the banks. Total assets of the banking system according to official figures amounted to ID 329 trillion (equivalent to 318 percent of GDP), dwarfing the market capitalization of the stock market of only ID 3.5 trillion. These numbers are inflated by the inclusion of large exchange rate valuation losses on the banks balance sheets and staff estimates indicate that bank assets only amount to ID 70.1 trillion (73 percent of GDP). More in line with this lower asset figure, credit extension by banks amounts to only ID 9.4 trillion (10 percent of GDP) and is very low by international standards. Nevertheless, bank credit by far exceeds the stock market as the principal outside source of funding for companies (other than self finance). There are no private bonds issued. The size of the insurance market is very small; no asset size is available. There are currently 46 banks operating in Iraq including 7 state banks. The state banks account for the bulk of assets and credits. Two of these, Rafidain Bank and Rasheed Bank are undergoing protracted reform efforts, including attempts to clean up their balance sheet. There are 36 private banks, most of which are relatively small. Seven of these have foreign participation and nine operate according to Islamic principles. While banking practices are improving, many banks provide only limited services. Credit is mainly short term and trade related. Several banks have questionable financial strength. The capital market is centered on the ISX, which was established under Act No. 74 of 2004 for the purpose of providing a private sector, regulated market place

34 10 for the issuance and subsequent sale and purchase of securities by investors. The ISC has recently issued a license for a second independent exchange to be established in Erbil. Trading is fully electronic and integrated into the clearing settlement and custodian facilities. Market intermediary companies carry out the sale and purchase of securities by investors and for their own account. Currently 48 are licensed by the ISC and are regulated primarily by the ISX. The size of the insurance market is very small, and cannot be properly assessed because of the lack of reliable data. The total aggregate annual amount of gross written premium for all insurance companies are by some market participants believed to be about US$ 60 US$ 80 million for the non-state owned insurance companies and four or five times that amount for the state owned insurance companies. Reinsurance is not much used and it is thought that the total amount of reinsurance premiums is equal to maybe percent of the gross premium written. In addition to the three state-owned insurance companies there are about 18 private sector companies. The market is dominated by the state owned companies. In addition, the financial sector includes the following companies; aggregate asset size is not available, but is believed to be relatively small: The Postal Saving Fund accepts public deposits and reinvests them in various fields. It has 640 branches, spreading over the various provinces. Exchange Companies were established in the eighties and are supervised by the CBI. Their only activity is selling and purchasing of foreign currency inside Iraq and its minimum new capital is ID 150 million. They amount to 308 companies, mostly in Baghdad, and a few at other provinces. CBI approved to grant new licenses for companies that have been established by the Registrar of Companies from 2003 till now, and was based on the Board of Director s decision adopted in its meeting which was held on January 10, Financial Transfer Companies are non-banking financial institutions that work according to the instructions issued by the CBI No. 93 of They are 32 companies and they perform the transfer and receipt process of funds from inside and outside Iraq, via opening an account in Iraqi banks. Financial Investment Companies are companies, whose main activity is to direct savings into Iraqi financial securities, including shares, bonds, treasury bills and fixed deposits. They are organized by the Financial Investment Company System No. 5 of such companies are listed on the ISX. Average market capitalization is only US$ 1.5 million. Companies providing small and medium loans, these are one of the newest institutions operating in the market and their capital is specified to lie within ID1 billion for limited companies, and ID 2 billion for joint stock companies. They are organized by instruction No. 3 of 2010, issued by the

35 FINANCIAL SECTOR OVERVIEW 11 CBI and published in the Official Gazette of Iraq No on 20/9/2010. There is only one company, which is the Iraqi Company for Short-term Loans and there are other smaller institutions, including the Zakat Fund (Alms Fund) and Minors Care Fund. The Iraqi financial system is characterized by: The large size of state ownership among banks and insurance companies and unclear strategy for moving forward. Weak capital. The capital of operating companies in the Iraqi financial system are limited, except for banks where CBI has requested its capital to be increased to at least ID 250 billion by 2013, compared to ID 5 billion for money transfer companies, ID 150 million for exchange companies, between ID1 2 billion for the Short and Medium-term Loans Company ID 150 million for Financial Investment Companies and ID 250 million for market intermediaries. Economic capital levels are unlikely to be significantly higher. Inadequate legal framework. The Iraqi financial system operates with significant weaknesses in company law, corporate governance codes, bankruptcy law, which hinder the evolution of the Iraqi economy into a market based one. An adequate legal framework is crucial for the participation of Iraqi and foreign investors in this market. There are also weaknesses in the transparency, completeness and accuracy of financial statements and other disclosures by companies which also need to be corrected. Poor interest rate and loan structure. Poor flexibility in the prevailing interest rates structure of banks, which grant mainly short term trade financing and only limited medium and long-term loans for real estate purposes. Weaknesses in financial intermediation. Low levels of capital in market intermediaries limit the ability of the market to facilitate the needs of investors when seeking to buy or sell securities. Also, the absence of credit rating agencies to assess the performance of issuers of securities and banks as borrowers hampers effective decision making by investors and depositors. Access to finance is low and SME and microfinance have started operating relatively recently. The regulatory framework is relatively well established by law and regulation, but further strengthening of its implementation is required. The payments system is relatively well developed.

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37 THE BANKING SECTOR 13 IV. THE BANKING SECTOR The Iraqi financial sector is still dominated by the banking system, accounting for more than 75 percent of the financial assets. There are currently 46 banks seven of which are state-owned. Private commercial banks are generally quite small and 20 have been established relatively recently, in the period following the second Gulf War (Appendix, Table 1). Seven of the private banks have foreign participation. As of end- 2010, total assets of the system amounted to ID 329 trillion ID 285 trillion (87 percent) and ID 13 trillion (4 percent), belonging to Rafidain Bank and Rasheed Bank respectively. Official figures indicate that private bank assets only amounted to 3 percent of total assets, but this understates the real picture. Total assets according to official figures are very large in relation to GDP when compared with the average for MENA countries (318 percent of GDP compared to 130 percent for the MENA average) however, as explained below, official numbers significantly overstate the real picture. When looking at the banking system it is important to keep the general political/ economic environment in mind. The difficult security situation imposes certain costs on banks (security, transport, and communication). Moreover the legacy of prevailing state intervention has not yet been fully addressed. Full transition to a market oriented system is still a long way off, requiring liberalization of large parts of the real sector from state control. Both of these factors impact on the ability of banks to find creditworthy clients. The comparison between state-owned and private banks is significantly skewed because the two large state-owned banks balance sheets are inflated by public sector

38 14 assets and liabilities accumulated under the previous regime, which have not yet been fully cleaned up (see below). Out of total assets of ID 302 trillion for Rafidain Bank at end 2010, ID 257 trillion reflected valuation losses from previous periods. 3 Once the financial restructuring of the state-owned banks has been completed, the balance sheet of the state-owned banks could be reduced by as much as ID 259 trillion. 4 Thus assets of the state-owned banks could amount to as little as ID 60 trillion, nevertheless still dwarfing the ID 10 trillion for the private banks (Table 3). The new state-owned bank, Trade Bank of Iraq (TBI), would account for ID 17.8 trillion, and rising rapidly. These figures are more in line with data on credit and deposits. Private banks accounted for 31 percent of credit (non-government) and for 11 percent of deposits (excluding government deposits, private banks accounted for 17 percent of deposits). The revised estimate of assets would be equivalent to 73 percent of GDP (compared to the MENA average of 130 percent). Overall, credit remains low by international standards, amounting to an estimated 9.8 percent of GDP in This is much lower than the average of 55 percent of GDP for all MENA countries, but not too far from that of state-led countries in the MENA region, which showed an average of 13 percent of GDP. Table 4.1: Illustrative Adjusted Balance Sheet Items ( ) (in Trillions ID) Total Assets Credits to the economy Deposits Rafidain Bank Rasheed Bank ITB Other State-owned Banks Total State-owned Banks Private Banks Total Source: Staff estimates. Credit is rising fast from a small base saw an increase of 75 percent, reflecting a near doubling of credit by the state banks and a 50 percent increase in credit from the private banks. Indeed, over the last 3 years credit to the economy has expanded by close to 40 percent on average. (Appendix, Table 5). 3. Rafidain Bank used to borrow on behalf of the Government. The Exchange rate at the time was US$1=ID 0.33 but is now US$1=ID1180, which led to a large exchange valuation loss. Since Rafidain Bank borrowed on behalf of, and is owned by, the Government, these losses and the offsetting liabilities should be removed from the balance sheet. The calculation is complicated by a number of other issues, see below. It should be noted that preliminary data provided by Rafidain Bank differ slightly from that reported by the CBI. 4. The team was not able to obtain any official estimate of the magnitude involved and the number given should be viewed as an illustrative approximation. They are based on an internal Rafidain Bank calculation for 2009, which was provided to the team. That calculation showed a reduction in total assets of Rafidai Bank from ID 288 trillion to ID 29 trillion.

39 THE BANKING SECTOR 15 Deposits have also risen relatively rapidly, albeit more slowly than credits. Over the last three years Broad Money rose by 26 percent on average. Deposits in 2010 amounted to ID 55.0 trillion, equivalent to 57.3 percent of GDP, somewhat below that of the average for MENA countries of 75 percent. However, Government deposits at the state-owned banks account for a significant share of deposits, and adjusting for these, the ratio to GDP drops to 37 percent of GDP. Some progress has been made over the past few years in strengthening the banking sector despite the complex security situation. This is evident in the start of financial and operational restructuring of the state-owned banks, the strengthening of the supervisory and regulatory authority, and improving the institutional financial infrastructure. Several measures to improve the banks governance have been taken. In an effort to strengthen the financial sector infrastructure, a set of prudential regulations applicable to all commercial banks was recently issued. However, overall, progress has been slower than initially envisaged. A. State-owned Banks The Government of Iraq has embarked in February 2009 on a two-phase Banking Sector Reform Strategy ( ) with the support of the World Bank, with the objective of modernizing its banking system. Financial sector work in Iraq has thus far focused on strengthening the two state-owned banks and on improving the overall regulatory framework. The assessment of the state-owned banks is complicated by shortcomings of data; some data has been lost because of the conflict and the reliability of others is questionable. Little work has focused on enhancing the (small) private banks and the non-bank financial sector, and it is unclear to what extent the new regulatory framework has succeeded in enhancing the viability of financial institutions. Box 4.1: Rafidain Bank and Rasheed Bank Rafidain Bank was established as a private bank in 1941 but was nationalized in the 60s. Rasheed Bank was established in 1988 by carving out non-performing assets from Rafidain Bank. Both banks suffered losses during the two gulf wars and economic sanctions, including through looting and physical damage to branches. Both banks have been performing quasi-fiscal activities including certain treasury functions without fees, directed lending, and foreign borrowing on behalf of the Government. The latter led to very large foreign exchange valuation losses because of the sharp depreciation of the Dinar following the second Gulf war. Past losses on account of war and valuation changes are still carried on the books of the banks, and assets are accordingly highly inflated (revaluation losses were equivalent to 185 perent of GDP in 2009). Rafidain Bank is the largest bank in Iraq and Rasheed Bank is the third largest; together they account for 62 percent of Staff adjusted bank assets (but more than 90 percent of bank assets, according to official figures). They also have the only nationwide branch systems (165 for Rafidain Bank and 137 for Rasheed Bank. Depositors believe Rafidain Bank and Rasheed Bank carry an implicit Government guarantee, which gives them an advantage in deposit mobilization. They are also recipient of Government deposits. These advantages are to some extent balanced by non-remunerated treasury functions on behalf of the Government.

40 16 The authorities have set up several committees to oversee the process of reforming the two large state-owned banks. The Bank Reconciliation Unit, with the help of Ernst and Young (E&Y) has made only slow progress in the reconciliation of conflicting external debt data between the two banks and creditors. Initially the process had been anticipated to be completed by June 2010; the deadline has now been set to June 2011, but is likely to be exceeded. A second working group is looking at non-performing assets, including loans to defunct state owned enterprises, other losses from previous periods (stemming in part from the two Gulf Wars), and claims related to fraudulent currency exchange. The authorities were not yet able to release official figures on the likely impact on the balance sheets of the two banks of the work of these two committees. As noted above, the clean-up of the balance sheet could reduce very significantly its nominal size. There was strong agreement between participants in the discussions that the restructuring process has taken much more time than anticipated, and needed to be brought to a speedy conclusion. Many examples were given to show that the 2006 MOU and Action Plan with regard to the financial and operational restructuring of Rafidain Bank and Rasheed Bank had not been implemented on many points. The 2006 MoU (Annex 3 and 4) addresses, with very specific, time bound actions, the full process of operational and financial restructuring, including twinning with foreign banks, a full audit, use of IFRS, putting both banks at arm s length of the Ministry of Finance, and puts these actions in the context of the need for these banks to start providing basic financial services to the Iraqi population as soon as possible, and in a competitive market oriented environment. The cleanup of the balance sheet of Rafidain Bank and Rasheed Bank must be brought to a speedy conclusion so that the banks can focus on moving forward. The best way to do so will be to carve out all the disputed elements listed in paragraph 89 and transfer them to a newly created asset/liability management company. This company should have a minimal staff and no branches and not be allowed to take deposits or extend new loans. Staff of Rafidain Bank and Rasheed Bank should still be called upon to participate in working groups that will be responsible for settling the items that have been transferred to the new company. The Restructuring Oversight Committee (ROC) has thus far not been very active in setting general policy decisions. The Executive Steering Committee has met 21 times and reported to the ROC on each occasion, but has received little further guidance from the ROC. The ROC only recently held its second meeting, but there is hope that it will become more active under the new Minister of Finance.

41 THE BANKING SECTOR 17 Figure 4.1: Structure of Oversight Committees Restructuring Oversight Committee (ROC) Governor CBI; Head Minister of Finance Board of Supreme Audit High-level Oversight Executive Steering Committee Deputy Governor CBI; Head Representatives of CBI, Ministry of Finance, and BSA Policy level discussions of bank reforms Bank Reconciliation Unit (BRU) Technical level staff from CBI, Ministry of Finance, BSA, Rafidain Bank, Rasheed Bank, and E&Y Cleaning up of balance sheet of Rafidain Bank and Rasheed bank by end of June 2011 Project Management Unit (PMU) World Bank financed experts Administrating World Bank grant money for training of Rafidain Bank and Rasheed Bank With the help of the World Bank funded Project Management Unit, a training project for the two state-owned banks has been started (supported by a US$ 10 million grant). Courses for Branch Managers and on human resources development (HRD); proposals for training on internal audit and compliance risk management; accounting and finance program; and credit and risk management are currently considered. Some progress has been made towards drawing up new organizational structures for the two banks, and in particular both have set up skeleton structures for the risk management function. However, these need to be fully implemented and staff trained to apply modern banking practices. Progress has also been made in acquiring new IT and accounting systems. But, these are not yet fully implemented, and certainly not at the branch level. Lack of progress is in part explained by the difficult security situation, which has made it difficult to identify qualified foreign expertise to assist with the organizational and operational reorganization. Only in March 2011 did two foreign experts (one in each bank) start work in the field.

42 18 On capacity building and training of banks, it is worth noting that a fundamental shift in policy is required to change the structure to be consistent with the international best practices, and, more importantly, the mentality of the stateowned banks. Some observers thought that this could only be accomplished by bringing in a reputed foreign bank to carry out a comprehensive reorganization process. This could either be as a strategic investor, or as a provider of services on a fee basis (twinning) as was done in other developing economies that were successful in conducting restructuring programs. For a description of a good framework for institutional and operational restructuring of the two banks (Annex 5). In discussions with Iraqi counterparts, there was general agreement, from the Governor of the CBI as well, that state-owned banks had to learn to operate on commercial principles. The Governor believed that an important step in this process was to corporatize the structure of the state-owned banks, which would be a positive step moving forward. Operating on commercial principles will also require a discontinuation of the quasi-fiscal activities performed by the state banks. Any services performed for the government should be clearly identified, and properly remunerated. Government must also refrain from any influencing of lending decisions, which should all be subject to proper risk assessments. The authorities intend to carry out a major recapitalization of Rasheed Bank and Rafidain Bank, but only after the completion of their financial restructuring. While the timetable remained to be confirmed, plans were to increase capital of Rafidain Bank from its current book level of ID 2 billion to ID 400 billion and that of Rasheed Bank from ID 25 billion to ID 300 billion. The Iraqi participants noted that, as a first step, discussions had centered on converting capital and general reserves into share capital. According to current figures on the balance sheet, this could take the capital of Rasheed Bank to ID 67 billion and of Rafidain Bank to ID168 billion. However, it is unclear how meaningful these latter figures are, given the significant prospective changes to their balance sheet. For example, an unofficial internal E&Y document indicated that the current net worth position (including reserve funds) could be slightly negative. But other observers have speculated as much as minus ID 25 billion. It is clear that a major infusion of Government capital is required to bring the two banks to reasonable capital levels. There would not at present appear to be a significant macro-economic risk given the low level of deposits. Rafidain Bank and Rasheed Bank are still highly liquid, with cash, deposits at the CBI, and foreign assets covering 97 percent of private deposits. Bringing the capital level of all state banks up to the new minimum level by June 2013 will require a capital injection equivalent to 1.4 percent of GDP. The Iraqi Government in 2004 set up a new state-owned bank, TBI to handle trade financing, which Rafidain Bank and Rasheed Bank could no longer do because of legal attachments stemming from the situation under the previous regime. The bank was to be a temporary institution that would be wound up,

43 THE BANKING SECTOR 19 once Iraq s international economic and financial relations were normalized. However, the TBI has been taking on an increasingly important role, and a draft law has been proposed to convert the bank into a universal commercial bank and to allow it to open up more branches. At the same time, control over TBI is opaque, and the ability of the CBI to take supervisory enforcement measures against this institution is not considered strong. Before allowing TBI to expand its business, the CBI must be fully confident that it has the powers and tools to effectively supervise this institution. While in terms of assets TBI is now the second largest bank (after restructuring Rafidain Bank), credit operations are still relatively small (ID 0.3 trillion). Several observers have indicated that some of TBI s operations are particularly opaque and are channeled to wellconnected parties. Four smaller state-owned banks continue to operate with relatively low capital levels. These banks, as their names imply (agriculture, real estate, industry, Iraq), were mainly set up to support development in key economic sectors. Total assets for these 4 banks amount to ID 3.1 trillion, or 4.5 percent of adjusted banking sector assets. The authorities intentions for these banks have not yet been spelled out. In the context of establishing a more level playing field, these intentions should be made clear as soon as possible, in order to establish how these banks will compete with the private banks, and what their role can be in providing basic financial services to the population. As noted above, credit extended by the state-owned enterprises (SOEs) to the private sector and state owned banks nearly doubled in 2010 to reach ID 6.5 billion in This amount is exceeded by claims on the Government of ID 7.7 trillion and dwarfed by deposits with the CBI of ID 28.9 billion. The structure of the balance sheets of the state owned banks differs significantly from that of the private banks as shown in table 4. 5 The state owned banks are surprisingly liquid, with two thirds of their assets in the form of foreign assets and deposits with the CBI. As noted, credit to the economy only accounts for 11 percent of assets, while credits to the Government accounts for 13 percent. On the funding side, the State owned banks draw heavily on deposits (81.5 percent of liabilities), a large share of which emanates from Government. By contrast, the share of capital, reserves, and provisions is quite small when compared to other banks. According to official figures, all the state banks are profitable. Net income declined slightly from 2009 to 2010 because of a decline in non-interest income (Appendix, Table 8). Income in relation to capital is significantly higher than for the private banks, because of relatively low capital levels. However, revenue to assets is low by international standards amounting to 0.9 percent in compared with an average for the MENA region as a whole of 1.9 percent. 5. The table draws on Annexes Based on the staff estimate for assets contained in table 1.

44 20 Table 4.2: Iraq Structure of Banks Adjusted Balance Sheet (2010) (in percent) Assets State owned banks Private banks Of which: conventional Of which: Islamic Foreign assets Deposits with CBI Claims on Government Credit to the economy Other assets Total Total Liabilities State owned banks Private banks Of which: conventional Of which: Islamic Non Govt. Deposits Govt. Deposits Foreign liabilities Capital, reserves, and provisions Other liabilities Total Total Source: Central Bank of Iraq (2011) B. Private Commercial Banks The strength and business expertise of the 36 small private banks appears to be improving. However, the range of services provided by many of many of them is still limited, and the financial strength of a few of them is weak (see below). Foreign banks have shown increasing interest in conducting business in Iraq. Seven banks have foreign participation, including a 70 percent share by HSBC in Bank of Dar el Salam. Nine banks operate according to Islamic principles. None of the private banks have country-wide branch networks, but many are increasing their networks. One bank has 61 branches, three banks have more than 30, and 9 banks between 10 and 20. In total, private banks have 383 branches, or roughly the same number as the state-owned banks.

45 THE BANKING SECTOR 21 The private banks compete on an unlevel playing field with the state-owned banks. State-owned enterprises and government agencies are not permitted to do business with the private banks, which is a major impediment to the development of a viable private banking sector. Government, government agencies, and state owned enterprises are not allowed to place deposits with private banks. Nor can state owned enterprises receive loans from private banks. Moreover, payments to the government (taxes and other payments) cannot be effected by check drawn on a private bank. 7 The large state-owned banks benefit from an implicit government guarantee on deposits. In contrast, depositors in the private banks are not protected. Discussions are under way among private banks to set up a self-funded deposit guarantee fund, but these do not appear to be at an advanced stage. Private banks have very little access to the lucrative business of issuing letters of credit for imports by the government and state owned enterprises. Several banks are now able to issue such letters of credit. 8 The state-owned TBI was set up explicitly to handle trade finance and has a monopoly on issuing letters of credit to the government and State-owned enterprises. In principle, the TBI may delegate letters of credit of less than $ 5 million to one of the private banks. In practice it does so only for LCs less than $2 million. Procedures for doing so are not fully transparent. A review of the web sites of private commercial banks indicate that they offer an increasingly wide range of services, In the area of business lending, banks generally offer trade financing, including letters of credit, guarantees, bills discounting, working capital and project lending, domestic and external settlements, and foreign exchange transactions. The bulk of loans are short term, although some banks offer project financing and several banks are granting SME financing at up to 3 years maturity. Also some Islamic banks provide funds of longer maturity. As private banks are relatively small they are not able to take on large projects as syndication of loans is not yet used. Many banks have introduced, or are in the process of introducing, retail lending services. Retail loans offered by some, but not all, include car loans, appliance loans, vacation loans, and unspecified personal loans. A number of banks also offer real estate loans; most real estate funding, however, appear to be for construction of housing projects. So far only a few banks have issued credit cards and ATM cards. In spite of the increased sophistication, interviews with banks and market participants, as well as available statistics, indicate that the services of most banks are still generally rather limited, and that trade financing, foreign exchange dealings, and payments services continue to constitute the bulk of banking business. The amount of retail loans is relatively low, albeit growing fast from a very small base. 7. The Ministry of Finance stipulated this in a decree, following difficulties in two of the smaller banks that led to problems with cashing their checks. 8. Frequently foreign banks insist on an endorsement by an internationally recognized bank (such as HSBC), which increases costs.

46 22 A clear difference between the composition of lending between private banks and state-owned banks is seen in table 5, which shows the heavy concentration of private lending to wholesale and retail trade. Table 4.3: Iraq, Breakdown of Credits (2009) (in percent) Agriculture, Forestry, Hunting & Fishing Rasheed Rafidain Other stateowned banks Private banks Total Mining & Quarrying Manufacturing Industry Electricity & Gas Wholesale, Retail Trade & Hotels Transport, Communications& Storage Finance, Insurance, Real Estate & Business Services Social services External World Building & construction Total Source: Central Bank of Iraq (2011). Interest on excess deposits at the CBI is a major share of banks earnings, as banks are quite liquid because of low lending levels. Other major revenue earners are trade financing and fees on foreign exchange transaction. All banks recorded profits, except a few banks that were in the process of starting operations. Profits are relatively high, although showing a significant decline from 2009 to Net income of private banks in relation to assets declined from 3.3 percent in 2009 to 2,4 percent in 2010 (Appendix, Table 8), but remained above the level of 1.9 percent which was registered for the MENA region as a whole, and significantly above that of the state owned banks. Net income in relation to capital and reserves declined from 12.1 percent in 2009, which is relatively good, to 7.3 percent in 2010, which is not a stellar performance. Income indicators were broadly similar for Islamic and non-islamic private banks. The revenue performance in 2010 indicates that banks will need to find additional income generating opportunities as minimum capital requirements are increased. Private banks are in general well capitalized and do not appear to give rise to significant macro-prudential risk at present. Capital adequacy ratios in 2010 exceeded 100 percent for some banks and were only below 20 percent for two banks. 9 The CBI publishes its CAMEL ratings of private banks on its web site. 9. It still needs to be confirmed whether some banks include loan loss reserves in the calculation of capital.

47 THE BANKING SECTOR 23 Most banks have a camel rating of 3 or less, and only a few have ratings of 4 and 5. While internationally a 3 rating is considered to warrant supervisory attention, the CBI awards the 3 rating to what they consider to be good banks. The CAMEL ratings have generally improved over the last three years, supporting some observers contention that the financial strength of banks is generally improving. Non-performing loans amounted to 4.5 percent of credit in Although prudential indicators overall appear relatively strong, market observers mention that questionable business, accounting, and auditing skills is still a problem for some private banks. Other observers have pointed to the fact that most of the private banks are currently family controlled banks, and that this tends to weaken governance and impede progress towards a modern full-service bank. The CBI placed recently two banks under conservatorship. No track record exists at this time of the effectiveness of the new prudential regulations in reinforcing the viability of financial institutions. The authorities believe there is a need for consolidation of the private banking sector. Partly also to diversify ownership away from family control, the CBI has required that banks increase their capital to ID 100 billion by June 2011 and in two further steps to ID 250 billion by June 2013 (equivalent to US$ 214 million). Several banks are well on the way to achieve the first step increase. At end September 2010, six banks had capital of ID 100 billion; eight banks had between ID billion; most clustered around ID 50 billion, and five had less than ID 30 billion. Market observers expect some consolidation. With perhaps 10 banks to be merged with others or closed by The effect of the decision to require more capital is not fully clear, as the true capital positions of the state-owned banks still has not been determined, and the private banks are not engaged in extensive risk bearing lending operations, given the large deposits they hold at the CBI. Under these conditions, the return on equity of the private banks would decrease if capital were increased without a corresponding increase in the asset side of the balance sheet. Nevertheless, on balance the staff team supports the proposed increase in minimum capital. C. Islamic Banks There are nine Islamic banks operating in Iraq (as shown in Table: 1, Annex 17). The Islamic banking activities in Iraq started in 1993, where the Iraqi Islamic Bank for Investment and Development was established as the first Iraqi Islamic bank. Iraqi Islamic Bank for Investment and Development was the only Islamic bank operating in Iraq till In 2001, Elaf Islamic Bank was established as the second Islamic bank in Iraq. The Islamic banking industry in Iraq increased rapidly since 2005, with seven new Islamic banks being established (Kurdistan International Bank for Investment and Development (2005), Islamic National Al Bank (2005), Dijah & Furat Bank for Development and Investment (2006), Bilad Islamic Bank for Investment & Finance (2006), Islamic Regional Cooperation Bank for Development & Investment (2007), Ceyhan Bank for Investment and

48 24 Islamic Finance (2008) and Abu Dhabi Islamic Bank (2010)). Islamic banks now have 83 branches and 1504 employees, with the ratio of branches and employees of the Islamic banks to that of all private banks being broadly similar at 19 percent and 17 percent, (Table:1, Annex 17). The Islamic banks in Iraq offer the following products: Murabaha (Profit-sharing); Musharakah (joint ventures); Mudarabah (Financing); Ijara (Renting); Istisnaa (Industrial - Financing); and Assets and Liquidity Management. In general, financing is of longer term than that of other private commercial banks. Most financial ratios and earnings performance are broadly similar to those of other private commercial banks (Annex 17). However, in general Islamic banks rely more on capital and reserves as a funding source than do other private banks (and much more so than the State owned banks). CAMEL ratings are only listed for seven of the nine Islamic banks. For six of these, CAMEL ratings are better than the average for private banks as a whole. One Islamic bank is facing difficulties, and the CBI is exploring whether a buyer can be found. The Islamic banks face some challenges in working without specific Islamic banking law and regulations except the internal instructions that were issued in Also, there is a shortage of qualified people who understand Islamic banking practices not only in the banks but also in the CBI. D. Access to Finance Bank finance. Insufficient data is available to conduct a rigorous assessment of access to finance in Iraq, but overall data on credit and other available indicators clearly shows that access to credit is low. As noted above, credit to the economy in relation to GDP is very low compared with other MENA countries and other country groups. Also, the number of branches in relation to the population size is relatively low. 10 There are no good estimates for unsatisfied credit demand. As a simple yardstick, to bring the credit to GDP ratio from 10 percent to GDP to the average level for MENA countries of 55 percent will require an increase in credit of ID 45 trillion. The planned increase in bank capital levels will be sufficient to support such a lending level, assuming that enhanced banking, and banking supervision, skills ensure no deterioration in credit quality. The Center for International Private Enterprise estimated that family savings and retained earnings accounted for three quarters of financing for businesses in Iraq in 2007, while bank financing accounted for only seven percent. 11 While bank credit has increased, the fundamental magnitudes are unlikely to have changed much. The share of bank financing of enterprises is thus significantly lower than in other MENA countries (13 percent) and in other middle-income countries (19 percent). 10. Data on number of deposit accounts and number of loans is not available. 11. Business Attitudes toward Political and Economic Reconstruction in Iraq, Center for International Private Enterprise, February 29, 2008, slide 14.

49 THE BANKING SECTOR 25 Latest household data also refer to As shown in table 6, only 3.4 percent of household borrowing in Baghdad emanates from banks. Significantly more households borrow in Baghdad (80.8 percent of households) than in the other regions. Interviews with market participants and donor estimates indicate that access by small and medium enterprises (SMEs) to bank finance is very low. 12 A 2005 ILO estimate put the total number of registered SMEs with 3 or more employees at 622,000. An additional 719,000 SMEs are registered as self-employed. And finally ILO estimated that another 1 million of SMEs were not registered. Table 4.4: Iraq Household Borrowing (2007) Friends and family Banks Other All borrowers Borrowers share of all households Kurdistan Bagdhad Other regions Source: Iraq Household Socio-Economic Survey IHSES (2007). A USAID Project team estimated that less than 5 percent of the SMEs in the formal sector have ever received a bank loan and that fewer than 10 percent of them have a bank account. With assistance from a USAID funded project, 26 private banks have jointly set up an institution to extend credit to SME the Iraqi Company for Financing SMEs (ICF). Also private banks have set up an institution to provide guarantees on loans up to 75 percent of the value of collateral The Iraqi Company for Bank Guarantees (ICBG). These initiatives have contributed to an increasing level of lending to SMEs, but from a small base and amounts remain low. The ICF has issued $15 million in loans since its inception in 2007 and at end 2010 outstanding loans amounted to $6.6 million distributed over 781 loans (equivalent to less than 0.1 percent of registered SMEs). The ICBG have guaranteed US$ 28 million on 2,100 banks loans (equivalent to less than 0.2 percent of the number of registered SMEs). Mobile phone banking could contribute significantly to banking penetration, but, like in the rest of MENA countries, has not taken off in Iraq. No initiative has been started in this area yet, but it will presumably be considered in the context of the USAID funded retail-banking project. 12. USAID in its publication on micro finance notes that: Bankers in Iraq lack experience lending to SME segment, thus limiting financial intermediation. Many banks are new, with inadequate skills for analyzing credit risk and in conducting cash-flow analyses. Other obstacles include loans with repayment terms that are too short to accommodate longer term investments, and collateral requirements in excess of 150 percent of loan amounts.

50 26 The authorities, and donors, have only recently started to focus on micro-finance institutions, and coverage is limited. A USAID funded project since 2004 has helped set up 14 micro finance institutions with a network of 100 offices covering all 18 provinces. The regulatory framework has improved with the adoption of a new law in March 2010, which explicitly allows for micro finance institution, which till then had been implicitly illegal. Total loans outstanding at end April 2010 amounted to US dollar 85.5 million (equivalent to about 1 percent of bank credits). Loans reached 62,000 clients, estimated to be less than 1 percent of Iraq s poor. Weak financial infrastructure is a clear impediment to access to finance in Iraq. Actions are needed in all areas, including credit registry, the collateral framework, judicial systems, and accounting and auditing skills. Iraq is alone in the MENA region in not having established a credit reporting system. World wide it has been found that credit reporting systems can play an important role in the early stages of financial development. Public credit reporting systems (PCR) are generally managed by central banks or bank supervisors and collect information from supervised institutions. Private credit bureaus (PCB) are generally owned by private international or local providers and collect information from a greater number of sources, including records of payments to other entities than bank (retailers, utilities, credit card issuers, mobile telephones). PCBs can therefore develop a more complete picture of a borrower s financial dealings. PCBs have been established in more than 90 countries including in most middle and high-income countries. PBCs have been established in less than half of MENA countries. PCBs are best introduced through a customized law. The CBI collects aggregate credit data. The collateral system is still very underdeveloped. Like in other countries in the MENA region, Iraqi banks have difficulty in all the components of the secured lending chain: registration, enforcement, and selling of collateral. Unlike most MENA countries, Iraq does not have a central collateral registry. Moreover, banks and other market participants stressed that collateral enforcement was a very time-consuming and unpredictable process. The CBI has compiled a nonlimitative list of acceptable types of collateral. Weak accounting and auditing skills also makes life difficult for bankers. Essentially, bankers cannot have sufficient faith in the accuracy of the balance sheets of their clients and will have difficulty in lending on the basis of projected cash flow of the client alone. And as noted above, collateral has its own problems. The difficult security situation poses its own particular problems for strengthening the banking system in general, and access to finance in particular. Institution building is a time consuming process and requires hands on expertise to be imparted to Iraqi counterparts. However, given security concerns it is not

51 THE BANKING SECTOR 27 possible for foreign donors to provide the kind of hands on training they would do otherwise. Security concerns also likely explain the so far limited support for micro finance institutions. E. Payments System The Iraqi payments system is relatively well developed. This represents in part significant technical support from foreign donors but since 2008 the CBI has taken administrative and financial responsibility for the technical support. A RTGS system was implemented in 2006, and after a slow start has witnessed a significant increase in volume. The number of subscribers rose from 16 banks in 2006 to all banks in The number of daily transactions also increased from 120 in 2006 to 500 in 2010, for a monthly volume of approximately ID 10 billion. These numbers remains relatively low compared to RTGS systems in similar countries. The RTGS system has entailed a sharp reduction in timing of process, as settlement is now instantaneous, as opposed to 3 days in CBI continues to provide capacity building to its staff, as well as those of banks. The Payments System Department undertook a brief self-assessment of the RTGS systems observance of the Core Principles for Systemically Important Payments systems. While the Bank team did not undertake a rigorous assessment, interviews based on this self-assessment support the Iraqi findings that the RTGS is likely in observance of all but one of the ten core principles. Principle III is not observed because of the insufficient procedures to manage credit risks and liquidity risks. To further strengthen the payments system and promote financial inclusion, a full Automatic Clearing House was established in 2006 for small payment orders. It is a netting system, and is fully operational. An average of ID 16 billion is exchanged per month. Until recently, all checks were cleared physically in paper form. Checks are cleared intra region if both payer and beneficiary are within the same region, otherwise the instrument is transferred physically to the payers region and cleared inter region. Accordingly the settlement of paper checks can be quite long (more than one week). An electronic check clearing system was started in January 2011 with a pilot project including 6 banks. The system is expected to be broadened to include most banks by end A system to handle CBI and Ministry of Finance auctions Government Securities Registration System (GSRS) went live in November Currently, 22 banks are participating in this system. The authorities are aware that continued work is required to enhance the payment system. For the RTGS, a major shortcoming is that although the system permits it, a mechanism for the provision of intra-day liquidity to facilitate settlement

52 28 has not yet been put in place. If a bank does not have funds, any of its payments will therefore be rejected, which could create a negative cascade in the system. This has not caused any problems thus far, as banks in general are quite liquid. Another shortcoming is that the RTGS system is not yet integrated with the core systems of many of the banks, but is operated via freestanding terminals that are integrated with the RTGS system at the CBI. A large value transfers therefore have to be inputted manually, with greater risk for errors. The retail payment system needs to be developed further. While some banks have introduced bankcards, these are bank specific and cannot be used at other banks terminals. The retail payment system is being supported by a US Treasury project funded by an USAID grant that will help develop the system, including through the establishment of a universal switch to link payment cards from different banks. In spite of the above progress, cash payments still play a very important role in Iraq. This reflects in part a thriving parallel economy, but also that there is still some mistrust as to the strength of banks.

53 BANKING SUPERVISION AND REGULATION 29 V. BANKING SUPERVISION AND REGULATION Over the past years, Iraq has benefited from a significant amount of technical assistance in banking supervision. It currently has the main elements in place of a legal and regulatory framework that allows for sound banking supervision, given the current state of development of the banking system. However, the Head of the Supervision Department acknowledges the need for significant training to effectively implement the new regulations. And more disturbingly, it is alleged by senior officials at the CBI as well as market observers that CAMELS ratings can be subject to undue influence by banks, which implies potential governance problems. Three conditions must be stressed. First, it is essential that the political will is confirmed to let the CBI exercise banking supervision using its full powers under the laws and regulations, and its professional judgment without any interference. Second, in particular, the 2006 Memoranda of Understanding between the CBI and the Ministry of Finance to the effect that the CBI shall exercise supervision of the two main state owned banks, Rafidain Bank and Rasheed Bank, are faithfully implemented. And third, the CBI should have the resources and expertise to be able to exercise authoritative supervision. At this time, the Ministry of Finance continues to determine the key policies and practices of these two banks, and the CBI cannot effectively supervise these banks. No conclusive information was available to the mission how Rafidain Bank and Rasheed Bank are supervised. Market observers point to similar concerns over the lack of effective supervision of TBI. The fact that the CBI is unable to exercise effective supervision over Rafidain Bank and Rasheed Bank implies that by far the greater part of the banking system in terms of assets is not under effective CBI supervision.

54 30 Reliable information on the capital position of Rafidain Bank and Rasheed Bank is not available. Private banks report adequate capital, against a statutory minimum risk weighted capital adequacy ratio of 12 percent. However, three private institutions have CAMEL ratings of four or five, at the lower end of the scale, requiring constant CBI supervision and intervention. A significant number of banks have 3-ratings, which also implies the need for keen vigilance to prevent further slippage. A. Assessment of the Effectiveness of Banking Supervision Preconditions for Effective Banking Supervision Macroeconomic Stability Although Iraq s overall economic growth prospects are favorable, risks to the economic development process include political factors, security issues, technical capability, governance weaknesses and institutional capacity issues to implement reforms. Real GDP growth rate fell from around 9.5 percent in 2008 to 4.2 percent in 2009 due to the slump in oil revenues. Macroeconomic stability in Iraq depends heavily on the stability of oil revenues. Growth rates declined further in 2010 but are expected to pick up in 2011, driven mostly by the oil sector. Revenues from crude oil exports account for about two-thirds of the country s GDP and for almost all of its export and fiscal revenues. The CPI increased by 3.3 percent in As of April 1, 2010, the CBI lowered the policy interest rate from 7 percent to 6 percent and reserve requirements from 25 percent to 20 percent. Gross international reserves of the CBI increased from US$ 44.3 billion at end-2009 to an estimated amount of US$50.6 billion at end The accumulation of foreign exchange reserves at the CBI allowed Iraq to stabilize the Dinar, reverse the dollarization process, and contain inflation. Since early 2009, the exchange rate has been kept at ID1170 per US dollar. Total external debt has decreased from percent of GDP in 2009 to percent of GDP in 2010, and is projected to decline further to 37.1 percent and 32.6 percent of GDP in 2011 and 2012, respectively. Public Infrastructure The legal framework for financial business shows serious lacunae, e.g. the absence of a general insolvency law, which makes loan collection for banks more challenging, while judicial loan enforcement proceedings even for simple claims can take several years to be completed. The Law on the Central Bank of Iraq and Banking Law contain provisions for the creation and functioning of a Financial Services Tribunal. The Banking law provides detailed rules on conservatorship, resolution and insolvency. A civil code and a companies law are in place. There is no collateral registry, which is indispensable for the reliable functioning of mortgage credit. Iraq ranks 141 out of 183 in contract enforcement, according to the World Bank publication Doing Business For more detail, see Annex 7 Assessment of Banking Supervision. 14. World Bank: Doing Business 2010, Washington DC, 2010.

55 BANKING SUPERVISION AND REGULATION 31 Effective Market Discipline However, currently a draft law on deposit insurance, prepared by the CBI and the banks, is being discussed in the State Consultative Council. Market discipline in Iraq faces a number of serious challenges: (i) Iraqi accounting standards are not consistent with IFRS, (ii) notwithstanding a legal obligation many companies, including banks, do not publish financial statements, or they are very difficult to obtain, and (iii) there are insufficient numbers of qualified public accountants in Iraq. General consumer protection rules do not exist in Iraq, other than the general civil code rules, nor is there a system for depositor protection. Moreover, financial information on Rafidain Bank and Rasheed Bank, which dominate the system, is unreliable, pending the ongoing regularization of the balance sheets of these institutions, which, moreover, are not compiled according to IFRS. Also, it is assumed that these banks enjoy a de facto guarantee from the state. Market discipline with regard to these banks is therefore not effective. Stock market analysts do, however, publish analyses of private bank stocks quoted on the Iraqi stock exchange, notwithstanding the unavailability, in many cases, of up to date, audited, balance sheet and income statement data. The CAMELS ratings of banks are routinely disclosed to the public by the CBI. The majority of the population still holds their deposits in the state owned banks, given their de facto government guarantee. Bank Resolution The CBI has a credible legal and regulatory framework to apply remedial measures, resolve banks, and initiate liquidation through a judicial process, and the CBI has taken corrective actions against small private banks in a number of cases. The remedial measures enumerated in the law include sending a warning, giving an order, requesting from the bank a program of remedial measures, issuing cease and desist orders, imposing restrictions on credit operations, keeping supplementary liquidity at the CBI, suspension of managers or Board members, dissolving the Board, imposition of monetary penalties, withdrawal of the license, and liquidation (through the Financial Services Tribunal). Article 59 of the law provides a basic form of prompt corrective action, imposing on the CBI the obligation (when capital falls below 50 percent of the required minimum) or the discretion (when capital falls below 75 percent of the minimum) to impose conservatorship. Article 56 of the Banking Law (2004) authorizes the CBI to take any measure or impose an administrative penalty for violation of the law or regulations, or the unsafe and/or unsound conduct of banking business. The latter criterion shows that the CBI has the authority to make qualitative judgments, rather than be purely compliance-based. The law authorizes the CBI to set up a bridge bank for a maximum of two years, plus a maximum of three one-year extensions. A moratorium may be imposed by the CBI to protect the financial condition of a bank in conservatorship. Banks are not subject to general bankruptcy law.

56 32 B. Supervisory Rules and Practices 1. Objectives, Independence, Powers and Resources The legal and regulatory texts clearly describe the objectives of banking supervision, and provide for a good measure of formal independence of the CBI as the supervisory agency, as well as adequate powers. There are a number of anecdotal indications, however, that the independence and powers of supervision are limited, in particular with regard to the state owned banks, and that current resource levels may not be adequate at this time to include full rigor supervision of the large state owned banks and a potentially growing banking system. The CBI s remedial powers should also be used more forcefully. Objectives: The basic regulatory and supervisory responsibilities of the CBI are laid down in Article 4 of the Law on the Central Bank of Iraq. Article 3 Law on the Central Bank of Iraq states that maintaining a stable and competitive market based financial system is one of the primary objectives of the CBI. Article 2 of the Banking Law (BL) states that regulatory objectives include promoting public understanding of the banking system, inter alia by maintaining an appropriate degree of protection for depositors and helping reduce financial crime including fraud, money laundering and terrorist financing. The CBI also exercises supervision over some 1750 other financial institutions. These include exchange bureaus, money transmission services, investment companies, lending operations of insurance companies, pension funds, microfinance institutions and the post office s depositary operations, as well as commercial companies with credit facilities for their staff. The Banking Supervision Department also deals with consumer complaints with regard to financial services. Independence: Article 2(2) Law on the Central Bank of Iraq states that the CBI shall be autonomous and accountable as provided for by the law, and stipulates further that except as otherwise specified in the law, the CBI shall not take instructions from any other person or entity including government entities. The governor is nominated by the Head of Government, and confirmed by the Legislature for a five year term of office, which can be renewed. The governor cannot be dismissed, except by the Head of Government, only for one of the reasons explicitly listed in Article 14(2) Law on the Central Bank of Iraq. These grounds include conviction of a criminal offence, bankruptcy, mental or physical infirmity, absenteeism and personal misconduct. A decision of removal from office, as well as the grounds upon which this decision rests, must be publicly disclosed and are subject to appeals at the Court of Cassation. Article 55 Banking Law stipulates that CBI officials or staff shall not be personally liable for damages for any act or omission committed in the discharge of official functions, including banking supervision. The CBI shall indemnify officials or staff for the legal expenses incurred in the defense against legal action brought against them.

57 BANKING SUPERVISION AND REGULATION 33 Box 5.1: Supervision and Restructuring of Rafidain Bank and Rasheed Bank Normalization of the position and activities of Rafidain Bank and Rasheed Bank is seen by the authorities as crucial to the development of a banking system that could support the growing economy of Iraq. In Memoranda of Understanding of 6 December 2006, the CBI and the Minister of Finance laid down the framework for the supervision and operational and financial restructuring of Rafidain Bank and Rasheed Bank. However, the Iraqi authorities have recently postponed the recapitalization of both banks to 2013, seven years after signing of the MOUs. It is widely acknowledged by most Iraqi counterparts in the financial sector that the MOUs have not been implemented. In particular, counterparts agree that effective banking supervision by the CBI over these two banks has not been possible. Main elements of the MOUs are: Achieve normalization of Rafidain Bank and Rasheed Bank through operational and financial restructuring, to prepare them for a competitive market economy, and ensure their long-term financial viability; Complete an operational audit by July 31, 2007, consisting of a review of the Bank s products, operations, policies, and procedures, as a basis for a new, commercially-oriented business strategy. Continue regular banking supervision by the CBI, applying normal prudential requirements, but taking into account the temporary forbearance granted by the MOUs. In particular, the MOUs specify that in case of non-implementation of the MoU, or excessive delays, the CBI has the authority to impose conservatorship. Apply strengthened corporate governance to Rafidain Bank and Rasheed Bank, by requiring them to adhere to OECD/World Bank Corporate Governance Guideline. Use Treasury bonds to recapitalize the bank. Identify all banking activities undertaken for the Government by these banks and charge market rates for these services. Powers: Article 59 of the law provides a basic form of prompt corrective action, imposing on the CBI the obligation to appoint a conservator when capital falls below 50 percent of the required minimum. It has the option to do so when capital falls below 75 percent of the minimum. Article 56 of the Banking Law 2004) authorizes the CBI to take any measure or impose an administrative penalty for violation of the law or regulations, or the unsafe and/or unsound conduct of banking business. The latter criterion allows the CBI to make qualitative judgments, rather than be purely compliance-based. The law authorizes the CBI to set up a bridge bank for a maximum of two years, plus a maximum of three one-year extensions. A moratorium may be imposed by the CBI to protect the financial condition of a bank in conservatorship.

58 34 Article 40 of the Law on the Central Bank of Iraq provides exclusive authority to take all such actions as may be necessary to license, regulate and supervise banks and their subsidiaries. The CBI has the authority to conduct off-site surveillance and on-site examination of licensees and their subsidiaries, and require banks to provide all information the CBI may request, and to take remedial action to enforce compliance with prudential standards. Article 42 of the Law on the Central Bank of Iraq authorizes the CBI to examine evidence with regard to suspected activities for which a CBI license is required, if necessary with the assistance of law enforcement officials. The CBI shall order cessation of such activities, and if necessary impose penalties. Article 62 permits imposing penalties on natural persons responsible for the breaches of the rules. Article 3(1) Banking Law prohibits the exercise of banking activities without a CBI license. Article 3(4) Banking Law prohibits the use of the word bank without having a banking license. Resources: At this stage of development of the banking system, it is critical that the CBI maintain the public confidence in the banks. This requires a higher than average level of supervisory resource allocation in the medium term. The CBI currently has staff of around 1600, down from approximately Counterparts have stated that the governor of the CB intends to decrease the number of staff further, to around 500. However, under those conditions resources may become over-stretched in the coming years, as foreign banks are showing increasing interest to enter the Iraqi market as the security situation improves, and the state owned banks will become subject to CBI supervision. This will lead to an expected increase in the need for qualified supervisors. There is also considerable scope for an increase in the number of bank branches, which currently stands at 1/40,000 inhabitants, whereas in the industrialized world, this figure averages at 1/10,000. The budget of the Banking Supervision Department has been steadily increasing by around 10 percent per year. Under Article 2 (1) CBIL, the CBI determines its own budget and funding, may administer and hold property, hire staff and define their duties. The banking supervision department, headed by a director general, has total staff of approximately 235, of which 135 at Baghdad headquarters, and 100 spread over the four branches of the CBI in Basra, Mosul, Arbil and Suleymaniyeh. Professional level banking supervision staff is required to have a bachelor s level education in banking, finance, law, accounting or IT (the latter for quantitative and off-site functions). Staff is provided with continued domestic and external training. 2. Licensing, Ownership and Acquisitions Licensing: Although the licensing framework is adequate, there is a need for better arrangements for cooperation with foreign supervisors, also with regard

59 BANKING SUPERVISION AND REGULATION 35 to ongoing supervision, as more foreign banks show interest for entry into the Iraq market. Banking Law Section 2, Articles 4-13 regulate the licensing process, and provide the legal basis for more extensive CBI regulations on the licensing process for domestic and foreign banks, subsidiaries, bank holding companies, branches, and representative offices. These regulations have recently been revised in January For domestic banks the licensing process is divided into two phases. During the first phase, the applicant must submit inter alia a three year feasibility study/business plan with pro-forma balance sheets, income statements and an organizational chart. At least two shareholders must have banking experience. Foreign shareholders are permitted, if they are a bank and are subject to banking supervision in their home country. If shares are owned by a corporate entity, audited balance sheets and income statements over the past three years, or whatever is available, need to be submitted. This requirement needs to be made more precise, the requirement to provide whatever is available is too openended. The request for the final license must be accompanied by information on the shareholders, Board of Directors, and the CEO. Foreign applicants must have an international credit rating, implying that only reputable banks can apply for a license. The founding foreign bank must show proof that it is subject to consolidated supervision in its home country and has been in business for at least three years. A foreign bank must also submit an overview of the institution s banking products, an assessment of the risks in the bank s plan, the IT to be deployed for work in Iraq, and the number of Iraqi employees and details about their training. Also, the home supervisor must confirm that it is in a position to exercise remedial powers over the branch. During the licensing process the CBI contacts the home supervisor of a foreign bank, usually through an exchange of letters, in the absence of a formal system of MOUs. Ownership: The rules on acquisition of significant shares or other forms of influence in a bank are adequate. Founders of banks need to provide information to the CBI in the context of the licensing process. Persons acting directly or indirectly or in concert with other persons who wish to acquire a holding of 10 percent or more in a bank, shall obtain prior approval of the CBI. The CBI will assess the expected effects of the acquisition on the financial soundness of the bank. Increases in the size of a holding to exceed a threshold of 20, 33, or 50 percent shall be notified to the CBI 30 days in advance. Also the bank itself shall inform the CBI of such changes in ownership. Moreover, mergers and substantial purchase and assumption transactions are subject to CBI approval. Acquisitions: The rule that Iraqi banks are permitted to invest in non-bank or non-financial equities, without prior CBI approval, provided that the acquired stocks do not exceed 20 percent of the bank s capital, needs tightening. The 15. See Organizing Regulations for Awarding Licenses to Banks and Non-bank Financial Establishments, Part 1, License Awarding to Local Banks, Phase 1, and 5th indent.

60 36 threshold of 20 percent below which no permission is required, is too high. The ability of Iraqi banks to acquire equity in other companies makes it even more urgent to introduce rules on consolidation of accounts and supervision on a consolidated basis. 3. Regulation and Prudential Requirements In January 2011 a new series of prudential regulations 16 was issued, providing generally workable basic rules on many of the main areas of prudential regulation, although refinements are needed, and enforcement seems to be weak, with large banks fundamentally ignoring key prudential standards. The definition of capital now seems to approximate more closely the Basel I definition, although revaluation reserves are still included in Tier 1 capital, which is not in conformity with the Basel definition. A significant general problem with regard to any capital calculation are the non-ifrs compliant accounting standards used in Iraq, consequently uncertain capital values, and the uncertainty about the rigor of loan classification and provisioning by banks, in particular the large state owned banks. The CBI has set a minimum risk weighted capital adequacy ratio of 12 percent. The CBI also intends to increase the absolute capital requirements even further by 2013, to encourage concentration of the banking sector, and to provide a larger buffer against the high degree of risk in the Iraqi financial system. However, given the limited opportunities for safe lending, it also raises the question how banks can safely gain a return on these increased capital investments. The liquidity regulations stipulate a minimum ratio between assets and liabilities maturing within a week, which has been set by the CBI at 30 percent. Banks are required to report their one-month liquidity forecasts to the CBI on a daily basis. The regulation on loan classification and provisioning appropriately combines quantitative criteria, in terms of time overdue, but also qualitative criteria. The regulation distinguishes five categories: good, requiring no provisions, average : overdue more than 30, but less than 90 days, and other criteria, also requiring no provisions; below average, overdue more than 90 but less than 180 days, requiring 20 percent provisions; doubtful, requiring a provision of 50 percent, and bad, requiring a 100 percent provision. The CBI states that it has authority to override the decisions taken by the banks with regard to the classification of credits, while this may be the practice, the text 16. Regulations issued addressed licensing of banks and non-bank financial institutions, voluntary liquidation, mergers and acquisitions, credit classification and provisioning, large exposures, lending to connected parties, credit practices, investments by banks in Iraq and abroad, investments in Iraqi banks, capital adequacy, liquidity, liquidity risk management, operational risk management, market risk, general risk management, interest rate risk management, foreign exchange positions, internal audit, governance, internal control, and disclosure.

61 BANKING SUPERVISION AND REGULATION 37 of neither the new nor the old regulation confirms this. It would be advisable to include this discretionary power explicitly in the regulation. Moreover, the zero provisioning for average loans does not seem justified, given the nature of the criteria for this classification, including unclear financial statements, defective management, and requests to restructure the loan. Large exposure rules are conservative, but weakly enforced. Large exposures are defined as exposures between 10 and 15 percent of the bank s capital, for which CBI permission is required, and exposures over 15 percent of the bank s regulatory capital are presumably prohibited altogether, although the text of the regulation is not clear on this point. The total of large exposures may not exceed 400 percent of the bank s capital. The Board of a bank as well as the CBI must give permission for connected lending, defined as credit to related companies, relatives or key officials in the bank. These credits may not exceed 5 percent of capital, with the aggregate total limited to 15 percent of capital. Banks are required to report connected lending to the CBI. 4. Supervisory Approach, Reporting and Supervisory Practices Prudential reporting and off-site analysis: Although the powers to collect information seem adequate, the processing of these data seems ineffective, given the extended lag times needed by the CBI to produce up to date and consistent capital adequacy figures for the banks. Moreover the risk that banks submit inconsistent and inaccurate data is increased due to the lack of a chart of accounts necessary to produce IFRS consistent data. Article 40 of the Banking Law states that the CBI has the authority to require banks and their subsidiaries to provide all such information as the CBI may request. At its request, banks shall provide the CBI with such information or data that reflect the risk position of banks. Each bank shall furnish the CBI at relevant intervals (i.e. quarterly) statements showing assets and liabilities, foreign currency exposures, reserve position, liquid assets, large exposures, and credit to related persons. Also information shall be provided on deposits, credit lines, credit plans, and off balance sheet commitments. Banks are required to submit annually their balance sheets and income statements. The Banking Supervision Department has a Bureau for Studies and Research, which performs the off-site analysis function. Moreover the CBI has a special bureau for the collection of prudential returns, which also independently flags discrepancies and contacts the banks for clarification. The CBI has also issued guidelines for the classification of banks in the CAMELS system: Approved Controls for Assessing Private Banks. A relatively high level of vigilance is required for the 3-rated banks in the current environment, the 4 rated banks (two) are under conservatorship, and the 5-rated bank is a candidate for takeover by a strategic partner. However, it is alleged by senior officials at

62 38 the CBI as well as market observers that CAMELS ratings can be subject to undue influence by banks, which implies potential governance problems. On-site inspections: The on-site inspection system seems appropriately organized, and inspections are well prepared, although follow-up on recommendations made on the basis of the inspection seems weak. Banks are inspected once per year, according to an annual inspection plan. On average, banks are inspected annually. A Terms of Reference for the inspection is prepared, taking into account known strengths and weaknesses, past off-site and inspection reports, and e.g. NPL-data. A letter is sent to the bank by the CBI to announce the inspection, communicating the names of the inspection team. The topics of the inspection are not mentioned in the letter. The CBI has recently issued a Manual for Effective Banking Supervision, which provides more detailed guidelines for on-site inspections. Due to the constraints mentioned above, the team was unable to obtain documented evidence of CBI follow up to verify banks compliance with corrective action mandated by the CBI. The bank has 30 days to respond to the draft inspection report, after which the CBI finalizes it. The head of the Banking Supervision Department subsequently sends a letter to the bank, instructing it to correct any adverse findings. The mission could not ascertain how the CBI follows up on how banks actually implement the corrections mandated by the CBI 5. Accounting, Audit, Internal Audit/Controls, Disclosure Accounting. International Financial Reporting Standards (IFRS) are not implemented by banks in Iraq, and there does not seem to be a chart of accounts to provide guidance how to compile the figures that are entered into the financial statements. Significant differences exist between IFRS and Iraqi accounting standards, such as the lack of a requirement to consolidate accounts (although Article 43(1) Banking Law requires banks to consolidate financial statements). Furthermore, there are no guidelines for the valuation of financial instruments, e.g. mark-to-market requirements. No clear guidance exists on revaluation of fixed assets. However, the CBI has requested banks to start preparing parallel accounts, one according to Iraqi accounting standards and another according to IFRS. External auditors of banks are required to report significant issues to the CBI, including issues of safety and soundness of the bank. Accountancy training is well structured, but the availability of accountants and auditors sufficiently qualified to work in banks is limited. A Commission of Supervision of the Accounting Profession oversees the quality of the accounting profession. Audit: The tasks of a bank s external auditor include helping to maintain proper accounting systems, financial control and risk management systems,

63 BANKING SUPERVISION AND REGULATION 39 the preparation of an audit report for the Board and an opinion on the annual statements. The auditor is also required to comment on the adequacy and performance of management, report on the loan classification and provisioning system, as well as on any deficiencies in provisioning. Internal audit: Article 24 Banking Law requires banks to form an Audit Committee. Banks seem to be required by regulation to have an internal audit unit, charged inter alia with oversight over connected lending, although the basis for the regulation in the law is not clear. The internal audit unit may communicate directly with any staff member of the bank and with the Board. The regulation also describes the role of a compliance officer in the bank. Disclosures: Extensive disclosures are required to shareholders, stakeholders (undefined in the regulation) and customers of the bank, and banks audited financial statements must be published in two general newspapers. Banks financial statements may only be published after approval of the CBI. 6. Abuse of Financial Services Notwithstanding the existence of important elements of a legal, regulatory and institutional Anti Money Laundering/Combating the Financing of Terrorism (AML/CFT) framework, external observers note that the implementation of the AML/CFT framework in Iraq is extremely weak. Article 4(2) of the Law on the Central Bank of Iraq stipulates that the CBI is authorized to take any action it considers necessary to counter money laundering and the financing of terrorism. External auditors need to certify whether or not adequate measures have been taken by banks to prevent money laundering or the financing of terrorism. Money laundering-sensitive operations such as money transfer offices and exchange bureaus are also under the supervision of the CBI. Banks have an obligation to report suspicious transactions, but no typology of suspicious transactions is available. Reporting forms for suspicious transactions and large cash transactions are in place. The anti-money laundering and anti-financing of terrorism framework is laid down in the Anti-Money Laundering Act of Currently, a new law is being drafted. According to Article 12 (2) of the Anti-Money Laundering Act of 2004, the Money Laundering Reporting Office shall be staffed and funded separately from the CBI, although it is administratively located under the CBI. In the new draft law, which has not yet been adopted, the new draft law states in Article 6 that the CBI shall establish the Anti-Money Laundering Bureau, headed by a General Director (or higher). The CBI and MLRO are authorized to exchange information with domestic and foreign agencies involved in Iraq in AML/CFT. Banks are required to apply know-your-customer practices and retain records of customers identities, as well as maintain transaction records for at least seven years. Banks must match customer information against a list of suspicious persons maintained by the CBI.

64 40 An FATF-MENA AML/CFT assessment has been tentatively scheduled for Much work will still need to be done, in particular in implementation, to achieve a reasonable level of compliance by Iraq. 7. Corrective and Remedial Powers of the CBI Although the CBI has an adequate range of options for enforcement action and penalties against breaches of prudential standards and the unsafe and /or unsound conduct of banking business, enforcement is considered weak. The CBI may send written warnings to a bank, give orders, request the bank to submit a program of corrective action, cease and desist orders, impose restrictions on certain credits, require the placing of deposits with the CBI, and/or request that the CEO or Board Chairman personally take responsibility for the implementation of remedial action. The CBI may also request the suspension of any manager, or remove the chairman or Board members, dissolve the Board and appoint a conservator, impose a penalty, or revoke the bank s license. The CBI also has special rapid response Urgent Action teams which can be deployed for periods of one or two weeks. The CBI may apply discretion to appoint a conservator when capital has declined to below 75 percent of the minimum level. It is obliged to appoint a conservator when it determines that capital of the bank has decreased below 50 percent, which represents a form of prompt corrective action. Forced liquidation is required when the CBI decides that capital has declined to below 25 percent of the minimum. The CBI may impose a moratorium with regard to a bank including a ban on taking new deposits. The conservator shall attempt to rehabilitate the bank if it is considered systemically important by the Minister of Finance. Currently, two banks are under conservatorship, and one bank is negotiating a take-over by a strategic partner, under CBI oversight. The Law on the Central Bank of Iraq provides for the establishment and functioning of a Financial Services Tribunal. This court is responsible for conducting the bankruptcy of banks, according to the rules set out in the Law on the Central Bank of Iraq and the BL. 8. Consolidated Supervision Although the law and regulations require consolidation of accounts and consolidated reporting in several places, the counterparts of the mission stated that there are no rules under the Iraqi accounting system on consolidation of accounts. This needs to be remedied as soon as possible, in the context of the implementation of IFRS. 9. Home-host Relations Although the CBI contacts home supervisors in the context of the licensing of foreign institutions, through ad-hoc contacts via , letters and/or information

65 BANKING SUPERVISION AND REGULATION 41 packages, there is no system of formal MOUs or other institutionalized contacts. Currently, six foreign banks have establishments in Iraq, either through joint ventures, branches or subsidiaries. C. Risk Management Banking risk management is considered to be one of the most important topics in the banking industry all over the world, especially after the global financial crisis. 1. The CBI Regulations In response to the increased risk awareness resulting from the global crisis, the CBI revised its regulations, and issued a revised set in January, The CBI s new regulations include one chapter regarding risk management in banks (Chapter 21) which deals with the principles of risk management and discusses them briefly. These regulations cover the following areas: Credit risk management; Interest rate risk management; Liquidity risk management and Operational risk management. Although there has been some improvement in the CBI s regulations of January 2011, the regulations on prudential standards require further review to establish whether or not they fully meet international standards or not, through a rigorous assessment on the basis of the Basel Core Principles and the 2006 Methodology. 2. Implementation of Risk Management Most Iraqi banks do not implement sound risk management principles, partly due to lack of organizational as well as IT resources. The Iraqi banks and the CBI concentrate mainly on credit risk management, and the implementation of risk management in banks is an area of weakness. Regulations need further refinement to bring them into full compliance with international standards, even though the current version is workable. Moreover, banks do not have adequate staff with risk management expertise. The new market risk prudential regulations covering interest rate risk, foreign exchange risk, equity risk and commodity are broadly consistent with international standards. However, the new regulations do not address the actual management of equity risk and commodity risk. The regulations on liquidity risk management, based on the principle of maturity gap analysis, conform broadly to the international standards. The CBI s regulations on operational risk are based on Basel Committee s document entitled Sound Practices for the Management and Supervision of Operational Risk.

66 42 Improvements have been made in the regulations regarding risk management, and the basic elements for banking supervision are in place, provided the CBI implements them vigorously. Nevertheless, a full and detailed review, based on a well-prepared self-assessment to assess consistency with international standards is recommended, in order to identify where amendments and additions are needed. D. Legal Framework for Islamic Banking The CBI is preparing a draft Islamic Banking Law to be issued in the near future. On the basis of this law, the CBI will be authorized to issue a complete set of laws and regulations applicable to Islamic banks, with the objective of maintaining the safety and soundness of both Islamic banks and the banking system as a whole. This draft consists of 17 articles that deal with the nature, characteristics and credit forms of the Islamic banks as well as the accounting treatment for each credit form. These forms of Islamic credit are Murabaha (Profit-sharing); Musharakah (joint ventures); Mudarabah (Financing); Ijara (Renting); Istisnaa (Industrial - Financing); and Assets and Liquidity Management. The draft law also determines which activities are permissible for Islamic banks and which are not permissible. It is therefore important than banks have a Sharia Committee which oversees that the Islamic bank s activities are consistent with (Sharia) Islamic rules. Currently, Islamic banks in Iraq must adhere to the Banking Law No. 94, of 2004 and the internal instructions of Islamic banking, issued in Pending new regulations specific for Islamic banking, based on the new Islamic banking law, any regulations issued by the CBI should be approved by the Shura Council. As a law on Islamic banking was not in place, the Shura Council did not approve any of the CBI s regulations concerning Islamic banking activities. Islamic banks are allowed to practice banking activities that are included in Article No. (27) Of the Banking Law. Moreover, they are allowed to use riba (interest rate), finance, and investment activities. Their activities are funded through the self-funding table operations. They may also invest funds of clients who wish to invest in other products in Islamic Banks. A key tenet of Islamic banking is that clients are considered to take part in investment risk, in proportion to their account balance and duration of balance, and to bear their share of losses. The contract between the bank and the client may be terminated if the bank is proven negligent or the client has willfully defaulted. Parties may also decide to terminate the contract by common consent. The activities should then be terminated and any results (gain or loss) from the contract should be shared between the client and the bank.

67 BANKING SUPERVISION AND REGULATION 43 An Islamic bank may practice any of the following activities, after obtaining CBI approval: Non-riba (interest rate) banking activities in all its forms, with clients in Iraq or abroad. Participation in industrialization, economic development and reconstruction projects as specified in the license granted by the CBI according to the Companies Act. According to the procedures for the establishment and capitalization of both limited and incorporated companies under the Companies Act. An Islamic Bank should have a Sharia Supervision Board, consisting of at least five, but no more than seven members, to oversee the bank s compliance with the Sharia law. Decisions of this Board are binding on the bank. In particular, the Islamic Supervision Board shall perform the following functions: Monitoring the Islamic Bank s activities in terms of its compliance to the Sharia rules. Delivering opinions on the Sharia-compliance of the conditions of the bank s products and activities. Considering any matters assigned to it according to the instructions of the CBI.

68 44

69 CAPITAL MARKETS 45 VI. CAPITAL MARKETS A. Capital Market: the Current Position Trading appears to be concentrated on the ISX. The stock exchange is small and under-developed but has potential to provide access to sources of permanent and long term capital via the issuance of equity and corporate bonds to institutional and retail investors, domestic and foreign. Access to capital for productive purposes and the provision of investment and savings mediums are dominated by the state owned banks. For major institutional investors such as the state owned insurance companies, real estate and direct equity investment in mixed companies (where the state owns 25 percent of the equity) are also viable alternative investment vehicles. The current regulatory position limits the possibility of developing a range of investment products particularly for retail investors, such as Iraq based collective investment schemes. Since its foundation in 2004 (under Interim Law No 74) ISX has made progress and has begun to attract international attention, but it has a long way to go to fulfill its potential as an agent for growth in the Iraq economy. As at February 2011 there were 85 companies listed on ISX. They are a mix of privately owned joint stock companies and mixed companies. Total market capitalisation was approximately ID 3.5 trillion (USD 3 billion) which is very small; in comparison for example the Amman Stock Exchange has a market capitalisation of USD 31.5 billion and Dubai totals USD 54 billion. As a percentage of Iraqi GDP the market cap of ISX is approx. 3.5 percent. In 20I0 the market traded a total value of ID 400 billion (USD 339 million) or USD 1.4 million per day. In comparison,

70 46 Amman in 2009 (last data available) traded USD 40 million per day (it has 3 times the number of listed companies) and Dubai traded USD 37 million a day but had fewer companies listed (65) than ISX. Trading in the shares of the private banks (22 percent of the listed companies) accounted for over 80 percent of turnover by volume and value. Table 6.1: Market Capitalization - Major MENA Equity Markets + ISX Major MENA Markets Market Capitalization % of GDP Saudi Arabia Kuwait Qatar Oman UAE Bahrain Jordan Egypt ISX Source: Bloomberg, Zawya, Global Research and ISX (2010). Although share prices overall have remained flat in the last three years (see chart below) there are indications that investors are becoming more aware of the market and more optimistic about its prospects. The ISX s own index was up over 27 percent in the first three months of In 2010 foreigners were strong buyers. They bought 36 billion shares worth ID 62.8 billion and sold ID 5.8 billion shares worth 8.5 billion ID. Some emerging market funds have begun to invest in Iraqi stocks and one US broker which specializes in so-called frontier markets now promotes the market in the US. Other than percentage restrictions in the ownership of the banks, non-iraqis are free to invest in the market.

71 CAPITAL MARKETS 47 Table 6.2: Average Daily Market Value Traded Major MENA Markets + ISX Daily Market Turnover (US$ bn) 2009 % Change from December 2008 Saudi Arabia Kuwait Qatar Oman UAE Bahrain Jordan Egypt HK Sing ISX Source: Bloomberg, Zawya and ISX (2010) ISX was established as a not-for-profit, member owned self regulatory organization in It is the only securities exchange currently operating in Iraq and enjoys a monopoly of trading in securities although the current law permits off-exchange trading if the ISC has made the appropriate regulations. No such regulations appear to have been made. There are currently 48 licensed brokerage companies with two applications pending. Banks can be members of the exchange via subsidiaries but the state owned banks are prevented from joining as their legal form prevents them from owning subsidiaries. This issue has not, it is understood, been finally resolved. The ISC currently limits new licenses to five a year and gives first priority to applicant firms from the regions. Figure 6.1: Broker s Proprietary Index Source: Rabee Securities, Baghdad (2011). The upper line is the broker s proprietary index in ID and the lower in USD.

72 48 ISX s trading platform is technologically modern. Since 2010 all shares can be traded electronically although the physical floor has been maintained for those brokers who wish to use it. ISX is open for trading on five days a week. ISX uses an integrated trading, clearing and settlement platform provided by NASDAQ OMX, one of the world s leading providers of such systems. All trades are settled in the Iraq Depository Center (IDC). All brokers must be members of the depository. There are no clearing members who act for other brokers. Day to day monitoring of brokers cash and securities positions, and therefore the setting of daily trading limits in compliance with the ISX s trading rules is carried out by IDC which reports to the ISX. IDC is in the process of dematerialising securities (as paper certificates are delivered on sold trades they are not reissued to buyers who receive a record of their holdings instead). This process is also facilitating a clean-up of company share registers as regards ownership. Trading rules are conservative as is not uncommon in the region, such as Dubai. Buyers must have funds in their brokerage account before their order is entered and sellers must have the shares in their accounts. The risk of a failed trade is therefore very small. Settlement is same day (T+0) which places a very high priority on cash and securities being in position when a trade is executed, but it also acts as a constraint on the level of trading business. ISX is considering extending the settlement period to T+2 or T+3 which provide greater flexibility. Plans are also well advanced for the creation of custodian banks which will make it easier for foreigners (and large domestic investors) to trade while keeping the restrictions. Short selling is not permitted and there are no derivatives contracts traded. Trading in Government securities is currently carried out on separate system operated by the CBI. Government securities consist of 365 day treasury bills auctioned on a regular basis via an electronic system - the Government Securities Registration System (GSRS) 17. Currently access is limited to the banks acting on their own account and for customers. There are plans to link the GSRS to the trading platform of the ISX (via IDC) in order to develop the primary market and encourage a secondary market. It is intended that a greater range of government and government guaranteed securities will be issued via the GSRS, such as bonds issued by the State owned banks. Currently the CBI plans to continue to limit access to the system to the banks. There does not appear to be a market in corporate debt. B. Preconditions for Developing the Capital Market Much academic research 18 over the last twenty years has demonstrated that capital market development is highly dependent on there being a 17. The Central Bank issues its own 91 and 182 day bills. 18. What Drives Stock Market Development in the Middle East and Central Asia - Institutions, Remittances, or Natural Resources? Page 5; Andreas Billmeier and Isabella Massa; IMF working paper, July 2007.

73 CAPITAL MARKETS 49 fair, equitable and transparent civil society. This is necessary if investors are to be able, with confidence, to invest in productive enterprises on their merits and without believing that they have to be insiders or majority shareholders. These include legal systems characterized by certainty of contract enforcement, protection of shareholder and creditors rights and an honest judiciary knowledgeable in commercial law and the practice in financial markets. Speed of dispute resolution, as well as fairness, is also an important element. High levels of transparency, completeness, timeliness and accuracy of financial statements and other disclosures by companies are also essential criteria, as is a fair end equitably enforced taxation system. A securities market regulator, even if equipped with all of the tools set out in the IOSCO Objectives and Principles of Securities Regulation will not be effective, nor will its work be seen as credible by investors and issuers if these preconditions are not in place. It appears that in Iraq, in all of these areas, much needs to be done to begin to approach internationally recognised standards in which investors, both domestic and foreign, will have confidence. Discussions with the authorities indicated a range of problems. The law on bankruptcy appears to contain numerous uncertainties and unpaid creditors appear to have limited means of recourse against a defaulting company.the quality and competence of the judiciary in the field of commercial law, the powers available to the courts and the time it take for cases to work through the process are also suspect. Iraq has no laws governing anti-trust or competition issues. As regards accounting attempts have been made to implement International Financial Reporting Standards (IFRS) but legislative change will be needed to impose it fully. According to the Board of Supreme Audit this will take at least two years to secure. There are numerous differences between IFRS and Iraqi accounting standards and it is highly unlikely that Iraqi accounting standard can be considered to be of an internationally acceptable standard. Accountants in Iraq use the outdated Unified Accounting System, which includes standards that have not been updated since the mid-nineties and others which are about 70 years old. Auditing standards are also likely to be weak. A detailed examination of the key issue of auditor independence will almost certainly reveal serious inadequacies and lack of effective regulation of the profession. It appears that knowledge of the International Auditing and Assurance Standards Board (part of the International Federation of Accountants (IFAC)) and its International Standards on Auditing (ISA) is slight. Training of local accountants and auditors in new, globally recognized standards, practical and ethical, will also take considerable time. Although it appears that efforts were made to begin the process in 2007 in several universities, it is not known if that work is on-going or how successful it has been. Two widely followed international indices also indicate the scale of the problems which need to be overcome if the private sector, and in

74 50 particular that part based on broadly dispersed public share ownership and the stock exchange, is to flourish. The Transparency International 2010 Corruption Perception Index rated Iraq 175 out of 178, between Afghanistan and Uzbekistan/Turkmenistan. 19 Iraq also scores poorly in the World Bank s Ease of Doing Business Survey 166 out of 183 globally and similarly poorly on a regional basis. For example, the survey states that in Iraq it costs almost 5 times as much to set up a business than in other Middle Eastern countries and the bureaucracy is excessive. C. Capital Market Regulations The current legal and regulatory infrastructure requires significant enhancement if it is to provide a sound basis for the development of the capital market. The issues and recommendations for change are discussed in Annexes 8 and 9. Some necessary measures are in the advanced planning stage and should be actioned as soon as possible. Others need to be initiated or developed fully. This section describes, to the extent possible based on available information, the current regulatory and self regulatory position. The statutory regulator is the Iraq Securities Commission (ISC). Established under the Interim Law No. 74 ISC is believed to be small (46 employees) and probably under-resourced. It should have a Chairman and four other Commissioners, three of whom are to be part-time. Its web site names only three Commissioners currently, the Chairman and two others. Commissioners are appointed by the Council of Ministers and should be experts in securities markets; the Chairman is a stockbroker by profession. Also according to its web site ISC is organized into 9 departments: Executive, Public Relations and Secretariat, Legal, Inspection and Implementation, Disclosure Department, Chief Accountant, Internal Auditor, Market Organization, IT and Research and Economic Analysis. The web site does not include an annual report of the Commission. As far as can be determined from the web site the ISC s primary, day to day, role is receiving the annual and quarterly reports that ISX listed companies are required to file with it. It also receives reports from persons who hold more than 10 percent of the voting shares of a listed company and any changes thereto. It has adopted a practice of publicly warning (via its web site) those companies, by name, which have not met their obligations to file quarterly unaudited financial reports within the 60 day deadline, and conversely congratulating those that have. Since 2007 ISC has issued a total of 14 instructions to brokers and issuers; some have simply modified previously issued instructions. These are generally short, one or two pages, and set out regulatory matters in outline only. As regards brokers it has issued instructions concerning minimum capital requirements (a highly simplified version of the Net Capital Rule of the US SEC); disclosure of financial statements to the Commission; information to be given to non-iraqis seeking 19. Russia, at 154 is the only economy which breaks the rule that high levels of perceived corruption and a thriving stock market do not positively correlate.

75 CAPITAL MARKETS 51 to trade on the ISX; procedures to be followed for the suspension and cessation of ISX membership of brokerage companies; procedures for the segregation of client accounts at brokerage companies; and procedures for opening branches of brokerage companies in the provinces. As regards listed companies the ISC has issued instructions concerning conditions and requirements for listing companies at the stock exchange; dates of suspending and re-allowing trading for shares of listed companies; financial disclosures by listed companies; disclosure of significant holdings and the procedure for delisting companies. It has stated that it will not issue regulations (which it presumably sees as having more force than instructions) until the permanent Securities Law is brought into force. Although the Interim Law states that no stock exchange may operate without a license from the ISC, the ISX (as successor to the Baghdad Stock Exchange) was licensed and operates by virtue of the Interim Law and is thus in a privileged position vis-a-vis the ISC. It is however subject to regulatory oversight by the ISC although it has not been possible to establish how that operates in practice. It would not be surprising, if, as in many emerging markets where the exchange pre-dates the statutory regulator and has many informal and long-standing relationships within the executive and industry, the ISC finds its oversight power is limited should it wish to exercise that power in a vigorous way. Stockbrokers who were in business prior to April 2004 were also grandfathered without having to go through a re-licensing process, which compounds the problem. 20 As a self regulatory organization ISX has the main responsibility for on-going regulation of its 48 members. From discussions with the Chairman of the Governors and the General Manager it appears that ISX takes its self regulatory role as a market operator seriously. The Chairman stated that when the law requires the Exchange to take action, this has been done. Sanctions have been imposed on brokers, and companies have been delisted, though not frequently. He subsequently provided various application and reporting forms which provide documentary support to some elements of his assurances. The General Manager provided further examples. Although the conservative nature of the trading rules coupled with the automated integration of electronic trading and settlement probably secures a degree of automatic enforcement of rules and limits systemic risk, the ISX has only five staff to supervise the brokers and carry out market surveillance which is too few. The trading rules appear satisfactory although consideration should be given to moving to a real time last trade tape. The Chairman noted that brokers are inspected on a semi-annual basis although it was not possible to establish how thorough that process is. Copies of the inspection manual or sample inspectors reports have not been provided. The recent move to electronic trading integrated with clearing and settlement, while not eliminating risk, should provide supervisors with better and more immediate warning signals. The ISC appears to have accepted that ISX should take the lead in day-to-day supervision of its members. 20. Although all brokers are subject to an annual review of their IT capabilities by ISX.

76 52 Shares are in the process of being dematerialized and the registers of ownership are being updated and problems resolved. Under the current law there is a significant degree of transparency of share ownership. Share registers are open to the public, listed companies have to disclose their five largest shareholders in the annual report and shareholders owning 10 percent or more of the voting shares of a joint stock company must report this to the ISX and the ISC which have an obligation to make this information public. These provisions, if fully enforced, should, over time, add to the integrity of the market and increase investor confidence in participating in it. D. Issuers and Infrastructure Only one company listed on ISX in 2010 and 5 delisted. New admissions to listing are the lifeblood of any stock exchange. On that basis ISX is at a critical stage of its development. It is not clear why growth in listings has come to a halt. It may be that ISC has attracted the majority of private and mixed companies in Iraq that are: (i) interested in listing and having their shares freely traded by public investors; and (ii) capable of meeting the criteria for listing. It may also be the case that currently listed companies do not have any great need for additional capital which would cause them to issue more shares. On the other hand, owners of closely held private companies may need incentives to encourage them to accept outside shareholders via a listing on ISX. In any case, the greatest number of companies which could potentially transform ISX is to be found in the state owned sector. According to ISX there are up to 296 companies which could be transferred to the private sector. The Ministry of Finance has established a committee structure charged with taking the process forward. One constraint appears to be that currently there is no clear authority in the law to enable a privatization program to be undertaken. It is understood that there is also an unresolved debate on the extent to which ownership should be transferred to private investors by means of public offers of securities and listing on ISX, and the extent to which significant stakes in major companies should be sold directly to foreign companies. Presumably the expectation, if the second course is adopted, is that these foreign direct investors will bring needed expertise and additional technical and financial resources to develop their Iraqi subsidiaries. As discussed below, to the extent that state owned companies need new capital when transferring into the private sector, there is also a question as to whether domestic Iraqi investors, whether institutional or retail, can provide sufficient funds. The fact remains that even if shares in only a minority of state owned companies were offered to the public in Iraq, whether for free or for cash, the ISX would be transformed into an exchange better capable of standing comparison with its regional peers such as Cairo (313 listed companies), Amman (272) and Saudi Arabia (135). Achieving a successful privatization program poses many challenges. As Iraq transitions from a largely state owned command economy to a free market in

77 CAPITAL MARKETS 53 which the securities market will play an increasing role in capital formation and allocation and a place for savings, it will be vitally important for the authorities to learn from the mistakes in other countries which went through this process. In many cases investors, particularly retail investors were inexperienced and naïve and regulators were poorly resourced and inexperienced. The clever and unscrupulous made fortunes. Flawed privatization methods coupled with poor regulation (such as the voucher schemes used in much of Eastern Europe and Mongolia) and extra-statutory criminal activities, such as Ponzi schemes masquerading as legitimate investment products, severely damaged investor confidence and destroyed savings. In some countries the development of the capital market was set back by a decade or more. Similarly, while the privatization of 296 state owned companies potentially opens up great opportunities for the ISX and its members it will require significant steps by ISX to increase investor confidence in the integrity of its market and to enhance expectations that they will be treated fairly. This will require: Close attention to be paid to the quality of the service provided to investors by brokers, from the suitability of advice, the handling of client orders and the safekeeping of client securities and cash Enhanced market surveillance and prosecution of insider dealers and other manipulators Securing technological enhancements when necessary, particularly in clearing and settlement, to minimize the risk of a market collapse from a surge in trading which exceeds the ability of the system to process. ISX wishes to develop a Second (or Junior) Market to provide access to equity capital for SME with short trading histories. It has identified 23 companies interested in listing. Many exchanges globally have established such markets. ISX s preferred model appears to be based on that adopted by the Amman Stock Exchange where a company can be listed and have its shares publicly traded as soon as it receives its permission to trade from the authorities rather than having to first establish a two year trading history which is the norm for a listing on the First Market in Amman, ISX and many other exchanges. This could provide a further stream of new listings although the average size of each company is likely to be small. Second tier companies are inherently riskier than those admitted to listing on the First Market. They are smaller and have little or no track record on listing. Their failure rate is therefore likely to be significantly higher. That need not be a concern as long as investors fully understand the risks to which they are exposed and have the resources to withstand sudden and sometimes total losses on their investment. It also requires a regulatory framework with a strong emphasis on brokers knowing their customers and having an obligation to propose only those investments suitable to the risk profile and other needs of the client. Currently it is not evident that either ISX or ISC have the capacity to supervise licensees with sufficient intensity to secure a reasonable level of

78 54 compliance with such rules. In this situation ISX needs to be very mindful of its responsibilities towards investors and the need to protect its reputation before creating a Second Market. Current rules governing the conditions under which buy and sell orders can be entered onto the trading platform of ISX are restrictive and are likely to be acting as a constraint in increasing volumes as ISX recognizes. In essence, before entering a buy order a broker must have sufficient funds from his client in his account. Similarly, a sell order can only be entered if the securities are in the account and unencumbered. Given that settlement is same day (T+0) this may be necessary given the current situation with regard to the payment system and the role of the IDC. It has the effect of virtually eliminating the risk of failed trades which is a virtue in its own right as a means of reducing systemic risk, even if the settlement period was extended, such as to T+3. Where this conservative approach to trading has been adopted its disadvantages (limiting the speed with which investment decisions can be carried out and therefore limiting daily trading volumes) have generally been ameliorated by the creation of Custodian Banks. These banks maintain cash and securities holdings for investors, generally foreign and institutional investors, and are closely linked to the clearing and settlement system, thus enabling active intra-day trading by their clients while keeping the risk of failed trades to a minimum. ISX is in an advanced stage of introducing the custodian bank system to its market. According to the Chairman, a major international bank is ready and is waiting for the necessary licenses to be granted. Others have also expressed interest in offering the service. The Chairman of the ISC has recommended that other measures in this area should be examined to further improve automated cash settlement of securities trades and to encourage market financing facilities by the banks. Trading in Government Securities can be a valuable source of revenue for exchanges in emerging markets. There are plans to integrate current issuance and trading in government debt, organized by the CBI, with the ISX s trading platform and the Iraq Depository Center (IDC), although the CBI wishes to continue to limit direct access to the banks. ISX would prefer to see access broadened to investors more generally. If its members are able to give advice on trading of government securities and then execute orders on the ISX s trading platform it seems likely that secondary market trading volumes would increase. However, currently the government issues debt with a maturity no longer than one year. This limits, but does not eliminate, the opportunities for profitable trading. The absence of a yield curve based on government debt beyond one year acts as a constraint on the pricing of longer term debt and the development of fixed income products generally. In particular it hampers the development of a corporate bond market as there are no baseline yields (the so called risk free rate ) on which to price corporate debt. 21 A legal and regulatory framework 21. There are few examples of deep, liquid corporate bond markets in emerging markets. The World Bank and IOSCO have recently initiated a project to seek to develop better understanding of the challenges in developing such markets and mechanisms by which their growth can be encouraged.

79 CAPITAL MARKETS 55 for a corporate bond market exists. Company Law No 21 Section 8 sets out the legal basis for the issuance of corporate bonds. They are also defined as securities in the draft permanent Securities Law; the ISC has prepared draft rules for issuers. There is however no specific legal structure governing the issuance of Sharia compliant securities (sukuk). Currently a corporate bond market does not exist in Iraq and its development is not on the ISX s agenda. It is probably also the case that uncertainty concerning bankruptcy law and related matters such as the status of mortgaged assets, and the perfection of title over collateral in the event of an insolvency are factors preventing this market from developing at the present time. Additional factors to which the authorities should give consideration are improving the efficiency of the process by which new businesses can be established and enhancing the confidence among customers, suppliers, creditors etc when dealing with privately owned businesses. Currently Iraq scores poorly in the World Bank s Ease of Doing Business Survey 166 out of 183 globally and similarly poorly on a regional basis. For example, the survey states that in Iraq it costs almost five times as much to set up a business than in other Middle Eastern countries; it takes, on average, 77 days to set up a company and there are 11 different procedures to go through; The Middle East average is 20 days and eight procedures. On the enforcement of contracts Iraq stands at 141. E. Developing the Capital Market Investors For a stock market to make a significant contribution to economic growth it needs investors as well as issuers, domestic as well as foreign, and in particular it needs a range of significant domestic institutional investors. Classically that would include state and private pension funds, insurance companies (especially life companies) and collective investment schemes such as mutual funds and the European equivalent, Undertakings for Collective Investments in Transferable Securities (UCITS). Such professional investors are generally regulated as to their qualifications and conduct, knowledgeable, take a medium to long term view, monitor the performance of their portfolios and are prepared to rebalance their portfolios to reflect their changing perceptions of issuers prospects. 22 They are thus likely to be active participants in both the primary and secondary markets. Retail investors who trade on their own account can also be very active if they perceive the market to be transparent, well regulated and not biased in favor of insiders. But they are likely to take a more short term and speculative interest in share prices and be driven to act collectively as a result of rumors, press speculation etc. The ISX was able to provide information on shareholdings by foreign investors but was unable to provide a breakdown of shareholdings by domestic investors, such as banks, insurance companies, pension funds, and retail; no other 22. Many hedge funds are the exception to this rule although the trend in recent years is for greater regulation of the sector and the emergence of more conservative long only strategies.

80 56 comprehensive data was available. In discussion with the Director General of Iraq s largest insurance company (Iraq National Insurance Co (INI) he observed that the company s reserves are invested in high quality assets including real estate, bank deposits and equities. In the case of the last the company invests in both mixed companies and fully private companies. Equity investments are extensive and sometimes substantial (over 50 percent in some mixed companies). Although the Director General was not able to provide a total for INI s equity investments he gave a figure of US$ 4 billion for the company s real estate investments in Iraq and elsewhere in the region. If the equity portfolio approaches this level it would match or even exceed the total current market capitalization of ISX (US$ 3.5 billion). The implication is that, as a group, the state owned insurance companies, which dominate the insurance sector, are currently major holders of equity in companies in the manufacturing materials and service sectors. Their contribution therefore, as Iraq seeks to expand the role of the private sector, has major potential. Much will, or should, depend on the split between general and life insurance. 23 The State Pension Fund is believed to have assets of ID 4.5 trillion (US$ 5 billion) although the Review did not establish how these are invested. Investment via the stock market rather than via direct investment, by institutions of this relative size, will also require modifications of the trading mechanisms of ISX. A system which is adequate for executing 300 trades a day for a value of US$ 1.4 million is unlikely to be satisfactory to meet the needs of substantial institutional investors. According to the Director General of INI problems already occur. The ISX and its members will in due course need to add a dealer market to the current brokerage market. This will require members with sufficient capital to be capable of facilitating client orders of substantial size by taking some or all of an order onto their own books until counterparty can be found. The role of an effective and comprehensive risk based regulatory capital regime will then also become of vital importance to minimize systemic risk which might otherwise arise. If the state owned insurance companies and the State Pension Fund themselves remain under state control, their acquisition of substantial or controlling stakes in privatized companies creates a dilemma. It would give the state a continuing and influential role in productive sectors of the economy and, depending on the precise policy objectives of the program, might create tensions. As for retail investors there are no collective investment schemes (CIS) currently offered to investors in Iraq nor is there a regulatory structure to support the product. A well regulated CIS sector can provide a valuable means of providing access to the stock market for investors, particularly inexperienced retail investors, and encourage them to recognize the benefits of equity investment as 23. The long time horizon of life insurance contracts permits responsible investing of reserves in longer term and less liquid investments. It also means that life companies and pension funds have a constant need to back long term liabilities with long term assets.

81 CAPITAL MARKETS 57 part of their medium to long term savings. As CIS are professionally managed they remove the need for investors to seek advice on day to day management of their portfolios, once the initial choice of which CIS to purchase has been made. They can also reduce specific risk by providing diversification for those investors without the financial resources to purchase sufficient individual investments (at reasonable or even any) cost to achieve this end. Whether a CIS market can develop, or indeed whether direct retail investment can become a significant source of funds in a stock market, depends on the level of savings and disposable income in the society. According to one estimate 24 Iraq GDP per capita on a Purchasing Power Parity basis in 2010 was USD 3,600. This was somewhat lower than, for example Jordan (4,800) Syria (4,700) Egypt (4,900) or Iran (11,300). Perhaps more significant when considering the resources of individuals available for stock market investment, the 2011 World Bank report Confronting Poverty in Iraq states that Compared with most other countries, there is relatively little inequality in Iraq. Few Iraqis today are well-to-do, and few are extremely poor. At the quoted level of GDP per capita this implies that the size of a middle class with a capacity to save a portion of its income is small, and such capacity as exists is likely to be placed in low risk investments, such as savings deposits in the state owned banks. It may be that, at the retail level, ISX will need to look to the diaspora to play the major role in purchasing new issues of securities CIA World Fact Book (2010). 25. At end of February 2011 on the Amman Stock Exchange foreign ownership accounted for 49.6 percent of ASE capitalization, 32.6 percent of which was owned by Arab investors (expatriate Jordanian investors percentage unknown) and 17.0 percent by non-arabs.

82 58

83 THE INSURANCE AND PENSION FUND SECTORS 59 VII. THE INSURANCE AND PENSION FUND SECTORS A. The Insurance Sector 26 The size of the insurance market cannot be properly assessed because of the lack of reliable date. The total aggregate annual amount of gross written premium for all insurance companies are by some market participants believe to be about US$ 60 US$ 80 million for the non-state owned insurance companies and four or five times that amount for the state owned insurance companies. Reinsurance is not much used and it is thought that the total amount of reinsurance premium is equal to maybe percent of the gross premium written. In addition to the three state-owned insurance companies there are about 18 private sector companies. Five insurance companies are listed on the ISX. The state-owned insurance companies dominate the market. The reason for the domination of the three state owned insurance companies (the National Insurance Company, the Iraqi Insurance Company, and the Iraqi Reinsurance Company) seems to be that all or almost all government contracts for insurance services are given to the state owned insurance companies. Although article 81 in the Insurance Business Regulation Act requires that government contract for insurance shall be procured through a public tender where all licensed insurance companies are allowed to participate, the common perception is that the state-owned insurance 26. The comparative materials from the Middle East and North Africa Region in this assessment are from the report: The Insurance Sector in the Middle East and North Africa Region: Challenges and Development Agenda, Rodney Lester, the World Bank. November Many of the recommendations in this assessment also draw on this report.

84 60 companies always are awarded the contracts with the government. In the other countries in MENA region government business also tends to be placed with insurers in which the government has a significant interest, but this is gradually breaking down. Mandatory placement of government business is declining as governments realize the benefits to be obtained from modern risk management technology available through the international brokers, and the fact that they have been cross subsidizing loss making insurance products. The dominant presence of the state insurers has been showed to slow down development of the insurance market so in order for the insurance sector to grow at normal pace, privatization of the state-owned insurance companies should be considered. It may be necessary for the state owned insurers to go through a process of full financial and operating audits and transitioning to become organized a corporation (joint-stock company) prior to eventual privatization. There are at least four other countries in the MENA region which are transitioning from a historical legacy of state monopolies (Algeria, Egypt, Libya, and Syria) and a common approach in the region has been to introduce private shareholders through direct placement (STAR in Tunisia) and/or an IPO (Libya Insurance in Libya). Some of the private insurance companies are very small and that creates some uncertainty as how many of the insurance companies are actually operational. It is worth noting that the insurance markets in the MENA region seem excessively fragmented in some countries and this may have hindered the sector s development. That would be the situation where there are too many companies sharing very small markets. As a result, the insurance companies are unable to generate scale, retain a sufficient volume of premiums, build meaningful risk pools and underwriting capacity and innovate. Many insurance companies seem to act simply as brokers or front offices, reinsuring most of the business. Minimum capital requirements are a traditional supervisory tool to screen the number and quality of applicants in insurance and other sectors, and the supervisor in Iraq should consider using the minimum capital requirement as a tool to prevent a situation of excessive number of insurers, some of which are playing only a marginal role. There is no compulsory insurance. Mandatory car insurance is very common around the globe as are other forms of compulsory insurance such insurance workmen s insurance for injuries and accidents at the workplace, but no compulsory insurance has been established in Iraq. The mandatory car insurance should be developed to provide protection to persons injured by vehicles. Once mandatory car insurance (MTPL insurance) is implemented it will be an important step in helping the insurance sector grow. The insurance sector is regulated by the Insurance Business Regulation Act from 2005 (the insurance act ). This act has many of the features of a modern insurance law, in that it establishes a supervisor, introduces the licensing concept, includes capital requirements, regulates intermediaries and has regulation on how an

85 THE INSURANCE AND PENSION FUND SECTORS 61 insurer shall exit the market place when it does not meet the requirements in the law. It does, however, in almost all the regulated areas fall short in respect of one or several of the essential elements listed in the ICP (Insurance Core Principles and Methodology) issued by IAIS (International Association of Insurance Supervisors). It is for that reason recommended to amend the insurance act so it brought in full compliance with the best practice standards. The supervisor for the insurance sector, the Iraqi Insurance Diwan, was established following the passing of the Insurance Business Regulation Act. The supervisor received support from USAID from March 2005 to June 2006 and set up a website, became member of the IAIS and entered into a MOU with the Iraq Insurance and Reinsurance Association. In the last years the supervisor has, however, been very passive. The lack of activity by the supervisor manifest itself by the fact that very few of the market participants know that there is an insurance supervisor and even government officials were confused about the existence of the supervisor, questioning its name etc. For the future development of the insurance sector, it will be important to strengthen the supervision of the insurance sector. The supervisor is now staffed by only a consultant and two civil servants, so the staffing of the supervisor also needs to be increased. The insurance act provides the insurance supervisor with some measure of independence. The insurance act has explicit procedures regarding the appointment and dismissal of the president of the supervisor. The president of the Diwan can only be dismissed based on a decision by the Prime Minister and approved by the Presidents Council and a justified reason needs to be provided for dismissing the president of the Diwan prior to the end of the tenure (article 7). The Diwan is founded by fees collected from the supervised entities (article 9) and this provides the supervisory with financing while not undermining its independence from political, governmental or industry bodies. The act also includes conflict of interest rules to employees of the Diwan such as imposing a prohibition on dealing in shares and investing in the companies they supervise (article 91). The supervisor furthermore has the authority to hire, contract or retain the services of external specialists through contracts or outsourcing arrangements if necessary (articles 8 and 54). The act requires that the supervisor publishes a report annually on the conduct of its policy and describes its performance in pursuing its objectives (Article 11). The act also allows for substantive judicial review if the supervisor denies an application for a license (Article 19). The insurance supervisor should, however, be strengthened and provided with adequate levels of legal, administrative and budgetary independence. The insurance supervisor is organized under the Ministry of Finance and subject to the Minster s direction. It is consequently not free from undue political and governmental interference in the performance of supervisory responsibilities. It should instead be provided with administrative autonomy and conditions needed to attract and retain qualified personnel. The insurance supervisor could be organized either as a separate supervisory agency, such as in Jordan, Syria and

86 62 Tunisia, by merging the insurance supervision with the capital market authority or other non-banking regulators, such as in Egypt and Oman or be set up inside the central bank, such as in Bahrain and Saudi Arabia. The insurance act requires insurers to be licensed but there are significant exemptions. The President of the Diwan can allow an insurer to operate before obtaining a license and foreign insurers or insurers affiliated with a foreign insurer can operate without a license provided they come from a country that apply the IAIS core principles for insurance. Insurers that hold an old license can also continue operating under the old license and are not required to apply to be license in accordance with the requirements under the act. The insurance act does not properly define the permissible legal forms of insurers and allows a wide array of company types to conduct insurance business. An insurer can in accordance with the act be organized as a public company, a private company, a mixed shareholding company (mix of owners from state sector and non-state sectors), a takaful and a retakaful company. There are five types of private companies of which three have unlimited liability (the joint liability company, the sole owner enterprise, and the simple owner company). In addition, an insurer or reinsurer that the President of the Diwan considers to be qualified and financially capable can conduct insurance business regardless of organization form (Aticle 13). The insurance act is on this point in conflict with the Company Law No. 21 of 1997 which requires that an insurance and reinsurance company must be organized as joint-stock company (Article 10). The insurance act should require that all companies conducting insurance business are licensed and the law should at least require that the insurance company is organized in a company structure with limited liability. As a general rule branches of foreign companies should only be allowed if it assets covering liabilities and required solvency are held locally and the parent company has very high claims paying and credit ratings. The insurance act does contain requirements to the board members and key functionaries professional experience, but does not include licensing criteria to the insurer s significant owners, auditor and actuary. The requirements to the board members and key functionaries integrity are also insufficient, making a criminal conviction or a serial violation of the insurance act or the corporate law the only barrier to not being considered fit and proper (Article 42). The insurance act does not stipulate that the supervisor shall assess the qualification of auditors and actuaries of an insurer as part of the licensing procedure or later. Instead the act requires that the shareholder committee select an independent accountant to examine the financial information of the insurer and notify the Diwan, if it is found that the insurer is unable to cover its financial obligations, meet the law s capital adequacy requirement or that the accounting practice of the does not conform to legal framework s requirement to acceptable accounting practice (Article 36).

87 THE INSURANCE AND PENSION FUND SECTORS 63 The insurance act does require that an insurer obtains the supervisor s approval before it transfers all or any part of its insurance business (Articles 48 and 50). The act should be amended so it includes a definition of the term control that gives the threshold for obtaining control in legal terms as a result of holding of a defined number or percentage of issued shares or specified financial instruments (such as compulsory convertible debentures) and the supervisor should check whether those seeking control meet the fit and proper criteria. The supervisor should also require that the structures of a financial group containing potential controlling owners of insurers should be sufficiently transparent so that supervision of the insurance group will not be hindered. Insurers are required by the insurance act to report on their financial position and the risks they are facing (article 38) but these requirements are not enforced by the supervisor so there is in practice no reporting of financial information from the insurers to the supervisor. The insurance act requires insurers to prepare and provide their annual report to the supervisor (Article 38), but they are not required to provide it to other stakeholders. The insurance act requires the insurer annually to provide an audit opinion, with its annual report and annual financial account (Article 38). The insurance act gives the supervisor the power to set the requirements for the submission of regular and systematic financial and statistical information, actuarial reports and other information from all insurers. The supervisor has not made use of the power to set requirements to the information from insurers including defining the scope and frequency of those reports and whether it should be audited. There is in general in the MENA region a lack of consistent, timely and high quality data available to the supervisors and those sections of the general public and the industry that need such information. This may among other things be caused by a desire by family and financial and industrial controlled groups to not reveal such information. All insurers should, however, be required to submit financial and statistical information to supervisors in electronic form according to agreed templates, timetables and definitions. The insurance act does not grant sufficient powers to the supervisor for effective discharge of its supervisory responsibilities. It is particularly serious that the act does not explicitly give the supervisor the power to conduct on-site inspections. There are no requirements in place that requires that insurers comply with standards on investment activity. The insurance act anticipates that the supervisor shall issue instruction regarding insurer s investments (Article 12) but regulations relating to allowable investments, matching of assets and liabilities and suitable forms of capital have not been issued. The insurance act (Article 12) delegates to the supervisor to issue regulation regarding solvency margin but such regulation has not been issued. The supervisor should consider following the lead from most MENA countries that

88 64 broadly follow the original EU Solvency 1 regime, with some countries modifying the premium and claims weightings according to the class of business. Two countries (Jordan and Syria) have adopted a modified US risk based capital approach, which implicitly allows for a graduated response to deteriorating insurer solvency. Saudi Arabia has also implemented such an approach in the context of a modified European solvency formula. As a number of other insurance legislations in the region the Iraqi insurance act have an old fashioned minimum guarantee requirement related to minimum capital. This requirement is not up-to-date and should be replaced with a more modern solvency regime. The result of following a minimum guarantee requirement is often that the minimum capital requirement instead takes on a default solvency role instead of fulfilling its main purpose of helping create an efficient industry structure and cover establishment costs. The insurance act includes provisions requiring that the insurer establish technical provisions (article 32), but these provisions are quite rudimentary and not based on sound accounting and actuarial principles. The law provides that the insurer shall make reserve provision in a sum similar to 40 percent of net premium and 25 percent of net insurance premium for marine insurance, plus a sum equal to 100 percent of outstanding clams, plus a sum proportionate to the amount of incurred but not reported claims. There is probably a translation mistake when the English version of the act requires a sum proportionate to the sum incurred but not reported claims to be included in the technical reserves. There should not be a deduction as indicated by the word proportionate when calculating the amount of incurred but not reported claims. The insurance act should be amended and in line with the more modern laws in Saudi Arabia and Egypt require actuarial input for long tail (i.e. liability) claims provisions. The reserves need to be determined by qualified individuals who can adjust for inadequate case estimates and incurred but not reported claims and life mathematical reserves require actuarial input. A good approach to developing a risk based supervisory model is to initially have a relatively simple but modern solvency requirements and first focus on ensuring that proper information is being provided. It is also essential to ensure that supervisor s analytical and intervention capacity is up to necessary standards. Developing markets that have taken this approach typically seek technical assistance in producing relevant operating manuals and in performing the initial full scope on site inspections. As it is likely that actuarial resources are thin in Iraq a more rules based approach could be taken to the setting of non life claims provisions, including IBNR (incurred but not reported losses) allowances. Long tail claims (an injury or other harm takes time to become known) are infrequent (not including MPTL Insurance) and reinsurer support could be sought here. The accounting, actuarial and auditing standards are not comprehensive, properly documented, transparent and consistent with international standards.

89 THE INSURANCE AND PENSION FUND SECTORS 65 Presently most of the institutions including financial sector are applying the Iraqi accounting standards (the Iraqi Unified Accounting Systems) that do not comply with international accounting and auditing standards. The Iraqi Unified Accounting System is completely different from IFRS and there is no description of the accounts. The insurance companies are not required to use the IFRS and with the possible exemption of the foreign own insurers do not apply the IFRS. The accounting and actuarial standards are not applied and disclosed in a manner that allows current and prospective policyholders, investors, intermediaries, creditors and supervisors to properly evaluate the financial condition of the insurers. Accountants, actuaries and auditors are generally not competent and experienced in complying with the IFRS standards. Some of the big international auditing firms such as E&Y are established in Baghdad, but in interviews with staff from these firms it was estimated that 99 percent of the local auditors are not skilled in applying the IFRS. The insurance act provides the supervisor with the power to take preventive and corrective measures if an insurer fails to operate in a manner that is consistent with sound business practices or regulatory requirements (articles 47 and 51). The act does, however, not allow the supervisor to take these measures in a timely fashion, but instead requires that the insurer has violated the law, regulations or instructions before preventive and corrective action can be taken (article 47 and 51). The insurance act should allow the supervisor to impose preventive and corrective measures at a much earlier stage when the chance for saving the insurer is better. An insurance industry association The Iraqi Insurance and Reinsurance Association is established but the insurance act explicitly states the association shall not have any regulatory role or responsibilities (Article 84). The World Bank s work in the region has shown that strong industry bodies, working closely with the supervisor and government can have a significant impact on public trust and awareness and in ensuring that the sector operates in an optimal fashion (i.e. properly balances competition and the public good). The Iraqi Insurance and Reinsurance Associations should be used more in building the insurance sector in Iraq. Good examples on the benefits of actively using the insurance industry association can be found in Bahrain and Morocco. The insurance act includes provisions to prevent money laundering (Article 35) but the provisions do not conform to the criteria specified by the Financial Action Task Force (FATF) recommendations. The insurance act does not require Customer Due Diligence; monitoring complex, unusual large transactions; and reporting suspicious of transactions to the Financial Intelligence Unit. The supervisor does not conduct any activity related to preventing money laundering or combating the financing of terrorism, such as requiring insurers and intermediaries, in general and in particular insurers and intermediaries offering life insurance products or other investment related insurance, to comply with anti money laundering and financing of terrorism measures.

90 66 The insurance act should also address insurance fraud. The supervisor should require that insurers and intermediaries take the necessary measures to prevent, detect and remedy insurance fraud. B. The Pension Sector The pension sector in Iraq is now undergoing a transition from its former structure with separate public and private sector pension funds. This transition was recommended in an analysis prepared by the World Bank in 2005 and presented in the report: Pension in Iraq: Issues, General Guidelines for Reform, and Potential Fiscal Implications. A pension law was passed in January 2006 that would combine the two existing pension systems. Following criticism that the system promoted by the law was fiscally unsustainable, the law was subsequently amended and ratified in December 2007 as the Unified Pension Law. The Unified Pension Law stipulates the unification of public and private sector pension schemes and created the National Board of Pensions (NBP) and the State Pension Fund (SPF), to replace the old State Pension System The Unified Pension Law which is only 15 pages long, includes provisions regarding the mandatory amount of payments into the pension system, it identifies who are entitled to pension, and the amount of payment from the pension system. The Unified Pension Law does, however, not comply with the Principles of Private Pension Supervision that has been developed by The International Organization of Pension Supervisors (IOPS). The Principles of Pension Supervision that has come to be recognized as the international best practice standards anticipate that pension funds shall be supervised by a regulator, but the Unified Pension Law does not require supervision of the pension funds. The Unified Pension Law is also lacking in other important areas, such as providing a robust and safe legal structure for the pension fund requiring that the pension assets are held by an independent depositary and that the depositary conducts net asset valuations of the independent accounts on a regular basis. It is recommended that the National Board of Pension consider amending the pension fund law requiring the establishment and use of a depositary and the establishment and use of a pension supervisor with all the needed powers to properly supervise the pension funds. The World Bank has established a Pension Reform Implementation Support Technical Assistance (PRISTA) project that shall support the implementation of the Unified Pension Law. It is recommended that the PRISTA project supports in establishing a supervisory body for the pension funds and strengthen the legal structure and transparency of the pension funds.

91 CONCLUSIONS AND POLICY RECOMMENDATIONS 67 VIII. CONCLUSIONS AND POLICY RECOMMENDATIONS This review has faced unique challenges, including limited access to officials and market observers in the field and limited track record for implementation of rules and regulations. Nevertheless, in spite of these caveats, this assessment point clearly to a number of key issues that need to be addressed to underpin the development of Iraq s financial system. Administrative and technical challenges, the uncertain security situation and the complex political landscape add additional urgency to a well focused prioritization. Key issues to be addressed up front are the role of state banks and the creation of a level playing field for all banks. This will need to be followed by the early adoption of the proposed permanent Securities Law and steps to turn the insurance Diwan into an effective supervisor. Supporting ongoing efforts will be needed to address financial sector infrastructure, including supervision, credit registry, collateral framework, judicial systems, and accounting and auditing skills. A crucial step, also to signal seriousness of intent, is to clean up the balance sheet of Rafidain Bank and Rasheed Bank, which has been under discussion since Since more time may be required to clarify some of the disputed items on the balance sheet, the best approach will be to transfer disputed assets and liabilities of the two banks to a newly created asset/liability management company to permit the slimmed down Rafidain Bank and Rasheed Bank to focus on moving forward with their operational restructuring. The latter process is well formulated in the 2006 memorandum of understanding between the Ministry of

92 68 Finance and the Central Bank of Iraq and should be carried out over the next two years. Once the balance sheet is cleaned up, the capital of the two banks should gradually be brought up to the level prevailing for private banks by June Once the reform of Rafidain Bank and Rasheed Bank is well under way, the authorities should consider more generally the role of state banks in the economy, including that of ITB and the four smaller sectoral banks. As noted above, private banks operate on an uneven playing field. An immediate priority should be to announce the removal of all impediments for private banks in doing business with the government and state owned enterprises. Given some concerns over the strength of private banks, some elements, such as the size of letters of credits, could be phased in over a period of two years (but preannounced) to permit enhancement of the effectiveness of banking supervision to take hold as well as some consolidation of the banking system following the increase in minimum capital levels. A permanent Securities Law has been under discussion for several years. The government need to urgently conclude these discussions, after also considering the recommendations contained in this report. The Law should then be presented to Parliament for speedy passage. Early passage of the Law is required to allow the ISC to enhance its role in developing capital markets. The insurance market is at an early stage of development. Nevertheless it is urgent that the Insurance Diwan be given the human resources to allow it to take on its assigned role of regulating the insurance market. As noted in the report, the insurance law will need to be amended to allow the introduction of internationally recognized principles of supervision. The following lists the key recommendations made in this report. A. Banking Sector Short term Carry out the overall strategy for Rafidain Bank and Rasheed Bank outlined in the 2006 MOU between the Ministry of Finance and the CBI, and broaden the strategy to include all state-owned banks. Elements will need to include: - Accelerate the financial restructuring and the cleaning-up of the balance sheet of the state-owned commercial banks Rafidain Bank and Rasheed Bank by carving out disputed items from their balance sheet and transfer them to a new asset/liability management company. (six months) - Consider whether a twinning program is needed to ensure a fundamental restructuring of the two state-owned banks. (six months) - Discontinue quasi-fiscal responsibilities of the state-owned banks. Any agreed payments services for the Government should be remunerated and all loans to government and government entities should carry an

93 CONCLUSIONS AND POLICY RECOMMENDATIONS appropriate interest rate. Government should refrain from intervening in lending decisions, which must all be subject to commercial risk assessments. (immediately) Decide on the role of the TBI, whether it should be wound up as initially planned or will it be allowed to stay as commercial bank. If the latter, it should be subject to normal CBI regulations and there is no need for a special law. (six months) Continue the operational and institutional restructuring of the two stateowned banks, and provide training programs. (ongoing) Level the playing field for state-owned banks and private banks, through: - Gradually increase the amount of letters of credit that private banks are allowed to execute for the state, and eliminate all restrictions over two years. - Allow private banks to lend to, and take deposits from, state enterprises. (immediately) - Allow tax and other payments to be made in instruments (including checks) drawn on private commercial banks. (immediately) - Ensure financial strength of private banks by effectively implementing new prudential regulations. (ongoing) - Implement the planned gradual increase in capital requirements. (ongoing) Further strengthen the payment system by: Introducing intraday liquidity facility for the RTGS system. (six months) Fully implement electronic check clearing system. (six months) - - Medium Term Carry out a well formulated strategy for the role of state banks. - Clarify the mandate of the smaller state-owned banks, and consider consolidation and conversion into a development bank, which will not take deposits. (Over next two years) - Ensure state-owned banks work according to commercial principles and on a level playing field. Early corporatization of state-owned banks should be considered a key element. (over next two years) - Over time the authorities should consider gradual privatization of the key state-owned banks. (medium term) Carry out a well-planned training program for the implementation of IFRS for all banks. (over next two years) Strengthening auditing profession by introduction of international auditing standards and training. (medium term)

94 70 Set up appropriate training facilities for commercial bank staff, perhaps in the form of a Banking Institute as is currently under development via a USAID funded project (over next two years). Enhance governance of commercial banks by the introduction of the OECD Code on Good Corporate Governance Practices. A review of corporate governance practices should also form part of on-site banking examinations. (immediately). Implement credit reporting system. (next two years) Set up centralized collateral registration system. (next two years) Strengthen judicial system. (ongoing) Strengthen financial integrity at all levels. (ongoing) Further improve the regulatory framework for micro-finance and encourage additional donor funding in this area. (ongoing) Develop the Islamic Banking industry, by (i) issuing the Islamic banking law as soon as possible; (ii) implementing the international standards of Islamic banking issued by the Islamic Financial Services Board (IFSB); (iii) implementing Basel II Accord according to the Islamic banking rules; and (iv) having extensive training programs on the Islamic banking. Strengthen retail payment system with support from the USAID funded project (two years). B. Banking Supervision 27 Short-term Minister of Finance and CBI to restore full supervisory powers of CBI over Rafidain and Rasheed and other state owned banks, in conformity with the 2006 MoU between the CBI and the Minister of Finance, as well as earlier recommendations in this area (e.g in Annex 9 of the World Bank s Emergency Project Paper of April 2009), and as required in IMF staff reports. CBI to conduct full rigor on-site inspection of Rafidain Bank and Rasheed Bank with special task force. CBI to prepare a full Basel Core Principles expert-assisted selfassessment applying the full rigor of the assessment criteria of the 2006 assessment methodology, providing more information on actual implementation and enforcement of prudential standards; prepare amendments to regulations and supervisory manuals. In particular, ensure full compliance with capital definition, standards on loan classification and provisioning, internal audit and controls, consolidation of accounts, divestiture by unsuitable shareholders, and risk management. 27. See Annex 6 and 7

95 CONCLUSIONS AND POLICY RECOMMENDATIONS 71 CBI and the banks should focus more on trainings on the prudential regulations, also in the area of banking risk management, including macroprudential risks. Government authorities and CBI to introduce IFRS-compliant accounting standards as soon as possible, as well as chart of accounts and explanatory materials; for Islamic banks refer to IFSB materials for guidance. Intermediate steps: comparison between Iraqi accounting standards and IFRS, drafting of new IFRS compliant Iraqi accounting standards; design of new chart of accounts for bank accounting, as well as new explanatory materials to the chart of accounts; outreach and training. Government and CBI to develop a comprehensive strategy paper by Iraqi government in cooperation with CBI on development of the banking system, including time-bound perspective for the state owned banks (restructuring, liberalization of business; privatization), depositor protection, commercially based relations between government and currently state owned banks. Start ongoing program to translate all banking sector rules and manuals into English, also to benefit foreign banks entry into the market in the coming years. CBI to develop and implement a plan to review in detail the 3-rated banks in the CAMELS system, as this is the group where casualties can be expected when conditions in the banking sector or the economy become less stable; CBI to conduct specific training of staff in the interpretation and implementation of the new regulations, possibly together with commercial bank staff. Stronger enforcement of breaches of prudential regulations, by inclusion of specific implementation actions in the letters from the CBI to the banks, including deadlines and follow up monitoring. Send letter to banks informing them of tougher CBI action in the coming time. Enforce stricter requirements for financial information from licensing applicants, only audited financial statements will be accepted, not just whatever is available. Medium-term CBI to implement public information campaign, on role of banking system, banking supervision, disclosure and depositor protection. CBI, Ministry of Justice, and Ministry of the Interior: develop strong push for effective anti-money laundering and combating of the financing of terrorism; enforce laws and regulations, banks internal, FIU effectiveness and CBI oversight, effectiveness of prosecution authorities.

96 72 C. Capital Market Short-term Discussions on the Permanent Securities Law should be concluded as a matter of high priority. In that process the authorities should consider making the amendments to the draft permanent Securities Law as recommended in this Review; the draft should forthwith be presented to Parliament within a procedural framework that provides for adequate discussion and a speedy passage. Specific recommendations to that effect are as follows: (i) better secure the independence of the ISC; (ii) clarify the powers of the ISC to assist and share information with domestic and foreign regulators; and (iii) reinforce the provisions governing takeover bids and extend the scope of the powers of the ISC to make and enforce rules in this area. The authorities should consider subjecting Company Law No 21 to detailed analysis by an international expert in the field. The objective should be to update it to reflect current standards of corporate governance and shareholder rights and clarifying the roles of ISC and the Registrar. The ISC should set out in greater detail the content of prospectuses for issues of securities to the public and for listing on ISX. This should be based on a globally recognized standard such as is found in the EU Prospectus Directive (See Annex 9). 28 The authorities should seek to work with the accounting and auditing professions to improve standards. The objective should be to secure international recognition as to their acceptability. The authorities should resolve the legal and practical issues around transferring ownership of companies from the state to private shareholders and move to the decision phase. This should include organizing the privatization process while having regard to the need to secure and maintain retail investor confidence in equity ownership. The authorities should consider incentives to encourage unlisted private companies to list on ISX. ISX should be given permission to proceed with its initiative to set up a Second Market, subject to its establishing a rigorous regime of risk disclosure and regulation of the broker client relationship. The custodian bank service for trading on ISX should be introduced and further improvements to cash settlement of securities trading and market financing by banks should be considered. In the short term, trading of Government securities should, as planned, be integrated with the ISX trading platform. The CBI might wish to consider 28. Directive 2003 of 71-EC on the prospectus to be published when securities are offered to the public or admitted to trading.

97 CONCLUSIONS AND POLICY RECOMMENDATIONS 73 opening trading to entities other than banks, perhaps initially limited to suitably qualified institutional investors. ISC and ISX should cooperate in developing a risk based capital regime for licensees based on the appropriate internationally applied quantitative and qualitative criteria. ISC, ISX and IDC should assess their rules and procedures regarding the bankruptcy or insolvency of a licensee. This should be by reference to Article 55 of the draft Permanent Securities Law and IOSCO Principle 32. The authorities should make any necessary amendments (or seek legal clarity) to secure protection of investors when doing business with licensees which is consistent with international standards. Medium to Long-term The Government might wish to consider issuing notes and bonds with maturities longer than one year, in order to create a yield curve as a contribution to accurate and efficient pricing in private credit markets. Establish the appropriate legal and regulatory framework to enable the foundation and operation of a CIS industry. ISC and ISX should keep three further issues under review: (i) whether there is scope to enhance the transparency of trading now that the new electronic platform is fully operational; (ii) whether the provisions prohibiting insider trading and other forms of market abuse as set out in Chapter 10 of the draft Permanent Law, and the maximum level of fines may, in the light of experience, need updating as to scope, specificity and severity; and (iii) whether the capacity of the trading, clearing and settlement systems may in due course, need enhancing when daily trading volumes build. D. Insurance and Pensions Short term Commence supervision based on current legal framework. Draw up a timebound action plan for strengthening insurance regulation and supervision. Increase staffing and training of the personnel of the Insurance Diwan and enhance its level of performance so that it can it conduct its supervisory operations as anticipated in the ICP. Medium term Conduct a comprehensive revision of the insurance legislation and bring the Insurance Business Regulation Act in compliance with the international best practice standards.

98 74 Commence on-site inspections as soon as legal framework permits. Ensure the independence of the Insurance Supervisor and move the agency out of the Ministry of Finance. E. Overall Recommendations to Enhance the Financial Sector in Iraq Increase the opportunities for cooperation and integration among the different players of the Iraqi financial system regarding the provision of services. Review the financial and banking legislations which regulate and control the business of non-bank institutions, in a way that meets the requirements of the market economy. Prepare a broad database regarding the sustainability of operating public institutions in the Iraqi financial markets, which will enable the decision-makers to make objective and scientific decisions regarding operating institutions in this market. Provide an adequate legal framework to gain the confidence of Iraqi and foreigner investors to establish new companies to operate in the Iraq. Develop the activity of the Iraqi Securities Market through the creation of a secondary market for trading the equity of currently unlisted companies and the appropriate regulatory measures. Establish an institution, to develop a National Strategy for Economic Development, which will include all state ministries for preparing the short, medium and long-term plans. Develop priorities for the different economic sectors, as well as focus during the first phase on the development of agriculture, tourism and housing sectors the most labor-intensive sectors. Establish a regulatory framework in which collective investment schemes, invested in equities and perhaps other financial assets can be operated and marketed to the public by banks and non-bank financial companies. Deliver training programs, in coordination with donors and development partners, for the employees in the financial sector, regarding international best practice and experiences in developing the financial sector. Create a clear mechanism and obvious instructions for the transition of the Iraqi economy from a centralized economy to a market-oriented economy.

99 ANNEXES 75 ANNEX 1: RESTRUCTURING OF RAFIDAIN BANK ACTION PLAN Republic of Iraq Restructuring of State-owned Banks Rafidain Bank Joint CBI/MOF Draft Action Plan 29 Timing Responsibility Action Immediately CBI & MOF 1. Signature of Memorandum of Understanding (MOU) between the CBI and the Ministry of Finance as Owner, for the establishment of the ROC, and for the restructuring of Rafidain Bank. Immediately MOF 2. Submission of the present MOU to the Council of Ministers (COM) for approval, with a government commitment to request from Parliament, at the appropriate time, the budgetary appropriations for the costs associated with the ROC, and the financial and operational restructuring of the bank, including any carrying costs associated with the issuance of recapitalization bonds, and technical assistance and other costs for the implementation of the activities and programs referenced in this MOU. [MOU, paras. 42 and 43]. Immediately CBI & MOF 3. Submission to the Council of Ministers Economic Committee of a proposal to establish a Bank Restructuring Oversight Commission (ROC), under Terms of Reference agreed with the IMF and the World Bank, and in accordance with Iraqi Law governing the establishment of such commissions in Iraq [MOU paras ]. Within 60 days CBI, and CBI coordinating with MOT (Company Registrar) 4. Submission to the Council of Ministers for submission to Parliament, appropriate amendments to the CBI Law (#56 of 2004), the Banking Law (including Article 59, Law #94 of 2004), the Company Law (#21 of 1997), and to the Law of Public Companies (#22 of 1997), to allow for: 29. Based on technical discussions of draft Joint CBI/MOF MOU in Amman during November 1 9, 2006.

100 76 Timing Responsibility Action a) the CBI, in exceptional circumstances and for systemic safety and soundness reasons, to restructure banks as an intermediate remedial action; b) the use of Treasury bonds in lieu of cash to recapitalize the Bank; and, c) strengthened Corporate Governance for all financial institutions under the authority of the CBI by requiring them to adhere to OECD/World Bank Corporate Governance Guidelines which, among others, allow for 4 b) above, accounting and auditing standards, and for independent external experts to serve as Directors on the Boards of bank and non-bank financial institutions. (Subject to verification with Iraqi counsel, this may also be achieved in whole or in part through the issuance by the CBI of modified, new regulations related to the application of the existing Banking Law.) [MOU, para. 42]. Immediately, with completion within 60 days Immediately, with completion within 90 days MOF, with CBI concurrence MOF, with CBI concurrence 5. Vetting process for the current Senior Management Team to ensure that all members understand the restructuring strategy laid out in the MOU, and are able and ready to support its implementation in full. Changes and additions to the Management Team, determined through an objective and transparent vetting process agreed with the IMF and World Bank will be made, as needed, by the Ministry of Finance with the concurrence of the CBI. [MOU, para. 38] 6. The incentive structure for Management and Employees of the Bank will be examined with a view to: 1) avoiding risks of conflict of interest and moral hazard during the restructuring; and 2) establishing and applying appropriate incentives to ensure Management and Employee full commitment to the restructuring. [MOU, para. 38]

101 ANNEXES 77 Timing Responsibility Action Immediately, with completion within 60 days Immediately, and ongoing Immediately, and ongoing Immediately, and then every month Immediately, and then every month Immediately, and then every month Banks, coordinated by MOF, and assisted by External Auditors & E&Y Bank MOF Bank and MOF Banks and CBI ROC CBI 7. Establish a Committee, comprised of members of the Banks and of the Ministry of Finance Public Debt Directorate, External Auditors, and Iraq s Debt Advisors, which will review all foreign liabilities in the book of the bank, and mark down their amounts to reflect progress already achieved in the renegotiation of Iraq s foreign debt [MOU paras. 27 and 29]. 8. Creation of an account called Counterpart to inherited foreign liabilities for settlement and release on the asset side of the balance sheet as part of the accounts receivable, as the balancing item for the inherited unresolved foreign liabilities. This account is continuously adjusted to reflect the amount of leftover foreign liabilities. [MOU, para. 28] 9. Creation of an account called Counterpart to inherited losses on the asset side of the balance sheet as part of the accounts receivable, and subsequently updating it daily, as the balancing item for the inherited losses. [MOU, paras. 35] 10. Submission, on a monthly basis, of financial statements, as well as a progress report on the implementation of this MOU and related Action Plan, to the ROC. [MOU, para. 40] 11. Meeting to review and discuss, at least on a monthly basis, the financial statements, the progress report on the implementation of the MOU, and to provide guidance to the Bank Management team. [MOU, para. 40] 12. Continuation, on a monthly basis, of regular banking supervision of the Bank by the CBI, taking into account the temporary forbearance granted by the MOUs, with external technical assistance, as appropriate. [MOU, para. 40]

102 78 Timing Responsibility Action Immediately, with continuation until the introduction of the SORP (November/ December, 2007) Immediately, and within 30 days from signing. Immediately, with continuation until introduction of SORP Immediately, with continuation until introduction of the SORP. Immediately, with continuation until completion Banks Banks, for ROC approval Banks Banks, ROC (and Ministry of Finance and CBI as Owner and as Supervisor) MOF, other public institutions & Banks 13. Focus on narrow banking activities, including the provision to the general public and economic entities of basic and essential financial services: taking care of their deposits, protecting the savings of the general public, managing current accounts and collections for businesses, and effecting payments securely and efficiently. [MOU, para. 15]. 14. Preparation and presentation by Management, for ROC approval, of a specific plan, within the general framework of the ORP, to continue to provide some new, low volume lending services to the bank s customers, based on strict lending criteria and limits. [MOU para. 17] 15. Investment of the available resources in government bills and bonds, and similarly safe assets, generally avoiding risky operations. [MOU, para. 16] 16. Maintaining the existing network of branches intact, as assets of the bank, except that a limited number of underperforming branches may be permanently closed for cost containment purposes, if found necessary by the Operational Audit and by the ROC, and in the context of the approved SORP. [MOU, para. 16] 17. Settlement and Release of all of the Bank s remaining inherited foreign liabilities not yet renegotiated with foreign creditors, including the completion of the UK insolvency proceedings satisfactory to the IMF, with the active involvement of the Ministry of Finance and any other relevant public institution, through the continued negotiation of Iraq s foreign debt with the creditors and through exchanges of their claims on the Bank against new claims on the Government, with a view to bringing these liabilities down to zero as soon as possible. [MOU, paras ]

103 ANNEXES 79 Timing Responsibility Action Establish group immediately; Complete preparation of ex-post review of audit process w/in 60 days Bank Management & Audit Preparation Working Group 18. Preparations to leverage the efficiency of the planned financial audit required under the SBA, to be carried out by an Audit Preparation Working Group that will identify bottlenecks, data shortages and discrepancies that had slowed down past assessments and audits, and will propose practical recommendations on how to remove or mitigate them in time for the next annual audit. [MOU, para. 21 and 35] Immediately, with submission within 60 days Audit Preparation Working Group 19. Design of Action Plan for the comprehensive appraisal and valuation exercise for assets and liabilities, and submission for review and approval to the ROC. [MOU, para. 34] Completion by end-march, 2007 Bank and Auditors 20. Conduct, by the Banks, of a systematic appraisal of all liabilities other than foreign and of all assets, as of end-2005, based on International Financial Reporting Standards (IFRS), relying as a starting point on the November 2005 report, Assessment of Iraqi State-owned Banks, and including in particular the computation of all accruals, a new valuation for all assets, reconciliation of pending book entries, and resolution of the huge suspense accounts. [MOU, paras ] January May, 2007 Bank and Auditors 21. As part of the systematic appraisal of all liabilities and of all assets as of end-2005 and end-2006, carry out largescale write-downs of the items that will prove difficult to reconcile or resolve because of their age or lack of proper documentation, on the basis of written and specific principles and criteria to be defined with the IMF, that will be applied symmetrically to asset and liability items.. [MOU, para. 33]

104 80 Timing Responsibility Action Within 90 days Bank 22. Preparation of a package of cost containment and cost recovery measures by the Bank s Management, within the shorter-term overall objective of balancing current income and expenses, that includes: (a) identifying and addressing, in a deliberate and progressive manner, some of the Bank s considerable overstaffing, notably as related to the introduction of the new Pension Law; and (b) introducing pricing on at least a full cost-recovery basis for banking services provided by the Bank to the Government of Iraq. [MOU, para. 18] March 31, 2007 July 31, 2007 Operational Audit Team 23. Performance of the Operational Audit of the Bank, agreed upon as part of the Stand-By Arrangement (SBA) with the IMF, providing a Strategic development plan and a related Operational Restructuring Plan (SORP) that defines the features of the bank in the medium-term, as an efficient, market-driven bank, able to compete and serve its constituencies well. [MOU, paras. 19 and 20] 24. In the context of the Operational Audit work (#23, above), identify all Bank activities undertaken for the Government that are banking services normally provided by banks, quantify their costs, and recommend market-driven corporate fees to charge the Government as customer, to be introduced under the SORP. For any activities identified through the Operational Audit that would normally be performed by Government agencies rather than by banks, quantify their costs and recommend appropriate actions and a timetable to address them in the SORP. [MOU, paras. 19 and 20] September, 2007 Banks 25. Preparation of an update of the Bank s plan for new, computerized information management systems, and identification of adjustments needed for the SORP. [MOU, para. 22]

105 ANNEXES 81 Timing Responsibility Action Immediately and ongoing Banks, ROC, CBI & MOF 26. Identifying and exploring with internationally reputable foreign banks, the potential for establishing strong twinning arrangements, aligned with the objectives of the ORP, SORP, and eventually the FRP, and on- and offthe-job training programs in key areas for the Staff and Management of the Banks. Key training areas would include: Compliance, Risk Management, Credit Analysis, and Marketing. [MOU, para. 23] April May, 2007 Banks and ROC 27. Repetition of the appraisal exercise for data, referred to in numbers 20 and 21, above, as of end [MOU, paras ] September, 2007 Bank Management, Operational Audit Team, and ROC 28. Submission to the ROC of the Strategic and Operational Restructuring Plan (SORP) for the Bank, based on the findings of the Operational Audit, to replace the preliminary ORP. Among other elements, the SORP should include the: a) elaboration of a new, commercially-oriented business strategy for the Bank; b) establishment of a new marketdriven, customer relationship between the Bank and the Government; and c) timebound commitments for the introduction of related banking services, and comprehensive operational policies and procedures (including, staffing, pricing, IT, etc.), to support a, above. [MOU, paras ] October, 2007 ROC 29. Review and approve the SORP and review the status of the reconciliation of foreign obligations, including for Rafidain Bank, the UK insolvency proceedings, as pre-requisites for the completion of the Financial Restructuring Plan. [MOU, paras , 25-29, and 37] October, 2007 CBI & MOF, Approval of the ROC 30. Preparation and approval of a revised and updated Action Plan for the Bank, based upon the SORP produced as a result of the Operational Audits of the Bank, and on the implementation experience to date of the present MOU and initial Action Plan. [MOU, para 45]

106 82 Timing Responsibility Action April-June 2007 July-September, 2007 Bank s External Auditors International Auditors 31. Normal audit of the accounts of the Bank as of end-2006 by its External Auditors, as required by the Law, and on schedule. [MOU, para. 36] 32. Conduct supplemental review of the Bank s financial position as of end-2006 by qualified, independent, international auditors, focusing on quality controls for the internal appraisal of assets and liabilities, and on the thoroughness of the routine External Audit, and certification of the accuracy of the Banks financial position on the basis of IFRS as of end-2006, as agreed under the IMF Standby Arrangement. [MOU, para. 36] October 2007 ROC 33. Assessment by the ROC regarding progress related to completion of the: (i) first three Steps of the CRP, including, for Rafidain Bank, the satisfactory completion of the provisional liquidation procedure against its London branch, and (ii) Operational Audits, including production of the SORP for the Bank. [MOU, para. 14, 25, and 37]

107 ANNEXES 83 ANNEX 2: RESTRUCTURING OF RASHEED BANK ACTION PLAN Republic of Iraq Restructuring of State-owned Banks Rasheed Bank Joint CBI/MOF Action Plan 30 Timing Responsibility Action Immediately CBI & MOF 1. Signature of Memoranda of Understanding (MOUs) between the CBI and the Ministry of Finance as Owner, for the establishment of the ROC, and for the restructuring of Rasheed Bank. [MOU, paras ] Immediately MOF 2. Submission of the present MOU to the Council of Ministers (COM) for approval, with a government commitment to request from Parliament, at the appropriate time, the budgetary appropriations for the costs associated with the financial and operational restructuring of the Bank, including any carrying costs associated with the issuance of recapitalization bonds, and technical assistance and other costs for the implementation of the activities and programs referenced in the attached MOU. [MOU, paras. 42 and 43] Immediately CBI & MOF 3. Submission to the Council of Ministers Economic Committee of a proposal to establish a Bank Restructuring Oversight Commission (ROC), under Terms of Reference agreed with the IMF and the World Bank, and in accordance with Iraqi Law governing the establishment of such commissions in Iraq. [MOU paras ] Within 60 days CBI, and CBI coordinating with MOT (Company Registrar) 4. Submission to the Council of Ministers for submission to Parliament, appropriate amendments to the CBI Law (#56 of 2004), the Banking Law (including Article 59, Law #94 of 2004), the Company Law (#21 of 1997), and to the Law of Public Companies (#22 of 1997), to allow for: 30. Based on technical discussions of draft Joint CBI/MOF MOU in Amman during November 1 9, 2006.

108 84 Timing Responsibility Action Immediately, with completion within 60 days Immediately, with completion within 90 days Immediately, with completion within 60 days MOF, with CBI concurrence MOF, with CBI concurrence Banks, coordinated by MOF, and assisted by External Auditors & E&Y a) the CBI, in exceptional circumstances and for systemic safety and soundness reasons, to restructure banks as an intermediate remedial action; b) the use of Treasury bonds in lieu of cash to recapitalize the Bank; and, c) strengthened Corporate Governance for all financial institutions under the authority of the CBI by requiring them to adhere to OECD/World Bank Corporate Governance Guidelines which, among others, allow for 4 b) above, accounting and auditing standards, and for independent external experts to serve as Directors on the Boards of bank and nonbank financial institutions. [MOU, para. 41] 5. Vetting process for the current Senior Management Team to ensure that all members understand the restructuring strategy laid out in the MOU, and are able and ready to support its implementation in full. Changes and additions to the Management Team, determined through an objective and transparent vetting process and criteria agreed with the IMF and World Bank, will be made, as needed, by the Ministry of Finance with the concurrence of the CBI. [MOU, para. 37] 6. The incentive structure for Management and Employees of the Bank will be examined with a view to: 1) avoiding risks of conflict of interest and moral hazard during the restructuring; and 2) establishing and applying appropriate incentives to ensure Management and Employee full commitment to the restructuring. [MOU, para. 37] 7. Establish a Committee, comprised of members of the Banks and of the Ministry of Finance Public Debt Directorate, which will collaborate with the Bank s External Auditors and Iraq s Debt Advisors, to review all foreign liabilities in the books of the Bank, and mark down their amounts to reflect progress already achieved in the renegotiation of Iraq s foreign debt. [MOU paras. 27 and 29]

109 ANNEXES 85 Timing Responsibility Action Immediately, and ongoing Immediately, and ongoing Immediately, and then every month Immediately, and then every month Immediately, and then every month Immediately, with continuation until the introduction of the SORP (November/ December, 2007) Bank MOF Bank and MOF Banks and CBI ROC CBI Banks 8. Creation of an account called Counterparty to Inherited Foreign Liabilities for Settlement and Release on the asset side of the balance sheet as part of the accounts receivable, as the balancing item for the inherited unresolved foreign liabilities. This account will be continuously adjusted to reflect the amount of leftover foreign liabilities. [MOU, para. 28] 9. Creation of an account called Counterparty to Inherited Losses on the asset side of the balance sheet as part of the accounts receivable, and subsequently updating it daily, as the balancing item for the inherited losses. [MOU, para. 34] 10. Submission, on a monthly basis, of the Bank s financial statements, as well as a progress report on the implementation of this MOU and related Action Plan, to the ROC. [MOU, para. 39] 11. Meeting to review and discuss, at least on a monthly basis, the Bank s financial statements, the progress report on the implementation of the MOU and related Action Plan, and to provide guidance to the Bank s Management team. [MOU, para. 39] 12. Continuation, on a monthly basis, of regular supervision of the Bank by the CBI, taking into account the temporary forbearance granted by the MOUs, with external technical assistance, as appropriate. [MOU, para. 39] 13. Focus on narrow banking activities, including the provision to the general public and economic entities of basic and essential financial services: taking care of their deposits, protecting the savings of the general public, managing current accounts and collections for businesses, and effecting payments securely and efficiently. [MOU, para. 15].

110 86 Timing Responsibility Action Immediately, and within 30 days from signing. Immediately, with continuation until introduction of SORP Immediately, with continuation until introduction of the SORP. Immediately, with continuation until completion Establish group immediately; Complete preparation of ex-post review of audit process w/in 60 days Banks, for ROC approval Banks Banks, ROC (and Ministry of Finance and CBI as Owner and as Supervisor) MOF, other public institutions & Banks Bank Management & Audit Preparation Working Group 14. Preparation and presentation by Management, for ROC approval, of a specific plan, within the general framework of the ORP, to continue to provide some new, low volume lending services to the Bank s customers, based on strict lending criteria and limits. [MOU para. 17] 15. Investment of the available resources in government bills and bonds, and similarly safe assets, generally avoiding risky operations. [MOU, para. 16] 16. Maintaining the existing network of branches intact, as assets of the Bank, except that a limited number of underperforming branches may be permanently closed for cost containment purposes, if found necessary by the Operational Audit and by the ROC, and in the context of the approved SORP agreed with the World Bank and the IMF. [MOU, paras. 14 and 16] 17. Settlement and Release of the Bank s remaining inherited foreign liabilities not yet renegotiated with foreign creditors, including the completion of the UK insolvency proceedings satisfactory to the IMF, with the active involvement of the Ministry of Finance and any other relevant public institution, through the continued negotiation of Iraq s foreign debt with creditors and through exchanges of their claims on the Bank against new claims on the Government, with a view to bringing these liabilities down to zero as soon as possible. [MOU, paras ] 18. Leverage the efficiency of the planned financial audit certification required under the IMF SBA, through an Audit Preparation Working Group that will identify bottlenecks, data shortages and discrepancies that had slowed down past assessments and audits, and will propose practical recommendations on how to remove or mitigate them in time for the next annual audit. [MOU, para. 21 and 35]

111 ANNEXES 87 Timing Responsibility Action Immediately, with submission within 60 days Audit Preparation Working Group 19. Design of Action Plan for the comprehensive appraisal and valuation exercise for assets and liabilities, and submission for review and approval to the ROC. [MOU, para. 33] Completion by end-march, 2007 Bank and Auditors 20. Conduct, by the Banks, of a systematic appraisal of all liabilities other than foreign and of all assets, as of end-2005, based on International Financial Reporting Standards (IFRS), relying as a starting point on the November 2005 report, Assessment of Iraqi State-owned Banks, and including in particular the computation of all accruals, a new valuation for all assets, reconciliation of pending book entries, and resolution of the huge suspense accounts. [MOU, para ] January May, 2007 Bank and Auditors 21. As part of the systematic appraisal of all liabilities and of all assets as of end and end-2006, carry out large-scale write-downs of the items that will prove difficult to reconcile or resolve because of their age or lack of proper documentation, on the basis of written and specific principles and criteria to be defined with the IMF, that will be applied symmetrically to asset and liability items. [MOU, para. 32] Within 90 days Bank 22. Preparation of a package of cost containment and cost recovery measures by the Bank s Management, within the shorter-term overall objective of balancing current income and expenses, that includes: (a) identifying and addressing, in a deliberate and progressive manner, some of the Bank s considerable overstaffing, notably as related to the provisions of the new Pension Law; and (b) introducing pricing on at least a full cost-recovery basis for banking services provided by the Bank to the Government of Iraq. [MOU, para. 18]

112 88 Timing Responsibility Action March 31, 2007 July 31, 2007 Operational Audit Team 23. Performance of the Operational Audit of the Bank, agreed upon as part of the Stand-By Arrangement (SBA) with the IMF, providing a Strategic development plan and a related comprehensive Operational Restructuring Plan (SORP) that defines the features of the Bank in the medium-term, as an efficient, market-driven bank, able to compete and serve its constituencies well. [MOU, paras. 19 and 20] 24. In the context of the Operational Audit work (#23, above), identify all Bank activities undertaken for the Government that are services normally provided by banks, quantify their costs, and recommend fully market-driven corporate fees to charge the Government as customer, to be introduced under the SORP. [MOU, paras. 19 and 20] September, 2007 Banks 25. Preparation of an update of the Bank s plan for new, computerized information management system, and identification of adjustments needed to support the SORP, and for compatibility with the requirements of Iraq s new payment system. [MOU, para. 22] Immediately and ongoing Banks, ROC, CBI & MOF 26. Identifying and exploring with internationally reputable foreign banks, the potential for establishing strong twinning arrangements, aligned with the objectives of the ORP, SORP, and eventually the FRP, and on- and off-thejob training programs in key areas for the Staff and Management of the Bank. Key training areas would include: Compliance, Risk Management, Credit Analysis, and Marketing. [MOU, para. 23] April May, 2007 Banks and ROC 27. Repetition of the appraisal exercise for data, referred to in #20 and #21, above, as of end [MOU, paras ]

113 ANNEXES 89 Timing Responsibility Action September, 2007 Bank Management, Operational Audit Team, and ROC 28. Submission to the ROC of the Strategic and Operational Restructuring Plan (SORP) for the Bank, based on the findings of the Operational Audit, to replace the preliminary ORP. Among other elements, the SORP should include the: a) elaboration of a new, commerciallyoriented business strategy for the Bank; b) establishment of a new market-driven, customer relationship between the Bank and the Government; and c) timebound commitments for the introduction of related banking services, and comprehensive operational policies and procedures (including, staffing, pricing, IT, etc.), to support a, above. [MOU, paras. 14, and 19 23] October, 2007 ROC 29. Review and approve the SORP and review the status of the reconciliation of foreign obligations, as pre-requisites for the completion of the Financial Restructuring Plan, to be agreed with the World Bank and the IMF. [MOU, paras. 14, 19-20, 25-29, and 37] October, 2007 CBI & MOF, Approval of the ROC 30. Preparation and approval of a revised and updated Action Plan for the Bank, agreed with the IMF and the World Bank, based upon the SORP produced as a result of the Operational Audits of the Bank, and on the implementation experience to date of the attached initial MOU and the present Action Plan. [MOU, para. 44] April-June 2007 Bank s External Auditors 31. Normal audit of the accounts of the Bank as of end-2006 by its External Auditors, as required by the Law, and on schedule. [MOU, para. 35]

114 90 Timing Responsibility Action July-September, 2007 International Auditors 32. Conduct supplemental review of the Bank s financial position as of end-2006 by qualified, independent, international auditors, focusing on quality controls for the internal appraisal of assets and liabilities, and on the thoroughness of the routine External Audit, and certification of the accuracy of the Banks financial position on the basis of IFRS as of end-2006, as agreed under the IMF Standby Arrangement. [MOU, para. 35] October 2007 ROC 33. Assessment by the ROC regarding progress related to: (i) completion of the first three Steps of the FRP, including resolution and settlement, satisfactory to the IMF, of the Bank s outstanding foreign obligations; and, (ii) completion of the Operational Audits, including production of the comprehensive SORP for the Bank. [MOU, paras. 14, 24-25, and 37]

115 ANNEXES 91 ANNEX 3: JOINT CBI MOF MEMORANDUM OF UNDERSTANDING RESTRUCTURING OF RAFIDAIN BANK Republic of Iraq Joint CBI Ministry of Finance Memorandum of Understanding Restructuring of Rafidain Bank (December 6, 2006) 1. This Memorandum of Understanding (MOU) is made this 6 th day of December, 2006, by and between: The Central Bank of Iraq (CBI), operating under the Central Bank of Iraq Law of 2004, hereby represented by H.E. Sinan Al-Shabibi, Governor; and The Ministry of Finance of the Republic of Iraq, represented by H.E. Bakir Jabr, Minister, as the Owner of Rafidain Bank (the Bank). 2. WHEREAS one of the two primary objectives of the CBI is to foster and maintain a stable and competitive market-based financial system, pursuant to Article 3 of the CBI Law of 2004 (the CBI Law); 3. WHEREAS the CBI, pursuant to Article 40 of the same Law, has the authority to take all such actions as may be necessary to regulate and supervise banks, including the authority to take remedial action, as provided in this Law and in the Banking Law of 2004 (the Banking Law); 4. WHEREAS, pursuant to Article 16 of the Banking Law, each bank shall at all times maintain capital of no less than 12 percent of the total value of its assets determined on a risk-adjusted basis; 5. WHEREAS it appears that the Bank has a negative net equity position, as a result of its foreign obligations contracted at the behest of the former regime, of other losses accumulated under the same former regime, and costs associated with the political transition since 2003, but retains a significant franchise value, branch network value, and the confidence of the Iraqi public; 6. WHEREAS the primary regulatory objective of the Banking Law, as expressed in Article 2, paragraph 1, is to maintain confidence in the banking system, and the Bank is of systemic importance to the country because of its size and of its nationwide network of branches that perform financial transactions critical for the continuity of public services and for serving the general public; 7. WHEREAS the MOF, as Owner of the Bank, hereby affirms its commitment to restructure the Bank operationally, while financial restructuring to restore the Bank s net equity position above the level required by Article 16 of the Banking Law will only be completed at a later stage, following resolution, satisfactory to the IMF, of outstanding foreign obligations of the Bank, and in a sequenced manner that will preserve the financial interests of the country by, among other things, preserving the fixed assets of the Bank, improving the efficiency and revenue of its operations, maximizing its value to the Owner, safeguarding the deposits of the public, and contributing to the development of a strong, market-driven, modern, and sound banking system, as detailed below in this MOU;

116 92 8. NOW THEREFORE, in consideration of the representation set forth above, the Parties agree as follows: Section I. Preamble 9. This MOU sets forth the principles for the Operational Restructuring Plan (ORP, see Section II), the Financial Restructuring Plan (FRP, see Section III), and for the development of a comprehensive Strategic and Operational Restructuring Plan (SORP, see Section II) for the Bank. The ORP is intended to stabilize the bank, on an interim basis, to prepare it to compete in and support the newly-established market-driven economy of Iraq. The SORP is designed to ensure the Bank s long-term financial viability, as a sound, efficient, and commercially-oriented bank, able to compete in and serve the economy, domestically and internationally. The FRP will restore, in agreed and time-bound steps, the Bank s net equity position above the level required by Article 16 of the Banking Law. 10. Detailed plans for the implementation of both the ORP (and eventually, the SORP), and the FRP will be defined by the Bank s Management Team, with qualified external technical assistance as appropriate, and will be subject to the review and approval of a Restructuring Oversight Commission (ROC, see Section IV). The ROC will also approve the design of the SORP, and will monitor the later implementation of the FRP and the SORP. 11. In case of failure to implement substantive provisions of this MOU, for whatever reason, or excessive delays, as determined by the CBI, and after due warning, the CBI will carry out its role under the CBI Law and Article 59, paragraph c of the Banking Law. Section II. Operational Restructuring Plan 12. The ORP s strategic objective is to establish an interim basis for the Bank s financial and operational viability, while the SORP s objective is to secure it in the medium and long-term as an efficient Bank, able to compete in and support the new, market-driven national economy. Operational restructuring typically unfolds over time (i.e., a two-tothree year period), and may require periodic adjustments during that time period, as more information develops from the implementation experience itself, and as broader sector and/or macro-economic adjustments take place. 13. At the current juncture in Iraq, only a preliminary Operational Restructuring Plan (ORP) can be defined and implemented under the present MOU, due to a lack of critical information and remaining uncertainties concerning the Bank s real financial position. The preliminary ORP defined below deliberately takes, during a transition period, a narrow focus, with two immediate priorities for the Bank: a) ensuring its status as a sound financial institution providing needed banking services to and for the people of Iraq and its economic entities; and b) preparing the Bank for a more comprehensive restructuring through the carrying out of a full Operational Audit (planned under Iraq s existing Standby Arrangement with the IMF) that will serve as the basis for defining a comprehensive Strategic and Operational Restructuring Plan (SORP). 14. The new, comprehensive version of the ORP (Strategic and Operational Restructuring Plan SORP), will be prepared after completion of the currently

117 ANNEXES 93 planned Operational Audit, as a pre-requisite for carrying out the final step of the financial restructuring by the Ministry of Finance (Step Four of the FRP para. 37). The SORP will be agreed with the World Bank and the IMF, and will be supported by qualified external technical assistance, as appropriate. Its eventual implementation will be defined in the context of revisions to the Action Plan attached to this MOU (see Attachment). Providing Sound Financial Institutions to the Public 15. The people of Iraq and the country s economic entities need a sound financial system, complying with international accounting, auditing, prudential and corporate governance standards, and providing basic and essential financial services, including: taking care of the population s deposits, protecting the savings of the general public, managing current accounts and collections for businesses, and effecting payments securely and efficiently. At the same time, full-fledged, modern banking activities, and in particular large-scale lending, can only be carried out by a significantly updated and improved Bank. Under the ORP, until it is determined that the operational capabilities of the Bank have advanced satisfactorily, the Bank s activities will be limited to providing the public with sound, safe, and efficient basic financial services, and it will function essentially as a narrow bank. 16. As such, the Bank will invest its resources in safe assets. It will generally avoid risky operations, particularly risky lending, and it will not provide any directed lending, subsidized or otherwise. Its branch network will remain intact as assets of the Bank during this phase, except that a limited number of underperforming branches may be permanently closed for cost containment purposes, if found necessary by the Operational Audit, and approved by the ROC. To preserve the value of the Bank to its present or future owners, no sale or transfer of Bank branches will occur during the restructuring. Any subsequent sale or transfer of Bank branches would be based on the conclusions of the Operational Audit as reflected in the SORP, and would require a full and transparent valuation as certified by qualified, independent, external, international auditors (Section III), and the approval of the CBI. 17. Continuation of the current limited lending activities as well as their extension to a few new, low volume, simple and safe lending activities (with demonstrable cashflows and appropriate collateral and/or guarantees) essential to support the Bank s customers is subject to the presentation of a specific plan, within the general framework of the preliminary ORP prepared by the Bank s Management, and must be reviewed and approved by the ROC. 18. Cost containment and recovery measures will be proposed by the Bank s Management within 3 months following signature of this MOU, including a plan to start addressing, in a deliberate and progressive manner, part of the Bank s considerable overstaffing, notably as related to the provisions of the new Pension Law. As long as the Bank s future has not been clearly defined through the finalization and agreement of the SORP, cost containment, together with asset safeguarding, will stay at the core of Bank Management s mandate. The immediate objective for the transitory period of the initial ORP should be to balance current income and expenses, and to resolve the Bank s remaining foreign obligations. Consistent with this, during the restructuring, all banking services provided by the Bank to the Government should be carried out on at least a full, cost-recovery basis (Action Plan, #21(b), #25).

118 94 Preparing for the Future 19. The Operational Audit of the Bank agreed upon as part of the current IMF standby arrangement, will start by March 31, 2007, and be completed by July 31, 2007 (Action Plan, #21(a)). The Operational Audit will consist of a review and assessment of the Bank s products, operations, policies, and procedures, and will provide the basis on which a new, commercially-oriented business strategy for the Bank will be defined, and a new, comprehensive operational restructuring plan will be established. The strategic development plan of the Bank will define the features of the Bank in the medium-term, as an operationally and financially viable, efficient, market-oriented bank, able to compete and serve all of its constituencies, and to comply with the prudential requirements of the Banking Law and of the CBI, on a sustained basis. Integral to this plan would be the establishment of an arms-length relationship between the Ministry of Finance and the Bank, and a commercial-orientation to the relationship between the Government (as a customer) and the Bank. 20. As the key output of the Operational Audit, the new, comprehensive, commerciallyoriented SORP will replace the preliminary ORP whose implementation is included in this MOU. The SORP will be submitted to the ROC for review and approval by September, It will then be submitted by October, 2007 to the CBI for verification against existing prudential requirements and for formal CBI approval as supervisor. As stated above, resolution, satisfactory to the IMF, of outstanding foreign obligations of the Bank, and approval by the ROC and separately, by the CBI, of the SORP, and agreement on the SORP with the World Bank and the IMF, are key prerequisites for the completion of the financial restructuring of the Bank. 21. In addition to the operational restructuring plans described above, the Bank will undertake a special effort to facilitate, and render more effective the regular External Audit process, and the subsequent additional certification by qualified, independent, external, international auditors, planned for To this end, an Audit Preparation Working Group, consisting of representatives of the Bank s Accounting and Internal Audit Departments, and its External Auditors, will start its work immediately following the signing of this MOU (Action Plan #15, #16). The Working Group will identify bottlenecks, data shortages and discrepancies that may have slowed past audits and assessments, and will produce practical recommendations on how to remove or mitigate them in time for the next External Audit, within 60 days following signature of this MOU. 22. Given the central importance of accurate bank information for effective management and efficient audit processes, and for business efficiency and effectiveness more broadly (including linkage to the new payment system, recently introduced), a new, comprehensive IT Strategy for the Bank will be elaborated and agreed, as part of the new SORP. 23. To secure the objectives of the ORP, the SORP and ultimately, the FRP, it is critical to enhance and upgrade the skills and experiences of Bank Management and Staff. The prospects for establishing strong twinning arrangements with reputable foreign banks, to strengthen institutional capabilities and introduce more efficient and modern banking practices and services, will therefore be actively pursued and defined by the ROC, as will be the need to ensure the provision of intensive on- and off- the job training and technical assistance support for the implementation of the SORP (Action Plan, #23).

119 ANNEXES 95 Section III. Financial Restructuring Plan 24. The FRP, as set forth in this Section, is meant to restore the Bank s ability to comply with minimum capital adequacy and other prudential requirements of the CBI, and to restore its full credibility with its business counterparts. It is predicated on the MOF s commitment, as Owner of the Bank, to resolve foreign obligations of the Bank, and to define the Bank s new business strategy and restructure its operations in line with such strategy, as a basis for its longer-term financial viability and competitiveness, including eventually restoring the Bank s net equity position to the level required by Article 16 of the Banking Law. The FRP consists of sequenced Steps that first reduce the Bank s liabilities, then sort and reconcile its asset and liability accounts, before ultimately considering the need for, and appropriateness of providing any new capital. It also ensures the preservation and protection of the Bank s assets (physical, financial, and franchise value), during the period of the restructuring. Finally, it takes into account the need to explicitly link recapitalization to prior actions, including resolution of outstanding foreign obligations, satisfactory to the IMF, and decisive progress on the operational side of the restructuring of the Bank. In line with these priorities, the Bank will verify the status of its obligations toward foreign creditors under the Paris Club and other arrangements with the responsible Ministry of Finance officials, and make appropriate accounting adjustments to its books, immediately. Such adjustments will be verified for accuracy ex-post by qualified, independent, external auditors. 25. The four steps of the FRP are: (i) foreign liabilities settlement and release, including the completion of the UK insolvency proceedings and the settlement of claims against Rafidain Bank held by bilateral creditors; (ii) appraisal of other liabilities and assets; (iii) certification by qualified, independent, external, international auditors; and (iv) recapitalization by the Owner. Step (i) is ongoing. Step (ii) will start immediately upon the signing of this MOU. Step (iii) will then follow, and is scheduled to take place in the middle of Step (iv) is conditional upon the successful implementation of the three previous steps and will come only provided that sufficient progress has also been achieved on the operational side of the restructuring (ORP/SORP), as described above and judged by the ROC with external expert participation, as needed, and separately by the CBI as the supervisory authority, and agreed with the IMF and the World Bank. Step One - Foreign Liabilities Settlement and Release 26. With the active involvement of the Ministry of Finance and any other relevant public institution, the Bank will be expeditiously relieved from its remaining inherited foreign liabilities. This includes, in particular, the foreign debt contracted on behalf of the former regime and all related items, i.e., accrued interest, fees, commissions, guarantees that have been called, and any other related charges and expenses. 27. Within 60 days of the signing of this MOU, all foreign liability accounts in the books of the Bank will be reviewed (without regard to whether Rafidain would be able to assert defenses, such as statute of limitations defenses, against an effort by a creditor to enforce such a claim in a legal proceeding), and their amounts marked down to accurately reflect the Bank s true financial position and the considerable progress already achieved in renegotiating Iraq s foreign debt. This process is expected to provide a more accurate view of the Bank s liabilities compared with the preliminary figures contained in the USAID-funded, November 2005 Assessment of Iraqi Stateowned Banks.

120 The unresolved, outstanding inherited foreign liabilities in the books of the Bank will then be balanced through the creation of an account called Counterparty of Inherited Foreign Liabilities for Settlement and Release (the Account) on the asset side of the balance sheet, as part of the accounts receivable. For prudential monitoring purposes, this Account will have a risk-weighting of zero percent. This Account will be continuously adjusted to reflect the amount of left-over foreign liabilities. 29. The Ministry of Finance will diligently pursue the disposal process for the leftover foreign liabilities in the Bank s balance sheet and in its foreign branches, including seeking an early conclusion to the ongoing UK insolvency proceedings. The Ministry of Finance will continue its efforts to settle the Bank s foreign debts with bilateral creditors through exchanges of their claims on the Bank against new claims on the Government, with a view to reducing these liabilities to zero as soon as feasible, on terms not more favorable to the creditors than those agreed with the Paris Club in November, Given the importance of these matters to Iraq and to the Bank, the Ministry of Finance recently (October 2006) established a Committee, comprised of members from Rasheed and Rafidain Banks, and of the MOF s Directorate of Public Debt, to follow-up on them and to finalize the reconciliation and accounting in the books of these Banks for foreign liabilities already settled with the Banks foreign creditors on the one hand, and those that remain to be agreed upon, on the other hand. 30. With regard to the London branch, Rafidain Bank s Management and the Ministry of Finance have been working with the Bank s English counsel on the legal implications of the ongoing UK insolvency proceedings, including the effect of a High Court discharge order on possible litigation by hold-out creditors. In that context, Bank Management is preparing a plan with the CBI and the MOF, on the steps to be taken in managing the legal and operational risks arising from the UK insolvency proceedings, and is examining ways to expedite the final conclusion of these proceedings. Step Two Valuation of Other Liabilities and Assets 31. The Bank s residual insolvency, above and beyond its foreign liabilities, represents its inherited losses accumulated from a number of sources over the years, and the costs associated with the political transition that started in The only available estimates of these inherited losses based on international accounting norms, as of end 2004, are those contained in the November 2005 USAID-funded, Assessment of Iraqi State-Owned Banks, which are preliminary in nature. 32. The Bank will conduct a systematic and comprehensive appraisal and valuation of all of its liabilities other than foreign and of all of its assets, as of end-2005, based on International Financial Reporting Standards (IFRS), and relying as a starting point on the November 2005 USAID Assessment. Each adjustment in valuation of assets and liabilities discussed in the USAID Assessment will be reviewed by the Bank, the CBI, and by qualified, independent, international auditors, and a determination will be made about its incorporation into the Bank s books. 33. This appraisal and valuation as of end-2005 will include, in particular, the computation of accrual on all relevant assets and liabilities, a reassessment of the valuation for all assets, the reconciliation of pending book entries, and resolution of the large suspense accounts that substantially increase and distort the Bank s balance sheet. Most of the items that will prove difficult to reconcile or resolve because of their age or lack of proper

121 ANNEXES 97 documentation will be written down. The write-downs will take place on the basis of written and specific principles and criteria (age of the transaction, nature, amount, etc.) that will be applied symmetrically to asset and liability items. This exercise is expected to result in another substantial decrease in the size of the Bank s balance sheet. 34. A work program for this comprehensive appraisal and valuation exercise will be designed by the Management of the Bank within 60 days following the signing of this MOU, and submitted for review and approval to the ROC, with a view to completing it by March 31, 2007, for the accounts as of end The exercise will then be immediately repeated to provide an update for data as of end The update should be completed by end-may The total of the inherited losses will fluctuate in line with the progress of the appraisal exercises. It will be reflected in a newly-created account called Counterparty of Inherited Losses on the asset side of the balance sheet, as part of the Accounts Receivable. For prudential monitoring purposes, this account will have a risk-weighting of zero percent. Step Three Certification by International Auditors 36. The accounts of the Bank as of end-2006 will be audited by its External Auditors, as required by the Banking Law, on a normal schedule, during the second quarter of In addition, qualified, independent, external, international auditors will subsequently conduct a second review of the Bank s financial position as of end-2006, as agreed upon as part of the current Stand-by Arrangement with the IMF. These auditors will focus on quality controls for the internal appraisal and valuation of assets and liabilities, and on the thoroughness and accuracy of the routine External Audit already undertaken, to provide a certification of the accuracy of the Bank s financial position based on IFRS as of end Their work is expected to be completed by September Step Four Recapitalization 37. The completion of Steps One through Three, including the completion of the UK insolvency proceedings regarding Rafidain Bank, plus satisfactory progress, as appreciated by the ROC and agreed with the World Bank and the IMF, on the operational restructuring of the Bank, are prerequisites for the completion of the FRP. These are the two tests that the Bank must pass to confirm its presumed financial and operational viability and ability to reform itself, before additional public funds are invested into the final stage of the restoration of its capital adequacy and overall financial condition. Section IV. Implementation and Follow-up 38. The primary responsibility for the day-to-day implementation of the ORP and eventually the SORP and the FRP resides with the Management of the Bank. The current Senior Management Team will be subjected to a vetting process, to verify the qualifications, character, and competencies of all of its members, and that they understand the restructuring strategy laid out in this MOU, and are motivated, committed, able, and ready to support its implementation in full. This vetting process will be carried out by the Restructuring Oversight Commission (ROC), and will be based on the information from the CBI s Fit and Proper Questionnaires currently being completed, and on objective and transparent criteria and selection process reflected in Terms of Reference, to be agreed with the IMF and the World Bank. This will ensure professional, skilled, and able managers

122 98 of the Bank, and will support the Bank s new commercial orientation, and the newlyestablished arms length relationship between the Ministry of Finance as Owner, and the Bank. Changes and additions to the Management Team will be made, as needed, based on the results of this vetting process, by the Ministry of Finance with the concurrence of the CBI as required by existing law, within 60 days following the completion of the vetting process (Action Plan, #5). In addition, the incentive structure for Management and Employees of the Bank will be examined with a view to: 1) avoid risks of conflict of interest and moral hazard during the restructuring; and 2) establish and apply appropriate incentives to ensure Management and Employee full commitment to the restructuring (Action Plan, #6). 39. The ROC will have a limited lifespan, and is being established to guide and monitor the implementation of both the ORP and the FRP by the Management of the Bank, and to oversee the development and implementation of the SORP, and the restructuring plans of all state-owned banks. The ROC shall consist of the Governor of the CBI (Chairman), the Minister of Finance, and the chairman of the Board of Supreme Audit (BSA). It will be supported by a Secretariat provided by the CBI, and a Chief Technical Advisor. To ensure international expertise, transparency, and modern best practice in the implementation of the restructuring programs, the ROC will also utilize, as appropriate, specialized, independent, external advisors, selected under Terms of Reference agreed with the IMF and the World Bank. The ROC will also ensure the preparation of the full Strategic and Operational Restructuring Plan (SORP) for the Bank, to be developed on the basis of the Operational Audit, and will oversee its approval and implementation, the details of which will be elaborated through the regularly scheduled review of the attached Action Plan, at the appropriate time. It will also develop and oversee the restructuring plans related to all other State-owned Banks, which should be considered in the context of strengthening the overall, marketbased framework for banking in the country. 40. The CBI will provide the ROC, on a monthly basis, with the Bank s financial statements, as well as with a progress report prepared by the Bank on the implementation of the provisions of this MOU, and related Action Plan. These documents will be reviewed and discussed by the ROC during monthly meetings, or more frequent ROC meetings, as needed. This is in addition to, not as a substitute for, regular banking supervision by the CBI that will continue normally, with the CBI retaining all of its independent supervisory authority provided to it by the CBI and the Banking Laws of Iraq. 41. To implement this MOU, the Ministry of Finance and the CBI will jointly submit, within 30 days following signature of this MOU, a proposal to the Council of Ministers Economic Committee, to establish the independent Restructuring Oversight Commission (Action Plan, #3), in accordance with Iraqi Law governing the establishment of such Commissions in Iraq. The Ministry of Finance and the CBI will prepare detailed Terms of Reference, and an annual budget for the ROC (including operating and technical assistance costs), to be agreed with the IMF, and appropriate budgetary allocations will be made from the Government s general budget. 42. In addition, the CBI will submit to the Council of Ministers for submission to Parliament, within 60 days following the signature of this MOU, amendments to the CBI Law (#56 of 2004), the Banking Law (including Article 59, Law #94 of 2004), the Company Law (#21 of 1997), and to the Law of Public Companies (#22 of 1997), to allow for:

123 ANNEXES 99 a) the CBI, in exceptional circumstances and for systemic safety and soundness reasons, to restructure banks as an intermediate remedial action; b) the use of Treasury bonds in lieu of cash to recapitalize the Bank; and, c) strengthened Corporate Governance for all financial institutions under the authority of the CBI by requiring them to adhere to OECD/World Bank Corporate Governance Guidelines which, among others, allow for independent external expert advisors to serve as Directors on the Boards of bank and non-bank financial institutions [Action Plan, #4]. 43. The Ministry of Finance will submit, immediately upon signature of this MOU, the MOU to the Economic Committee of the Council of Ministers for approval. As appropriate and agreed with the IMF and the World Bank, it will also secure the Government s formal commitment to request from Parliament, when the time will come, the budgetary appropriations for the issuance of bonds related to the FRP, and of other restructuring costs (i.e., technical assistance, and pension/social costs for staff reductions). 44. As part of its budgetary management process, the Ministry of Finance will incorporate in its projections the carrying costs of the future recapitalization bonds for the Bank, computed on the basis of the latest available balance from the account inherited losses. It will also incorporate in its projections the full operational, restructuring and technical assistance costs, needed to elaborate and implement the Bank s restructuring plans. 45. The attached Action Plan is an integral part of this MOU. A revised and updated version of the attached Action Plan, agreed with the IMF and the World Bank and governed by this same MOU, will be submitted to the Council of Ministers for information, as appropriate, when the new, comprehensive SORP becomes available after the completion of the Operational Audit of the Bank. 46. The provisions of the present MOU and related Action Plan shall supersede and replace any directives, regulations, or text that are inconsistent with it. Signature Signature Attachment: Action Plan Rafidian Bank

124 100

125 ANNEXES 101 ANNEX 4: JOINT CBI MOF MEMORANDUM OF UNDERSTANDING RESTRUCTURING OF RASHEED BANK Republic of Iraq Joint CBI Ministry of Finance Memorandum of Understanding Restructuring of Rasheed Bank (December 6, 2006) 1. This Memorandum of Understanding (MOU) is made this 6th day of December, 2006, by and between: The Central Bank of Iraq (CBI), operating under the Central Bank of Iraq Law of 2004, hereby represented by H.E. Sinan Al-Shabibi, Governor; and The Ministry of Finance of the Republic of Iraq, represented by H.E. Bakir Jabr, Minister, as the Owner of Rasheed Bank (the Bank). 2. WHEREAS one of the two primary objectives of the CBI is to foster and maintain a stable and competitive market-based financial system, pursuant to Article 3 of the CBI Law of 2004 (the CBI Law); 3. WHEREAS the CBI, pursuant to Article 40 of the same Law, has the authority to take all such actions as may be necessary to regulate and supervise banks, including the authority to take remedial action, as provided in this Law and in the Banking Law of 2004 (the Banking Law); 4. WHEREAS, pursuant to Article 16 of the Banking Law, each bank shall at all times maintain capital of no less than 12 percent of the total value of its assets determined on a risk-adjusted basis; 5. WHEREAS it appears that the Bank has a negative net equity position, as a result of its foreign obligations contracted at the behest of the former regime, of other losses accumulated under the same former regime, and costs associated with the political transition since 2003, but retains a significant franchise value, branch network value, and the confidence of the Iraqi public; 6. WHEREAS the primary regulatory objective of the Banking Law, as expressed in Article 2, paragraph 1, is to maintain confidence in the banking system, and the Bank is of systemic importance to the country because of its size and of its nationwide network of branches that perform financial transactions critical for the continuity of public services and for serving the general public; 7. WHEREAS the MOF, as Owner of the Bank, hereby affirms its commitment to restructure the Bank operationally, while financial restructuring to restore the Bank s net equity position above the level required by Article 16 of the Banking Law will only be completed at a later stage, following resolution, satisfactory to the IMF, of outstanding foreign obligations of the Bank, and in a sequenced manner that will preserve the financial interests of the country by, among other things, preserving the fixed assets of the Bank, improving the efficiency and revenue of its operations, maximizing its value to the Owner, safeguarding the deposits of the public, and contributing to the development of a strong, market-driven, modern, and sound banking system, as detailed below in this MOU;

126 NOW THEREFORE, in consideration of the representation set forth above, the Parties agree as follows: Section I. Preamble 9. This MOU sets forth the principles for the Operational Restructuring Plan (ORP, see Section II), the Financial Restructuring Plan (FRP, see Section III), and for the development of a comprehensive Strategic and Operational Restructuring Plan (SORP, see Section II) for the Bank. The ORP is intended to stabilize the bank, on an interim basis, to prepare it to compete in and support the newly-established market-driven economy of Iraq. The SORP is designed to ensure the Bank s long-term financial viability, as a sound, efficient, and commercially-oriented bank, able to compete in and serve the economy, domestically and internationally. The FRP will restore, in agreed and time-bound steps, the Bank s net equity position above the level required by Article 16 of the Banking Law. 10. Detailed plans for the implementation of both the ORP (and eventually, the SORP), and the FRP will be defined by the Bank s Management Team, with qualified external technical assistance as appropriate, and will be subject to the review and approval of a Restructuring Oversight Commission (ROC, see Section IV). The ROC will also approve the design of the SORP, and will monitor the later implementation of the FRP and the SORP. 11. In case of failure to implement substantive provisions of this MOU, for whatever reason, or excessive delays, as determined by the CBI, and after due warning, the CBI will carry out its role under the CBI Law and Article 59, paragraph c of the Banking Law. Section II. Operational Restructuring Plan 12. The ORP s strategic objective is to establish an interim basis for the Bank s financial and operational viability, while the SORP s objective is to secure it in the medium and long-term as an efficient Bank, able to compete in and support the new, market-driven national economy. Operational restructuring typically unfolds over time (i.e., a two-tothree year period), and may require periodic adjustments during that time period, as more information develops from the implementation experience itself, and as broader sector and/or macro-economic adjustments take place. 13. At the current juncture in Iraq, only a preliminary Operational Restructuring Plan (ORP) can be defined and implemented under the present MOU, due to a lack of critical information and remaining uncertainties concerning the Bank s real financial position. The preliminary ORP defined below deliberately takes, during a transition period, a narrow focus, with two immediate priorities for the Bank: a) ensuring its status as a sound financial institution providing needed banking services to and for the people of Iraq and its economic entities; and b) preparing the Bank for a more comprehensive restructuring through the carrying out of a full Operational Audit (planned under Iraq s existing Standby Arrangement with the IMF) that will serve as the basis for defining a comprehensive Strategic and Operational Restructuring Plan (SORP). 14. The new, comprehensive version of the ORP (Strategic and Operational Restructuring Plan SORP), will be prepared after completion of the currently

127 ANNEXES 103 planned Operational Audit, as a pre-requisite for carrying out the final step of the financial restructuring by the Ministry of Finance (Step Four of the FRP para. 37). The SORP will be agreed with the World Bank and the IMF, and will be supported by qualified external technical assistance, as appropriate. Its eventual implementation will be defined in the context of revisions to the Action Plan attached to this MOU (see Attachment). Providing Sound Financial Institutions to the Public 15. The people of Iraq and the country s economic entities need a sound financial system, complying with international accounting, auditing, prudential and corporate governance standards, and providing basic and essential financial services, including: taking care of the population s deposits, protecting the savings of the general public, managing current accounts and collections for businesses, and effecting payments securely and efficiently. At the same time, full-fledged, modern banking activities, and in particular large-scale lending, can only be carried out by a significantly updated and improved Bank. Under the ORP, until it is determined that the operational capabilities of the Bank have advanced satisfactorily, the Bank s activities will be limited to providing the public with sound, safe, and efficient basic financial services, and it will function essentially as a narrow bank. 16. As such, the Bank will invest its resources in safe assets. It will generally avoid risky operations, particularly risky lending, and it will not provide any directed lending, subsidized or otherwise. Its branch network will remain intact as assets of the Bank during this phase, except that a limited number of underperforming branches may be permanently closed for cost containment purposes, if found necessary by the Operational Audit, and approved by the ROC. To preserve the value of the Bank to its present or future owners, no sale or transfer of Bank branches will occur during the restructuring. Any subsequent sale or transfer of Bank branches would be based on the conclusions of the Operational Audit as reflected in the SORP, and would require a full and transparent valuation as certified by qualified, independent, external, international auditors (Section III), and the approval of the CBI. 17. Continuation of the current limited lending activities as well as their extension to a few new, low volume, simple and safe lending activities (with demonstrable cashflows and appropriate collateral and/or guarantees) essential to support the Bank s customers is subject to the presentation of a specific plan, within the general framework of the preliminary ORP prepared by the Bank s Management, and must be reviewed and approved by the ROC. 18. Cost containment and recovery measures will be proposed by the Bank s Management within 3 months following signature of this MOU, including a plan to start addressing, in a deliberate and progressive manner, part of the Bank s considerable overstaffing, notably as related to the provisions of the new Pension Law. As long as the Bank s future has not been clearly defined through the finalization and agreement of the SORP, cost containment, together with asset safeguarding, will stay at the core of Bank Management s mandate. The immediate objective for the transitory period of the initial ORP should be to balance current income and expenses, and to resolve the Bank s remaining foreign obligations. Consistent with this, during the restructuring, all banking services provided by the Bank to the Government should be carried out on at least a full, cost-recovery basis (Action Plan, #21(b), #25).

128 104 Preparing for the Future 19. The Operational Audit of the Bank agreed upon as part of the current IMF standby arrangement, will start by March 31, 2007, and be completed by July 31, 2007 (Action Plan, #21(a)). The Operational Audit will consist of a review and assessment of the Bank s products, operations, policies, and procedures, and will provide the basis on which a new, commercially-oriented business strategy for the Bank will be defined, and a new, comprehensive operational restructuring plan will be established. The strategic development plan of the Bank will define the features of the Bank in the medium-term, as an operationally and financially viable, efficient, market-oriented bank, able to compete and serve all of its constituencies, and to comply with the prudential requirements of the Banking Law and of the CBI, on a sustained basis. Integral to this plan would be the establishment of an arms-length relationship between the Ministry of Finance and the Bank, and a commercial-orientation to the relationship between the Government (as a customer) and the Bank. 20. As the key output of the Operational Audit, the new, comprehensive, commerciallyoriented SORP will replace the preliminary ORP whose implementation is included in this MOU. The SORP will be submitted to the ROC for review and approval by September, It will then be submitted by October, 2007 to the CBI for verification against existing prudential requirements and for formal CBI approval as supervisor. As stated above, resolution, satisfactory to the IMF, of outstanding foreign obligations of the Bank, and approval by the ROC and separately, by the CBI, of the SORP, and agreement on the SORP with the World Bank and the IMF, are key prerequisites for the completion of the financial restructuring of the Bank. 21. In addition to the operational restructuring plans described above, the Bank will undertake a special effort to facilitate, and render more effective the regular External Audit process, and the subsequent additional certification by qualified, independent, external, international auditors, planned for To this end, an Audit Preparation Working Group, consisting of representatives of the Bank s Accounting and Internal Audit Departments, and its External Auditors, will start its work immediately following the signing of this MOU (Action Plan #15, #16). The Working Group will identify bottlenecks, data shortages and discrepancies that may have slowed past audits and assessments, and will produce practical recommendations on how to remove or mitigate them in time for the next External Audit, within 60 days following signature of this MOU. 22. Given the central importance of accurate bank information for effective management and efficient audit processes, and for business efficiency and effectiveness more broadly (including linkage to the new payment system, recently introduced), a new, comprehensive IT Strategy for the Bank will be elaborated and agreed, as part of the new SORP. 23. To secure the objectives of the ORP, the SORP and ultimately, the FRP, it is critical to enhance and upgrade the skills and experiences of Bank Management and Staff. The prospects for establishing strong twinning arrangements with reputable foreign banks, to strengthen institutional capabilities and introduce more efficient and modern banking practices and services, will therefore be actively pursued and defined by the ROC, as will be the need to ensure the provision of intensive on- and off- the job training and technical assistance support for the implementation of the SORP (Action Plan, #23).

129 ANNEXES 105 Section III. Financial Restructuring Plan 24. The FRP, as set forth in this Section, is meant to restore the Bank s ability to comply with minimum capital adequacy and other prudential requirements of the CBI, and to restore its full credibility with its business counterparts. It is predicated on the MOF s commitment, as Owner of the Bank, to resolve foreign obligations of the Bank, and to define the Bank s new business strategy and restructure its operations in line with such strategy, as a basis for its longer-term financial viability and competitiveness, including eventually restoring the Bank s net equity position to the level required by Article 16 of the Banking Law. The FRP consists of sequenced Steps that first reduce the Bank s liabilities, then sort and reconcile its asset and liability accounts, before ultimately considering the need for, and appropriateness of, providing any new capital. It also ensures the preservation and protection of the Bank s assets (physical, financial, and franchise value), during the period of the restructuring. Finally, it takes into account the need to explicitly link recapitalization to prior actions, including resolution of outstanding foreign obligations, satisfactory to the IMF, and decisive progress on the operational side of the restructuring of the Bank. In line with these priorities, the Bank will verify the status of its obligations toward foreign creditors under the Paris Club and other arrangements with the responsible Ministry of Finance officials, and make appropriate accounting adjustments to its books, immediately. Such adjustments will be verified for accuracy ex-post by qualified, independent, external auditors. 25. The four steps of the FRP are: (i) foreign liabilities settlement and release; (ii) appraisal of other liabilities and assets; (iii) certification by qualified, independent, external, international auditors; and (iv) recapitalization by the Owner. Step (i) is ongoing. Step (ii) will start immediately upon the signing of this MOU. Step (iii) will then follow, and is scheduled to take place in the middle of Step (iv) is conditional upon the successful implementation of the three previous steps and will come only provided that sufficient progress has also been achieved on the operational side of the restructuring (ORP/SORP), as described above and judged by the ROC with external expert participation, as needed, and separately by the CBI as the supervisory authority, and agreed with the IMF and the World Bank. Step One - Foreign Liabilities Settlement and Release 26. With the active involvement of the Ministry of Finance and any other relevant public institution, the Bank will be expeditiously relieved from its remaining inherited foreign liabilities. This includes, in particular, the foreign debt contracted on behalf of the former regime and all related items, i.e., accrued interest, fees, commissions, guarantees that have been called, and any other related charges and expenses. 27. Within 60 days of the signing of this MOU, all foreign liability accounts in the books of the Bank will be reviewed (without regard to whether Rasheed Bank would be able to assert defenses, such as statute of limitations defenses, against an effort by a creditor to enforce such a claim in a legal proceeding), and their amounts marked down to accurately reflect the Bank s true financial position and the considerable progress already achieved in renegotiating Iraq s foreign debt. This process is expected to provide a more accurate view of the Bank s liabilities compared with the preliminary figures contained in the USAID-funded, November 2005 Assessment of Iraqi Stateowned Banks.

130 The unresolved, outstanding inherited foreign liabilities in the books of the Bank will then be balanced through the creation of an account called Counterparty of Inherited Foreign Liabilities for Settlement and Release (the Account) on the asset side of the balance sheet, as part of the accounts receivable. For prudential monitoring purposes, this Account will have a risk-weighting of zero percent. This Account will be continuously adjusted to reflect the amount of left-over foreign liabilities. 29. The Ministry of Finance will diligently pursue the disposal process for the leftover foreign liabilities in the Bank s balance sheet. The Ministry of Finance will continue its efforts to settle the Bank s foreign debts with bilateral creditors through exchanges of their claims on the Bank against new claims on the Government, with a view to reducing these liabilities to zero as soon as feasible, on terms not more favorable to the creditors than those agreed with the Paris Club in November, Given the importance of these matters to Iraq and to the Bank, the Ministry of Finance recently (October 2006) established a Committee, comprised of members from Rasheed Bank and Rafidain Bank, and of the MOF s Directorate of Public Debt, to follow-up on them and to finalize the reconciliation and accounting in the books of these Banks for foreign liabilities already settled with the Banks foreign creditors on the one hand, and those that remain to be agreed upon, on the other hand. Step Two Valuation of Other Liabilities and Assets 30. The Bank s residual insolvency, above and beyond its foreign liabilities, represents its inherited losses accumulated from a number of sources over the years, and the costs associated with the political transition that started in The only available estimates of these inherited losses based on international accounting norms, as of end 2004, are those contained in the November 2005 USAID-funded, Assessment of Iraqi State-Owned Banks, which are preliminary in nature. 31. The Bank will conduct a systematic and comprehensive appraisal and valuation of all of its liabilities other than foreign and of all of its assets, as of end-2005, based on International Financial Reporting Standards (IFRS), and relying as a starting point on the November 2005 USAID Assessment. Each adjustment in valuation of assets and liabilities discussed in the USAID Assessment will be reviewed by the Bank, the CBI, and by qualified, independent, international auditors, and a determination will be made about its incorporation into the Bank s books. 32. This appraisal and valuation as of end-2005 will include, in particular, the computation of accrual on all relevant assets and liabilities, a reassessment of the valuation for all assets, the reconciliation of pending book entries, and resolution of the large suspense accounts that substantially increase and distort the Bank s balance sheet. Most of the items that will prove difficult to reconcile or resolve because of their age or lack of proper documentation will be written down. The write-downs will take place on the basis of written and specific principles and criteria (age of the transaction, nature, amount, etc.) that will be applied symmetrically to asset and liability items. This exercise is expected to result in another substantial decrease in the size of the Bank s balance sheet. 33. A work program for this comprehensive appraisal and valuation exercise will be designed by the Management of the Bank within 60 days following the signing of this MOU, and submitted for review and approval to the ROC, with a view to completing it by March 31, 2007, for the accounts as of end The exercise will then be immediately

131 ANNEXES 107 repeated to provide an update for data as of end The update should be completed by end-may The total of the inherited losses will fluctuate in line with the progress of the appraisal exercises. It will be reflected in a newly-created account called Counterparty of Inherited Losses on the asset side of the balance sheet, as part of the Accounts Receivable. For prudential monitoring purposes, this account will have a risk-weighting of zero percent. Step Three Certification by International Auditors 35. The accounts of the Bank as of end-2006 will be audited by its External Auditors, as required by the Banking Law, on a normal schedule, during the second quarter of In addition, qualified, independent, external, international auditors will subsequently conduct a second review of the Bank s financial position as of end-2006, as agreed upon as part of the current Stand-by Arrangement with the IMF. These auditors will focus on quality controls for the internal appraisal and valuation of assets and liabilities, and on the thoroughness and accuracy of the routine External Audit already undertaken, to provide a certification of the accuracy of the Bank s financial position based on IFRS as of end Their work is expected to be completed by September Step Four Recapitalization 36. The completion of Steps One through Three, plus satisfactory progress, as appreciated by the ROC and agreed with the World Bank and the IMF, on the operational restructuring of the Bank, are prerequisites for the completion of the FRP. These are the two tests that the Bank must pass to confirm its presumed financial and operational viability and ability to reform itself, before additional public funds are invested into the final stage of the restoration of its capital adequacy and overall financial condition. Section IV. Implementation and Follow-up 37. The primary responsibility for the day-to-day implementation of the ORP and eventually the SORP and the FRP resides with the Management of the Bank. The current Senior Management Team will be subjected to a vetting process, to verify the qualifications, character, and competencies of all of its members, and that they understand the restructuring strategy laid out in this MOU, and are motivated, committed, able, and ready to support its implementation in full. This vetting process will be carried out by the Restructuring Oversight Commission (ROC), set up under a separate MOU related to the restructuring program of Rafidain Bank,, and will be based on the information from the CBI s Fit and Proper Questionnaires currently being completed, and on objective and transparent criteria and selection process reflected in Terms of Reference, to be agreed with the IMF and the World Bank. This will ensure professional, skilled, and able managers of the Bank, and will support the Bank s new commercial orientation, and the newlyestablished arms length relationship between the Ministry of Finance as Owner, and the Bank. Changes and additions to the Management Team will be made, as needed, based on the results of this vetting process, by the Ministry of Finance with the concurrence of the CBI as required by existing law, within 60 days following the completion of the vetting process (Action Plan, #5). In addition, the incentive structure for Management and Employees of the Bank will be examined with a view to: 1) avoid risks of conflict of interest and moral hazard during the restructuring; and 2) establish and apply appropriate incentives to ensure Management and Employee full commitment to the restructuring (Action Plan, #6).

132 The ROC will have a limited lifespan, and is being established to guide and monitor the implementation of both the ORP and the FRP by the Management of the Bank, and to oversee the development and implementation of the SORP and the restructuring plans of all state-owned banks (see Rafidain Bank MOU). The ROC shall consist of the Governor of the CBI (Chairman), the Minister of Finance, and the chairman of the Board of Supreme Audit (BSA). It will be supported by a Secretariat provided by the CBI, and a Chief Technical Advisor. To ensure international expertise, transparency, and modern best practice in the implementation of the restructuring programs, the ROC will also utilize, as appropriate, specialized, independent, external advisors, selected under Terms of Reference agreed with the IMF and the World Bank. The ROC will also ensure the preparation of the full Strategic and Operational Restructuring Plan (SORP) for the Bank, to be developed on the basis of the Operational Audit, and will oversee its approval and implementation, the details of which will be elaborated through the regularly scheduled review of the attached Action Plan, at the appropriate time. It will also develop and oversee the restructuring plans related to other State-owned Banks, which should be considered in the context of strengthening the overall, market-based framework for banking in the country. 39. The CBI will provide the ROC, on a monthly basis, with the Bank s financial statements, as well as with a progress report prepared by the Bank on the implementation of the provisions of this MOU, and related Action Plan. These documents will be reviewed and discussed by the ROC during monthly meetings, or more frequent ROC meetings, as needed. This is in addition to, not as a substitute for, regular banking supervision by the CBI that will continue normally, with the CBI retaining all of its independent supervisory authority provided to it by the CBI and the Banking Laws of Iraq. 40. To implement this MOU, the Ministry of Finance and the CBI will jointly submit, within 30 days following signature of this MOU, a proposal to the Council of Ministers Economic Committee, to establish the independent Restructuring Oversight Commission (Action Plan, #3), in accordance with Iraqi Law governing the establishment of such Commissions in Iraq. The Ministry of Finance and the CBI will prepare detailed Terms of Reference, and an annual budget for the ROC (including operating and technical assistance costs), to be agreed with the IMF, and appropriate budgetary allocations will be made from the Government s general budget. 41. In addition, the CBI will submit to the Council of Ministers for submission to Parliament, within 60 days following the signature of this MOU, amendments to the CBI Law (#56 of 2004), the Banking Law (including Article 59, Law #94 of 2004), the Company Law (#21 of 1997), and to the Law of Public Companies (#22 of 1997), to allow for: a) the CBI, in exceptional circumstances and for systemic safety and soundness reasons, to restructure banks as an intermediate remedial action; b) the use of Treasury bonds in lieu of cash to recapitalize the Bank; and, c) strengthened Corporate Governance for all financial institutions under the authority of the CBI by requiring them to adhere to OECD/World Bank Corporate Governance Guidelines which, among others, allow for independent external expert advisors to serve as Directors on the Boards of bank and non-bank financial institutions [Action Plan, #4]. 42. The Ministry of Finance will submit, immediately upon signature of this MOU, the MOU to the Economic Committee of the Council of Ministers for approval. As appropriate and agreed with the IMF and the World Bank, it will also secure the Government s

133 ANNEXES 109 formal commitment to request from Parliament, when the time will come, the budgetary appropriations for the issuance of bonds related to the FRP, and of other restructuring costs (i.e., technical assistance, and pension/social costs for staff reductions). 43. As part of its budgetary management process, the Ministry of Finance will incorporate in its projections the carrying costs of the future recapitalization bonds for the Bank, computed on the basis of the latest available balance from the account inherited losses. It will also incorporate in its projections the full operational, restructuring and technical assistance costs, needed to elaborate and implement the Bank s restructuring plans. 44. The attached Action Plan is an integral part of this MOU. A revised and updated version of the attached Action Plan, agreed with the IMF and the World Bank and governed by this same MOU, will be submitted to the Council of Ministers for information, as appropriate, when the new, comprehensive SORP becomes available after the completion of the Operational Audit of the Bank. 45. The provisions of the present MOU shall supersede and replace any directives, regulations, or text that are inconsistent with it. Signature Signature Attachment: Action Plan Rasheed Bank

134 110

135 ANNEXES 111 ANNEX 5: FRAMEWORK FOR INSTITUTIONAL AND OPERATIONAL RESTRUCTURING OF STATE-OWNED BANKS I. General Scope of the Program 1. This note defines the overall framework of the program of operational and institutional strengthening which will enable the Bank to function successfully as a modern, competitive commercial bank. Due account is being taken of the effectiveness and reliability of the Bank s accounting, financial, administrative and control procedures and their upgrading. The Iraq authority has commissioned a comprehensive independent audit to assess the Bank s performance, outline the main areas of institutional weaknesses and present recommendations to address the weaknesses detected. The next step would be a set of detailed measures aim at implementing an operational and institutional action plan under the scrutiny of the Restructuring Committee headed by the Vice Governor of CBI. The US Treasury is assisting the two state-owned banks in drafting this detailed action plan. But more technical help (consultants) should be needed to assist the two state owned banks in the institutional and operational restructuring focusing on management functions, human resources, and IT and MIS, as well as, strengthening accounting, reporting and auditing policies and procedures in compliance with international best practices. 2. More specifically, the objective of the program is to support the CBI, the state-owned bank s board of directors and management team efforts in developing a detailed, credible business strategy and plan, and to recommend, inter-alia, steps that should be taken to streamline operations, optimize the branch and distribution network, and strengthen organizational, operational and management structures. The plan proposed under the program should include a candid and detailed assessment of needed professional skills in critical business areas (front, middle and back office), as well as staffing and staff training. The strategy of the public banks would need to be strictly defined under its proposed business plan to preclude lax lending policies and ensure a level playing field for all banks with private as well as public ownership. The proposed scope of work under the program should cover as detailed in the following sections the specific areas of: (i) strategic and business planning; (ii) organization structure; (iii) budgeting and performance measurement; (iv) management information system and management accounts; (v) operations; (vi) automation and technology support; (vii) internal audit; (viii) credit analysis and portfolio management; (ix) asset and liability management; (x) market development and marketing; and (xi) human resource management and training. A. Strategic and Business Planning 3. The public banks should consider creating a strategic and business plan. Given the need to build and develop the Bank in a changing economic and market environment, the completion of a comprehensive strategic plan is a priority as it is the necessary foundation for building a program of institutional change. The banks mandate from the owner would provide the basis for formulating the strategy. The strategic plan must clearly define the Bank s mission and objectives, target markets, products and services, financial goals, resource requirements and action plans for executing its strategy and achieving its goals and objectives One of the program s outcomes will be to support the board of directors and management design and implement a formalized strategic planning process for the Bank as a whole 31. Page 22 of the Rafidain Bank and Rasheed Bank reports.

136 112 and the individual business and staff units. That process must establish how the task of planning is organized, conducted and monitored on an on-going basis. The role of various departments (including, if necessary a specialist strategic planning unit within the banks) in the planning exercise must be established and the steps in the process with appropriate deadlines for completion of tasks must be outlined and agreed with the banks management. 5. The preparation of the strategic plan will be based inter-alia on the analysis of the external environment, the competition, current and potential markets, and the banks current market position. To this end, there would be a need to conduct relevant internal analyses to identify the banks strengths and weaknesses in relation to the market, the competition and future business opportunities. These internal analyses should include profitability analyses of existing businesses such as corporate and consumer lending. It is expected under the program, that the banks board of directors and senior management would then address and define the banks mission and strategy, and prepare business and action plans to execute that strategy. This corporate strategy will then be extended into a series of plans, each covering a major business of the banks defining specific goals, target markets, products and services, resource requirements, and actions programs as needed to provide practical guidance to each business unit and tools for monitoring and evaluating performance. 6. In the frame of the program, it would be expected to train banks staff in strategic and business planning in the course of the work, so that the banks have the ability to continue the planning process in the future. Any identified gaps in critical skills within the banks should be reported to management. B. Organization Structure 7. Once the strategy and business plans are developed, the banks must review their organizational setting so that it may execute its strategy successfully. 32 In this regard, the banks Board and management will work together to develop and document the organization structure of the head-office and their specific relationships to the branch offices. This would entail a definition of each organizational unit (including permanent committees), its mission, main responsibilities, key functions to carry out each responsibility, and required staffing levels. 8. To build the new organization structure, the Bank s board and management will define the specific requirements and will be expected to prepare a plan for implementing the new organization indicating implementation actions and responsibilities, schedule and support requirements. C. Budgeting and Performance Measurement 9. The budgeting functions in the public banks are at a very early stage. 33 The banks do not have a Budgeting Committee, which is a key internal body to oversee this core function. In the current situation, the budgeting functions are part of the finance department and report to the management. It would be best practices to establish such an independent committee within the banks. The budgeting process within the banks suffers from major weaknesses (no information system to prepare, compile and monitor the function s 32. Page 24 of the Rafidain Bank and Rasheed Bank reports. 33. Page 31 of the Rafidain Bank and Rasheed Bank reports.

137 ANNEXES 113 processes, There will be a need to strengthen the banks existing capital planning and budgeting systems. The objective will be to ensure that the capital planning (in terms of economic rather than regulatory) and budgeting systems are sufficiently comprehensive to meet fully the needs of the banks, including as a basis for providing incentives for, and controlling, management and staff performance throughout the institution. The banks will have to revise their system which should be formally linked to the strategic planning process to ensure that the annual financial plan for the banks truly represents and reflects the strategic objectives. 10. Beyond the necessity to close those gaps 34, the budgeting process will have to ensure that individual branches and units within the banks prepare budgets for all income and expenditure items over which they have responsibility. The process should ensure in particular that: (i) annual budgets for the banks and its departments and branches are linked to the strategic planning process and objectives; (ii) budget targets are agreed to between head-office and individual department and branch managers to ensure challenging but realistic targets and secure good motivation and performance from managers; (iii) detailed and relevant variance analyses take place on a regular basis and all significant variances from the banks targets and objectives are highlighted and explained as necessary and corrective actions are initiated; and (iv) the management accounts for the banks and its constituent parts are designed to report actual performance against budgets and strategic targets. 11. In addition to variance analysis, the banks will have to ensure that they have a comprehensive system of measuring performance against targets through the use of a well defined set of management accounts and reports and through a system of individual performance management (they will also have to state the milestones at which they will measure their performances). The banks will train a core staff in the utilization of the new systems and processes that may be developed. D. Management Information System and Management Accounts 12. There is a need to define the information required to manage the banks, measure their performances and control their risks. On completion of the banks strategic plan, a detailed plan of the management information required to execute the strategy will need to be completed, including management reports at each managerial level. The new management information requirements must be integrated into the automation strategy of the banks. 13. In assessing the adequacy of the existing management information system and recommending adjustments as needed, the Bank will ensure that the management information plan would cover all the key areas of Bank operations and management, including: (i) credit and portfolio status; (ii) treasury including liquidity, interest rate and FX risks, funding, asset and liability management, and deposits management; (iii) operations (front, middle and back-office), head-office and branches; and (iv) strategy, budgeting and performance measurement including the design and implementation of an appropriate management accounting system. A key item will be improving the interconnection of bank branches with the banks headquarters. 14. This will cover the accounting system needed to provide management with reliable and timeliness financial information for each of the operational units and product lines, 34. Page 32 to 37 of the reports.

138 114 as well as for the banks as a whole. The accounting system should include information on a profit and cost-center basis with appropriate transfer pricing for inter-unit transactions. The management accounts should also be designed to give revenue, cost and profitability information by product, customer, branch and business line. 15. The banks management will ensure that the new management information requirements, including the management accounts, are integrated into the automation strategy and technology support framework of the banks. Rafidain Bank and Rasheed Bank will also need to train a core staff in the utilization of the new systems and processes that may be developed. E. Operations 16. In light of the strategic plan which would have addressed the systems requirements for new business units the adequacy of the banks operating systems and procedures will be assessed, together with the need for their strengthening to ensure their effectiveness. There will be a need to ensure that any strengthened or revamped systems would take into account the banks planned businesses, methods of operations, service and control requirements and the automation strategy. 17. New operations systems and procedures would need to cover both head-office and branch operations and other product/service production and distribution networks/systems, and the interconnection of the branches with headquarters. Indeed, with intensified competition for products and services, and pressure on margins, it would be necessary to strengthen operations at the branch level. These efforts will involve substantial training of the banks branch staff in handling basic deposit-taking transactions, using computers. They will also involve development of loan officers capacity. Unless training can be held in Iraq, these efforts will involve training of a cadre of selected bank staff outside Iraq to act as trainers of the staff ( training of the trainers ) in Iraq. The numbers trained at this stage are projected to be at least one from each branch of the two banks. Following the training of these cadres, training programs will be set up in Iraq, if possible linked by video conference to the original trainers of the trainers so they can provide answers to more complicated questions. This is likely to entail travel to a centralized training center in Iraq. Finally, the project will support better use of information technology and interconnection of branches of the banks. At the moment, efforts have been made to improve functions of Rafidain Bank s head office and foreign offices but efforts are needed to train staff in the rest of Rafidain Bank and in Rasheed Bank. F. Automation and Technology Support 18. The current information systems within the public banks run on an antiquated environment. 35 There is no information security function in the banks or formal information security policies and procedures in accordance with international standards. In the same vein, the banks have not developed any disaster recovery site or disaster recovery plans. 19. Moreover, there is no IT governance or IT strategic planning in the public banks and information security as well as IT operations is currently managed on an ad-hoc basis. To ensure that IT systems (i) support efficiently the key current banking operations, (ii) meet the current and future business needs and user s expectations and (iii) effectively manage, maintain and control data availability, integrity and confidentiality, banks management 35. Page 43 to 85 of the Operational diagnostic review reports.

139 ANNEXES 115 should consider defining an IT strategy development framework at short notice and have a formal information system strategic planning document in place. This IT strategic plan will have to support fulfillment of the overall operational banks strategies and enable business growth. 20. Once the management information needs have been defined, the efficiency and effectiveness of the hardware architecture and system engineering in the Bank will be reviewed and evaluated (taking into account any contingency plans relating to business continuity risks). In so doing, due account will be taken of the need for congruence between the banks strategy, business goals, and existing technology. The work would require more specifically: (i) an assessment of the information and processing requirements, and a definition of a set of additional application needs for the banks; (ii) an analysis of the information and processing effectiveness of existing systems; (iii) an estimate of the cost of additional hardware, software (especially for the basic banking functions related to customer accounting, portfolio analysis and management, FX operations, etc ); (iv) an outline of the management, organization, manpower and training requirements needed to implement the program; and (v) an implementation schedule together with critical milestones. Due attention will be needed in integrating any new initiative: internally, with regard to a compatible system of hardware, software and communications from branch to head-office; and externally, with any new payments system and inter-bank arrangements. G. Internal Audit 21. The Ernst & Young audit concluded that the internal control system of both banks does not meet the international standards. Several major flaws are flagged. Chief among these, (i) the banks do not have an active audit committee; 36 (ii) the internal audit functions are not independent and (iii) the internal audit functions methodology is based on compliance testing rather than a risk-based approach. Banks internal audit schemes will have therefore to be strengthened. 22. In line with the strategic plans and the implications of these plans in terms of organization structure, financial instruments, operations, systems and procedures, and automation there will be a need to propose adjustments as required to the internal audit system and process with appropriate corresponding manuals. 23. There will be specifically a need to: (i) advise on improvements to audit methodologies, and adequacy of audit coverage in terms of scope (e.g. credit, operations, assets and liabilities management), depth and reporting standards; (ii) suggest required follow-up and monitoring; (iii) define the audit organization; and (iv) identify complementary audit skill requirements. The Bank auditing staff will need to be trained in the utilization of new methodologies (risk-based versus compliance-based). This sub-component which requires specialized skills - would call for interaction with/involvement of the external auditors. H. Credit Analysis and Portfolio Management 24. Long standing problems of portfolio quality have taken a heavy toll on the banks operations and financial position. The Ernst & Young asset quality reports show that loan loss reserves are largely underestimated (239 billion IQD for Rafidain Bank 36. Operational diagnostic review reports (page 91).

140 116 and 138 billion IQD for Rasheed Bank). 37 In terms of capital adequacy, regulatory capital shortfalls based on Basel II requirements and worldwide practices in terms of classification and provisioning of bad assets- may vary between 359 billion IQD for Rasheed Bank and 15.3 trillion IQD for Rafidain Bank). 38 With regard to the credit administration process, several weaknesses were identified within the banks: (i) the Credit Committees do not have a charter spelling out inter alia their mission, objectives, authorization matrix; 39 (ii) the banks credit functions do not forecast the cash flows generated from loan collections and do not perform a reassessment of the collateral value; the banks do not collect customers financial statements A formalized and thorough management and operational structure delineating credit policies, procedures and systems must be developed as a matter of priority. Special emphasis should be given to portfolio control and problem loan management. The revised structure should bring up-to-date market skills and techniques to the process of credit management, especially in the context of the asset quality problems faced by the banks. The banks management will need to enhance credit management policies, procedures and systems, regarding both aspects of credit analysis and portfolio management, and problem loan management. 26. (a) Credit analysis and portfolio management. There would be a need for improvement in policies and procedures regarding: (i) target market guidelines; (ii) portfolio limits; (iii) risk tolerance criteria; (iv) credit approval authorities; (v) credit analysis, structuring and pricing; (vi) loan documentation, contracts and security; (vii) loan disbursement procedures; (viii) loan follow-up and monitoring; (ix) credit recovery and legal enforcement; (x) credit administration and controls, including disbursement, amendment to terms and other sanction authorities, credit audit and policy exceptions; (xi) organization of credit within the context of the strategic plan; and (xii) automation of reports needed to monitor asset quality. 27. (b) Problem loan management. There would be a need to optimize policies, procedures and organizational arrangements [including if warranted, special workout unit for certain types of problem assets) related to: (i) problem loan definition and identification; (ii) problem loan reporting; (iii) problem loan follow-up; (iv) delinquent loan recovery; (v) viability analysis and loan restructuring options; (vi) repossession and legal recovery actions; and (vii) provisions and interest accruals. 28. There will be a need to train a core staff in the utilization of each of the new processes that may be developed. I. Asset and Liability Management 29. For both public banks, the Ernst & Young asset quality reports show that the banks do not have a formal ALM function. 41 There are no centralized treasury departments 37. Amounting to US$ 204 million and US$ 117 million (IQD 1,000 = US$ ). 38. Amounting to IQD 306 million and US$ 13.1 billion (18.4 % of GDP the 2008 GDP would reach IQD 83.6 trillions, ie. US$ 71.2 billion). The capital shortfall of US$ 13.1 billion (Rafidain Bank) is based on a number of adjustments which are likely to be required. Chief among these is a difference arising from the reevaluation of assets and liabilities denominated in foreign currencies. IQD 8.33 trillion (US$ 7.1 billion) are currently recognized as an asset due from the Ministry of Finance and are included within other assets of the Rafidain Bank. This amount relates to 2006 and may be recognized as an expense in the income statement. 39. Page 101 of the operational diagnostic review reports. 40. Page 12 of the asset quality reports. 41. Page 113 of the Operational diagnostic review reports.

141 ANNEXES 117 to perform treasury function related processes and there is no documented policy and procedures manual to govern ALM processes. 30. The banks management will have to design and activate an ALM function as part of the revised organizational structure of each bank. The skills, policies and systems required to manage these risks must be strengthened, so that comprehensive risk management policies be developed or improved to govern interest rate, liquidity, FX and other non-credit related risks. In this regard, the management will be responsible for the implementation of the processes, the organization, and the information systems required managing the range of ALM risks currently facing the banks and any additional risks inherent in the execution of the banks strategic plan. The management will have the responsibility of developing and documenting processes to cover, at a minimum, such ALM areas as liquidity, interest rate and duration gap and pricing, and FX. Further, the management will put in place an organization structure that will execute the proposed, upgraded ALM processes - defining specific responsibilities, authorities, and functions of each unit, as well as required staffing skills. In addition, it will be necessary to define the information required to support the ALM processes (e.g., external and internal information, formats and time-frames) There will probably be important needs to train key staff (treasury staff and management, and other senior managers who will participate in, or contribute to, ALM decisions) in utilizing the ALM system and implement the practical day-to-day functions. J. Market Development and Marketing 32. There will be a need to assess the adequacy of the banks formal marketing function and strategy and the degree to which these are aligned to its activities and to the requirements of the market. This would include an assessment of staff marketing and sales experience. In this regard recommendations, as needed, regarding adjustments to the marketing function and strategy would need to be developed as part of the banks strategic and business plan. In this context, a market analysis might be critical to the success of the strategic plan and vital for the proper execution of the business plan. 33. In each bank, in conjunction and congruent with the strategic plan, the management would need to complete a detailed marketing plan and each of its business units covering, as the case may be, new product introductions, service innovations and improvements. These plans should include: (i) a definition of market objectives; (ii) an analysis of market targets, products, and growth rates and shares; (iii) an analysis of customer needs, and marketing image of the Bank and its services; (iv) a marketing strengths, weaknesses, opportunities and threats analysis for the Bank; and (v) a plan of organization of marketing and sales at head-office and branch levels. 34. In particular, the banks management will have to make sure that business units are defined to meet the requirements of customers and the achievement of the banks strategic goals. For instance, the assessment could be made as to whether there is a need for relationship or account managers to handle major clients, the different organizational arrangements required for retail, small corporate, private sector clients or the possible requirement to set up specialist units for individual product areas. 35. The banks management will have to ensure that skills needed for market analysis and planning, and help institute a formalized market planning and development

142 118 process within the framework of the banks strategic planning process are in place. The management of the banks will have to define: (i) a training program regarding the banks marketing strategy and methods of sales and customer service; and (ii) an advertising and public relations program. K. Human Resource Management and Training 36. For both public banks, the operational diagnostic review report show that the current situation raised major issues in terms of human resources practices. There is no clear manpower plan (recruitments are conducted spontaneously based on number of authorized vacancies) and no consistent selection criteria 42, no performance management system. 43 There will be a need to assess the banks human resources and their adequacy for commercial banks operating in a competitive environment. Following the assessment of the adequacy in terms of staff skills, recommendations may be needed to address identified deficiencies in light of the banks business strategy and business focus and plans. To this end, a comprehensive training needs analysis will be required and a formalized training (and as needed recruitment) plan 44 should be established A human resource management system will have to be put in place in both banks to meet both current and future human resource requirements. There will be a need to address: (i) first the banks immediate needs for building critical skills and efficiently deploying the work force to staff its new organization, and support the execution of its strategy and business plan; then (ii) the banks medium-term needs for developing and managing its human resources. 38. Rafidain Bank and Rasheed Bank will need to implement a first set of high-priority human resource management systems consisting specifically of: (i) a training needs analysis; (ii) a training and development master plan, including a prioritization and planning of how all training needs will be met, and the launching of highest priority programs; (iii) a performance appraisal system, including the assessment of the performance and potential of employees, and the identification of major development needs; and (iv) a staffing program which entails the effective matching of people to jobs in the revised organization structure. 39. The banks next order of priority is to build, implement and train staff in applying the human resource management systems, related to: (i) manpower planning, covering supply and demand analysis, projection of manpower gaps and excesses (over 2 to 4 years) by major skill and rank level, and plans to fill the gaps and deal with the excesses; (ii) recruitment, with pro-active methods for finding and selecting key talents; (iii) rewards management, along a compensation scheme that will attract, retain and motivate managers, technical personnel and staff; (iv) management development, with methods for developing general and technical managers; (v) performance management, through an effective system for managing individual performance (e.g., goals, standards, monitoring, evaluation); and (vi) work culture development, under a program for building a competitive, commercial work culture throughout the organization. 40. These steps will include documentation of each system in the form of an operating manual, as well as pilot implementation and training of implementation staff. In particular, as needed, the management of the banks will be responsible of conducting on- 42. Page 120 of the operational diagnostic review reports. 43. Page 125 of the operational diagnostic review reports. 44. Page 127 of the operational diagnostic review reports.

143 ANNEXES 119 the-job training for the staff so that the banks have the full ability to carry on the work in the future. The management may set as a priority although this would have to be based on the training needs analysis the focus on two selected and critical groups of managers: (i) branch managers, where training should cover inter-alia, business planning, profit and cost management, human resource management, management control and marketing; and (ii) head-office department directors, where training should cover inter-alia, business and staffing planning, profit and cost management, human resource management, change management, performance monitoring and measurement. II. Output 41. The management will work with the board of directors of the banks to develop, along the specifications of the framework outlined in this note, the following program: (i) a strategic plan; (ii) business plans for individual business units; (iii) an organization structure; (iv) a budgeting and performance measurement framework; (v) identification and framework design of required management information systems; (vi) automation and technology support program; (vii) accounting and internal audit processes; (viii) implementation of a credit risk management process with emphasis on management of problem loans; (ix) implementation of asset and liability management systems for significant non-credit related risks; (x) development and initial implementation of plan for marketing of the Bank s products and services; and (xi) human resource management and training program including the implementation of priority human resource management systems. 42. It is recommended within this framework that performance indicators be established to assist in monitoring achievements.

144 120

145 ANNEXES 121 ANNEX 6: BANKING SUPERVISION ACTION PLAN Policy recommendations Minister of Finance and CBI: restore full supervisory powers of CBI over Rafidain Bank and Rasheed Bank and other state owned banks, in conformity with the 2006 MoU between the CBI and the Minister of Finance, as well as earlier recommendations in this area e.g in Annex 9 of the World Bank s Emergency Project Paper of April 2009, and as required in IMF staff reports. CBI: Conduct full rigor on-site inspection of Rafidain Bank and Rasheed Bank with special task force. Ministry of Economy and CBI: introduce IFRS-compliant accounting standards as soon as possible, as well as chart of accounts and explanatory materials; for Islamic banks refer to IFSB materials for guidance. Intermediate steps: comparison between Iraqi accounting standards and IFRS, drafting of new IFRS compliant Iraqi accounting standards; design of new chart of accounts for bank accounting, as well as new explanatory materials to the chart of accounts. Rationale Restoration of level playing field between state owned and private banks; empowerment of CBI s banking supervision function; extension of supervision to 100 percent of banking system assets Assuming confirmation of full CBI powers to supervise Rafidain Bank and Rasheed Bank need to exercise newly restored powers over these banks immediately, to assess safety and soundness. Special team required given complexity and scope of the task. IFRS-compliant accounting standards are essential for greater transparency and higher quality of banks financial statements and prudential reports, also in the interest of capital markets development and attractiveness of the Iraqi financial system to foreign investors. Immediately Immediately Timeframe Start immediately, complete over next 4 years; Comparison IrAS IFRS end 2011, design new chart of accounts and explanatory materials, including outreach and industry inputs end 2012; introduction bookyear 2014.

146 122 Policy recommendations Government and CBI: development of comprehensive strategy paper by Iraqi government in cooperation with CBI on development of the banking system, including time-bound perspective for the state owned banks (restructuring, liberalization of business; privatization), depositor protection, commercially based relations between government and currently state owned banks CBI: Implement public information campaign, on role of banking system, banking supervision and depositor protection; Rationale Further development of banking sector is stifled by predominance of state owned banks, opacity of their financial condition, privileged treatment of capital and liquidity and prevalence of directed lending, none of which are healthy conditions to build strong and competitive institutions. Building confidence of public at large in the banking system, also the private banks. Timeframe Start immediately, complete over next 3-4 years. Start immediately, complete end 2011, including discussion with the industry and in parliament. CBI, Ministry of Justice, Ministry of the Interior: develop strong push for effective antimoney laundering and combating of the financing of terrorism; enforce laws and regulations, banks internal KYC and reporting systems, FIU effectiveness and CBI oversight, effectiveness of prosecution authorities. Strengthen confidence, domestically and abroad, in government s will to address financial crime and corruption in an effective manner. Start immediately; ongoing efforts

147 ANNEXES 123 Technical Recommendations CBI: preparation of a full expert assisted Basel Core Principles assisted selfassessment applying the full rigor of the assessment criteria of the 2006 assessment methodology, providing more information on actual implementation and enforcement of prudential standards, as well as a review of required technical improvements in the regulations (some of which are mentioned below). CBI: review of the capital definition in the capital adequacy regulation to comply in all details with the Basel definition; recalculate banks capital and capital adequacy. To be done in conjunction with introduction of IFRS CBI: introduce tighter loan classification and provisioning for average loans; a zero provision seems inadequate; CBI: development and implementation of a plan to review in detail the 3-rated banks in the CAMELS system, as this is the group where casualties can be expected when conditions in the banking sector or the economy become less stable; Rationale Need to present an authoritative full rigor assessment, on a par with an FSAP type assessment, and to identify remaining technical deficiencies in the regulations. Present accurate capital figures, according to international standards, to improve supervision, and increase confidence of domestic banking partners and potential foreign investors. Correct provisioning is the single most important element in determining accurate capital figures Prevention; avoid a situation where CBI needs to deal with multiple problem banks at the same time, and where public confidence in the banking system could suffer severely. Timeframe Start immediately, complete end Start immediately, complete in September 2011 Immediately Start immediately; complete by fall 2011, in time before the 2011 financial statements are compiled and problems will come to light.

148 124 Policy recommendations CBI: issuance of more prescriptive regulations on internal audit and internal controls; the current regulations are not sufficiently binding; CBI: conduct specific training of staff in the interpretation and implementation of the new regulations, possibly together with commercial bank staff; Stronger enforcement of breaches of prudential regulations, by inclusion of specific implementation actions in the letters from the CBI to the banks, including deadlines and follow up monitoring. Send letter to banks informing them of tougher CBI action in the coming time. Enforce stricter requirements for financial information from licensing applicants: only audited financial statements will be accepted, not just whatever is available ; Draft clearer rules on divesting of shareholders who have become unsuitable over time; current rules only address approval at the acquisition phase; Issue of a regulation on consolidation of accounts and banking supervision on a consolidated basis; to be done in conjunction with introduction of IFRS. Rationale These areas are key to good risk management, safe and sound banking in general as well as accurate financial information. Banks complain that inspectors are inadequately trained in the CBI s regulations; this requires action, as the CBI s authority and effectiveness can be seriously undermined. Enforcement is too weak at this time; Rigorous licensing practices are key in keeping the banking system strong and reputable; in particular financial information needs to meet the highest standards of quality. Currently no such option seems available under the law or regulations. This is key to ensuring the suitability of shareholders also after the licensing stage. Such rules do not seem to be in place. They are essential to obtain an overview of the actual risk profile and financial condition of a bank. Timeframe Start preparation immediately, issuance beginning Start immediately, complete end Start immediately. Start immediately Start immediately, introduce fall Start immediately, issue end 2011.

149 ANNEXES 125 ANNEX 7: INFORMAL ASSESSMENT OF BANKING SUPERVISION IN THE REPUBLIC OF IRAQ I. Introduction 1. This review of the state of banking supervision in Iraq was performed as part of a study of the Iraqi financial sector, conducted by the World Bank in February June, The assessment is based on a study of the current laws on the CBI (CBIL), and the Banking Law (BL), as well as other relevant laws and regulations, insofar as available in English, including the latest January 2011 CBI regulations on banking supervision. Furthermore, interviews were conducted in February and March 2011 with officials of the banking supervision department of the CBI, foreign observers and aid agencies. 2. This review does not provide compliance ratings against the formal BCP criteria, and does not represent a ROSC. The assessment of supervisory rules and practices uses the 25 Basel Core Principles for Effective Banking Supervision (BCP) and the 2006 assessment methodology as an organizing framework. 3. Conduct of the assessment encountered significant challenges: No access to a fully developed self-assessment prepared by the authorities on the basis of recent laws and regulations. Earlier external assessments of 2003 and 2004 were based on the pre-2006 BCP, and on a far less developed supervisory system. Only a limited track record of compliance and enforcement had been built at the time of the assessment. Moreover, as most of the discussions were held outside Iraq, the mission had limited possibilities to assess actual implementation and enforcement, as only a few English language examples of remedial action files, and other documentary evidence of actual implementation were available; The CBI in practice has no effective supervisory powers over the state-owned banks, and no clear information was available whether and, if so, how supervision over these banks was exercised by other agencies. II. Assessment 2. Institutional and Market Structure--Overview 4. The Iraqi banking sector consists of 42 banking institutions, of which 7 are state- owned: Rafidain Bank and Rasheed Bank, the Trade Bank of Iraq, specializing in trade finance, and four specialized banks: the Industrial Bank of Iraq, the Agricultural Cooperation Bank, the Real Estate Bank, and the Iraq Bank. The private banking sector consists of 35 institutions, of which eight conduct business based on Islamic principles, and six are foreign owned, (three branches and three subsidiaries). 5. Total assets of the banking sector amount to around 10 percent of GDP. Rafidain Bank and Rasheed Bank hold around 97 percent of banking system assets, whereas the private banks hold 3 percent. The sector is stable and liquid;

150 126 banks report adequate capital, with statutory minimum capital adequacy of 12 percent. However, three institutions have CAMEL ratings of 4 or 5, at the lower end of the scale, requiring constant CBI supervision and intervention, and a significant number are rated 3, which is a potential risk and requires keen vigilance to prevent further slippage. Credit to the private sector amounts to roughly 5 percent of GDP. Also by other measures, Iraq is under-banked, with one bank branch per inhabitants, versus roughly per branch in many industrialized countries. The financial system is dominated by the banking system. Commercial banks, including Rafidain Bank and Rasheed Bank, hold around 75 percent of financial system assets 6. As shown above, the banking sector is heavily skewed toward the state-owned banks, that also have a near monopoly of financial transactions with the state owned non-financial enterprises, which in turn form a large part of the real sector. Any transaction with the state, including payment of salaries of government workers, taxes and utility bills, are to be conducted solely through the publicly owned banks. The state owned banks are implicitly heavily subsidized, and would at this point probably not be capable of operating under normal, competitive conditions. 7. The real level of capital of Rafidain Bank and Rasheed Bank, both stateowned, cannot at this time be reliably established, as a result of the structure of their balance sheets, which contain many legacy assets, revaluation differences of unknown magnitude, and un-reconciled asset and liability accounts from the past. Iraqi counterparts did not expect this normalization of the balance sheets to be completed before end 2011, with recapitalization by end 2013, notwithstanding earlier commitments that this process would be completed already several years ago. Moreover, there still are a number of substantial differences between Iraqi accounting standards and IFRS which need to be corrected when assessing the financial condition of the state owned banks.. 8. An audit of these two institutions was attempted in 2006 by one of the large international auditing firms. However, the accountants were unable to come to an opinion whether the accounts presented a true and fair view of their financial condition. It is understood that the state owned banks are not required to comply with the CBI- mandated increase in capital for the privately owned banks to a minimum of 100 bln. ID by January 2011, and to 250 bln ID by the end of January So long as the government guarantees the liquidity of Rafidain Bank and Rasheed Bank implicitly or explicitly and the population at large retains confidence in these institutions which still seems to be the case - they can keep operating, notwithstanding possible insolvency. As there is currently no deposit insurance system in Iraq a draft law is being discussed depositors in private banks do not have this protection. 10. However, the cost of this privileged position of the state owned banks is high: Inefficient financial intermediation; A potentially large contingent liability of the government; and Stunted development of a more efficient, market oriented banking sector.

151 ANNEXES Preconditions for Effective Banking Supervision Macroeconomic Stability 11. Macroeconomic stability in Iraq depends heavily on the stability of oil revenues, and, although Iraq s overall economic growth prospects are favorable, risks to the economic development process include political factors, security issues, technical capability, governance weaknesses and institutional capacity issues to implement reforms. 12. Iraq s economic growth performance has deteriorated since 2008, but is expected to recover in Real GDP growth rate fell from around 9.5 percent in 2008 to 4.2 percent in 2009 due to the slump in international oil prices and stagnating petroleum output. Economic growth rates declined further in 2010 but are expected to pick up in 2011, driven mostly by the oil sector. 13. The CPI rose by 3.3 percent in Gross international reserves of the CBI increased from US$44.3 billion at end-2009 to an estimated amount of US$50.6 billion at end The accumulation of foreign exchange reserves at the CBI allowed Iraq to stabilize the Dinar, reverse the dollarization process, and contain inflation. 14. Total external debt has decreased from percent of GDP in 2009 to percent of GDP in It is projected to decline further to 37.1 percent and 32.6 percent of GDP in 2011 and 2012, respectively. Public infrastructure 15. The legal framework for conducting financial business in Iraq shows a number of serious lacunae, e.g. the absence of a general insolvency law. A civil code and a companies law are in place. Rules for judicial loan enforcement are cumbersome, requiring for instance that the debtor be physically present in the courtroom. Judicial proceedings, even with regard to simple claims can take several years to complete. However, bank conservatorship, resolution and insolvency are regulated in considerable detail in the Law on the Central Bank of Iraq and Banking Law. A special financial services tribunal has been created to handle bank insolvency. 16. Of the ten 45 main components of the Legal Rights Index (2009) in the World Bank s Doing Business Report, 46 Iraq only has in place rules allowing the use of movable assets as collateral without surrendering possession, priority in bankruptcy for secured creditors, and exemption from enforcement stays during financial reorganization. There is no collateral registry for instance, which is indispensable for the reliable functioning of mortgages and some other forms of secured credit. Iraq ranks 141 out of 183 in contract enforcement, according to Doing Business. 17. Financial data on companies and banks is difficult to obtain, even though banks are required to publish annual statements (Art. 44 BL). Iraqi accounting 45. Including e.g. the establishment of a security interest in certain forms, existence of a collateral registry, priority for secured creditors in and out of liquidation, exemption of a stay on enforcement for secured creditors during financial reorganization, out of court enforcement options. 46. Doing Business 2010, World Bank.

152 128 standards deviate from IFRS on a number of significant points. There are few qualified public accountants in Iraq. General consumer protection rules do not exist in Iraq, other than the civil code rules, nor is there a system for depositor protection. Effective market discipline 18. The scarcity of reliable financial statements, the opacity of governance arrangements, in particular with regard to the state owned banks and TBI, in effect mean that a large part of the banking market is not subject to effective market discipline. Stock market analysts do, however publish analysis of private bank stocks quoted on the Iraqi stock exchange, although up to date, audited, balance sheet and income statement data are not always available. The CAMELS ratings of banks are routinely disclosed to the public by the CBI, with a considerable number of banks rated 3, 4 or even 5. The majority of the population still hold their deposits in the state owned banks, given the implicit government guarantee enjoyed by these institutions. Bank resolution 19. Although to date no banks have been liquidated in Iraq since 2003, the CBI has a credible framework to apply remedial measures, resolve banks, and initiate liquidation through a judicial process, and has taken corrective actions against banks in a number of cases. In the case of three banks, rated 4 or 5 according to the CAMELS system, strong action was taken. In two banks, conservatorship was imposed, and in one case negotiations are under way with a potential strategic partner. Article 56 of the Banking Law 2004) authorizes the CBI to take any measure or impose and administrative penalty against violation of the law or regulations, or the unsafe and/or unsound conduct of banking business. 20. The latter criterion allows the supervisor to use a degree of discretion to take action against unsafe banking practices, also when no concrete regulation has been breached. This shows that the CBI has the authority to be more than purely compliance oriented. The measures enumerated in the law include sending a warning, giving an order, requesting from the bank a program of remedial measures, issuing cease and desist orders, imposing restrictions on credit operations, keeping supplementary liquidity at the CBI, suspension of managers or Board members, dissolving the Board, imposition of monetary penalties, and withdrawal of the license. 21. Article 59 of the law provides the CBI with the authority to impose conservatorship. When the CBI determines that, among other criteria, a bank s capital has fallen below 75 percent of the required minimum, the CBI has the discretion to appoint a conservator. When, among other criteria, capital falls below 50 percent of the required minimum, the CBI shall mandatorily appoint a conservator, under a form of prompt corrective action. When capital falls below 25 percent, liquidation becomes mandatory. The conservator is accountable to the CBI. The law authorizes the CBI to set up a bridge bank for a maximum of two years, plus a maximum of three one-year extensions. A moratorium may be imposed by the CBI to protect the financial condition of a bank in conservatorship. Section 12 of the Law provides authority to start rehabilitation proceedings for a bank. Section 13 deals with liquidation of a bank. Banks are not subject to general bankruptcy law.

153 ANNEXES Assessment of supervisory rules and practices Objectives, independence, powers and resources (BCP 1) 22. Objectives: While the basic responsibilities of the CBI are laid down in the Law on the Central Bank of Iraq (CBIL), the Banking Law (BL) specifically provides the legal basis for banking regulation and supervision. Article 3 Law on the Central Bank of Iraq states that maintaining a stable and competitive market based financial system is one of the primary objectives of the CBI. Under Article 4 (1) (i) CBIL, the CBI issues licenses or permits to banks and regulates and supervises banks, as further specified in the Law on the Central Bank of Iraq and Banking Law. Article 2 Banking Law elaborates and states that the primary regulatory objective is to maintain confidence in the banking system. Other regulatory objectives include promoting public understanding of the banking system. An appropriate degree of protection for depositors shall be maintained, and the CBI shall help reduce financial crime including fraud, money laundering and terrorist financing. 23. Independence: Article 2(2) Law on the Central Bank of Iraq states that the CBI shall be autonomous and accountable as provided for by the law, and stipulates further that except as otherwise specified in the law, the CBI shall not take instructions from any other person or entity including government entities. The autonomy of the CBI shall be respected and no person or entity shall seek improperly to influence any member of a decision making body of the CBI in the discharge of his/her duties toward the CBI or to interfere in the activities of the CBI. 24. The CBI is governed by a nine-member board, chaired by the governor, and consisting of two deputy-governors, three CBI senior managers and three other individuals with suitable expertise. The governor is nominated by the Head of Government, and confirmed by the Legislature. The governor is appointed for a five year term of office (Article 13(1), and cannot be dismissed, except by the Head of Government, and only for one of the reasons limitatively enumerated in Article 14(2) Law on the Central Bank of Iraq. These grounds include conviction of a criminal offence, bankruptcy, mental or physical infirmity, absenteeism and personal misconduct. A decision of removal from office, as well as the grounds upon which this decision rests, must be publicly disclosed and are subject to appeals at the Court of Cassation. 25. Article 55 Banking Law stipulates that CBI officials or staff shall not be personally liable for damages for any act or omission taken in the discharge of official functions, including banking supervision. The CBI shall indemnify officials or staff for the legal expenses incurred in the defense against legal action brought against them for the exercise of their official function. A government attempt earlier this year to subject the CBI to closer accountability was de facto reversed.

154 130 Box 1: Supervision and Restructuring of Rafidain Bank and Rasheed Bank Normalization of the position and activities of Rafidain Bank and Rasheed Bank is seen by the authorities as crucial to the development of a banking system that could support the growing economy of Iraq. In Memoranda of Understanding of 6 December 2006, the CBI and the Minister of Finance laid down the framework for the supervision and operational and financial restructuring of Rafidain Bank and Rasheed Bank. However, the Iraqi authorities have recently postponed the recapitalization of both banks to 2013, seven years after signing of the MoUs. It is widely acknowledged by most Iraqi counterparts in the financial sector that the MoUs has not been implemented. In particular, counterparts agree that effective banking supervision by the CBI over these two banks has not been possible. Main elements of the MoUs are: Achieve normalization of Rafidain Bank and Rasheed Bank through operational and financial restructuring, to prepare them for a competitive market economy, and ensure their long-term financial viability; Complete an operational audit by July 31, 2007, consisting of a review of the Bank s products, operations, policies, and procedures, as a basis for a new, commerciallyoriented business strategy; Continue regular banking supervision by the CBI, applying normal prudential requirements, but taking into account the temporary forbearance granted by the MOUs. In particular, the MoUs specify that in case of non-implementation of the MoU, or excessive delays, the CBI has the authority to impose conservatorship; Apply strengthened corporate governance to Rafidain Bank and Rasheed Bank, by requiring them to adhere to OECD/World Bank Corporate Governance Guideline. Use Treasury bonds to recapitalize the Bank. Identify all banking activities undertaken for the Government by these banks and charge market rates for these services. 26. Powers: Article 4(2) states that the CBI may take whatever action it deems necessary to (i) counter money laundering and terrorist financing and (ii) regulate and supervise lending companies, microfinance companies and any other non-bank financial institutions not otherwise regulated under Iraqi law. Under Article 13 of the BL, the CBI may revoke a license on a large number of grounds, including safety and soundness related reasons. 27. Article 4(3) Law on the Central Bank of Iraq states that the CBI shall have the power to issue regulations to implement the Law on the Central Bank of Iraq and carry out its functions under this law. Article 4(5) Law on the Central Bank of Iraq states that the CBI shall have the power to issue legally binding orders addressed to specific individuals or entities, and direct such persons or entities to undertake specific actions in accordance with the Law on the Central Bank of Iraq. In particular, Article 40 of the Law on the Central Bank of Iraq provides exclusive authority to take all such

155 ANNEXES 131 actions as may be necessary to license, regulate and supervise banks and their subsidiaries to obtain compliance with the Law on the Central Bank of Iraq and the BL, including authority to conduct off-site surveillance and on-site examination of licensees and their subsidiaries, require banks to provide all information the CBI may request regarding the affairs of the bank, its subsidiaries, and their customers, and to take remedial action to enforce compliance with prudential standards. 28. Article 42 of the Law on the Central Bank of Iraq authorizes the CBI, after obtaining a warrant, to examine documentary evidence with regard to suspected activities for which a CBI license is required, if necessary with the assistance of law enforcement officials. The CBI shall order cessation of such activities, and if necessary impose penalties. Article 62 permits imposing penalties on natural persons responsible for the breaches of the rules. 29. Article 3(1) Banking Law prohibits the exercise of banking activities without a CBI license. Article 3(4) Banking Law prohibits the use of the word bank without having a banking license. 30. Resources: Under Article 2(1) CBIL, the CBI determines its own budget and funding, may administer and hold property, hire staff and define their duties. The banking supervision department, headed by a director general, has total staff of approximately 235, of which 135 at Baghdad headquarters, and 100 spread over the four branches of the CBI in Basra, Mosul, Arbil and Suleymaniyeh. The CBI branches also have supervisory responsibilities. The CBI exercises supervision over 43 banking institutions, formally including Rafidain Bank and Rasheed Bank, as well as over some 1750 other financial institutions, including exchange bureaus, money transmission services, investment companies, lending operations of insurance companies, pension funds, microfinance institutions and the post office s depositary operations, but also commercial companies with credit facilities for their staff. The Banking Supervision Department also deals with consumer complaints with regard to financial services. 31. Professional level banking supervision staff is required to have a bachelor s level education in banking, finance, law, accounting or IT (the latter for quantitative and off-site functions). Staff is provided with continued training from a variety of external sources, such as USAID, FSVC, EU, Treasury, Egyptian Banking Institute, IMF (METAC), but also from Iraqi sources, including the Ministry of Finance, the Iraqi High Institute of Finance and Accounting, the College of Business Administration and private banks. 32. When allocating CBI resources, it needs to be recognized that the required supervisory resources are a function of the level of development and size of the financial sector. The CBI currently has staff of around 1600, down from approximately The governor intends to decrease the number of staff further, to around 500. The governor recognizes the importance of banking supervision, and the budget of the Banking Supervision Department has been steadily increasing by around 10 percent per year. 33. However, this does not keep up with the expansion of the financial sector, which can be expected to grow even more rapidly in the coming years, given the currently low level of intermediation, the interest of foreign banks to enter the Iraqi market, possibly improved security and the prospective liberalization of the state owned banks and non-financial enterprises. There is also considerable

156 132 scope for an increase in the number of bank branches, which currently stands at 1/40,000 inhabitants, whereas in the industrialized world, this figure averages at 1/10, Greater efficiency and use of technological tools are intended to produce substantial savings in staff numbers, without loss of functionality of the CBI. Work is ongoing on an XBRL based reporting system, which will allow substantial increase in efficiency in off-site analysis. However, the challenges facing the CBI supervision department now and in the future will require more highly qualified staff. Also new software and technology is needed, also to improve off-site data collection, and analysis, as well as links between the CBI and the branches, which conduct a significant part of the on-site banking supervision work and off-site data collection. Licensing, ownership and acquisitions (BCP 2-5) 35. Licensing: Banking Law Section 2, Articles 4-13 regulate the licensing process, as the legal basis for more extensive CBI regulations on the licensing process for domestic and foreign banks, subsidiaries, bank holding companies, branches, representative offices. These regulations have recently been revised and reissued in January The Banking Law is more detailed than the regulations in many respects. 36. Natural persons cannot obtain a banking license. The applicant must be a legal entity, either domestic or foreign. For domestic banks the licensing process is divided into two phases. During the first phase, the applicant must submit inter alia a three year feasibility study/business plan with pro-forma balance sheets and income statements, details about the internal control system, a commitment by an auditor to audit the bank, a list of shareholders, including information on their profession and experience. At least two shareholders must have banking experience. 37. Foreign shareholders can take participations in Iraqi banks, if they are a bank and are subject to banking supervision in their home country. If shares are owned by a corporate entity, audited balance sheets and income statements over the past three years, or whatever is available, need to be submitted. An organizational chart needs to be submitted, as well as the number of prospective staff of the bank. Once the required documentation has been submitted to the satisfaction of the CBI, it gives a temporary license for one year. During this period the second phase the bank must complete the setting up and registration of the corporation, and submit the request for the definitive license. 50 percent of the required minimum capital must have been paid up, and the remaining 50 percent must be acquired within 18 months of the granting of the final license. 38. The request for the final license must be accompanied by information on the shareholders, Board of Directors, and the CEO. The shareholders are required to submit a questionnaire to test whether they are fit and proper. Main criteria include whether they have been found guilty of a crime for which imprisonment of a year or more is required, have been declared bankrupt, have been banned from exercising their profession by a professional body, have been found unsuitable to manage a company. Also Board members, the CEO and other unspecified key officers of the bank must submit similar information on their fitness and propriety.

157 ANNEXES Foreign banks subsidiaries must follow a similar procedure, with a few differences, for instance the requirement that the applicant must have an international credit rating, implying that only reputable banks can apply for a subsidiary license. The initial 50 percent of capital must be placed in an escrow account at the CBI. The founding foreign bank must show proof that it is subject to supervision in its home country and has been in business for at least three years. The applicant must submit information on the internal controls of the bank. There is no requirement that the remaining 50 percent of capital be collected within eighteen months after the granting of the license, as is required for domestic banks. Information must be provided on the bank s other activities on the Middle East, and in emerging market or developing countries. 40. A foreign bank must submit a three-year feasibility study, with funding forecasts and credit strategies, an overview of the institution s banking products, an assessment of the risks in the bank s plan, the IT to be deployed for work in Iraq, and the number of Iraqi employees and details about their training. Also, the home supervisor must confirm that it conducts supervision on a consolidated basis. The CBI must receive confirmation from an international auditor that he\she will perform the audit, receive confirmation that the home supervisor can exercise remedial powers over the branch, and that the head office is committed to combat money laundering and the financing of terrorism. During the licensing process the CBI contacts the home supervisor of a foreign bank, usually through an exchange of letters, in the absence of a formal system of MoUs. 41. Ownership: The founders of banks need to provide information to the CBI in the context of the licensing process. Moreover, Article 22 of the Banking Law provides rules on the transfer of ownership and acquisition of bank shares. Persons acting directly or indirectly or through, or in concert with, other persons, who propose to acquire a qualifying holding (10 percent or more) in a bank, shall give 90 days notice of this intention, and obtain prior approval of the CBI. This shall include information on beneficial ownership, three years financial information, other holdings, and intentions with regard to the use of the acquisition. The CBI will assess the expected effects on the financial soundness of the bank. Increases in the size of a holding to exceed a threshold of 20, 33, or 50 percent shall be notified to the CBI 30 days in advance. Also the bank with regard to which such changes in ownership occur, shall inform the CBI. Also mergers, and substantial purchase and assumption transactions are subject to CBI approval, according to Article 23 Banking Law. The CBI will only give its approval if the merged bank is able to meet all the requirements as would apply to an applicant for a new license. 42. Acquisitions: Iraqi banks are permitted to invest in non-bank or non-financial equities, without prior CBI approval, provided that the acquired stocks do not exceed 20 percent of the bank s capital. For each new acquisition of bank- or financial equities by an Iraqi bank, CBI approval must be obtained. 43. Given banks freedom to invest in other companies, the lack of a specific regulation on consolidation of accounts and supervision on a consolidated basis is a real deficiency. The mission understood that Iraqi accounting standards do not require consolidation of accounts.

158 134 Regulation and prudential requirements (BCP 6-16) 44. The regulatory powers of the CBI are laid down in Article 4(3) Law on the Central Bank of Iraq. In January 2011 a new series of prudential regulations was issued, providing basic rules on many of the main areas of prudential regulation The definition of capital now seems to approximate more closely the Basel I definition. Core capital should now consist of paid in capital, legal reserves, share issue premium, retained earnings, revaluation reserves, unallocated profit from past years. The Basel I definition of Tier 1 capital includes paid up capital on common shares, share premium, retained earnings, audited current year earnings and unallocated earnings from previous years. However, in the Iraqi regulations, revaluation reserves are treated differently than under Basel I, which allows these only as Tier 2 capital, and then only at a discount of 55 percent. A significant caveat when interpreting the capital adequacy figures are the non-ifrs compliant accounting standards used in Iraq, and the uncertainty about the rigor of the loan classification and provisioning by banks as well as verification by the CBI. 46. The CBI has imposed a risk weighted capital adequacy minimum ratio of 12 percent, and intends to increase capital requirements even further by This is partially justified by the high degree of risk in the Iraqi financial system, but also raises the question how banks can safely expand their portfolio to gain a return on these increased capital amounts. Credit to the private sector is only a relatively small part of many private banks balance sheets. 47. The liquidity regulations, covering the liquidity ratio and liquidity risk management, stipulate a minimum ratio between assets and liabilities maturing within a week. The regulations refer to a minimum ratio, which has been set by the CBI in a separate disposition at 30 percent. Banks are required to report their one-month liquidity forecasts to the CBI on a daily basis. The liquidity regulation provides definitions of the numerator and denominator of the ratio. The liquidity risk management regulation requires that senior bank management put into effect a policy and compliance system for liquidity risk management, including a contingency plan and stress testing to deal with liquidity stresses. The regulation also prescribes a system for monitoring and managing foreign currency liquidity. Liquidity management is to be incorporated into the internal controls system of the banks. 48. The January 2011 set of regulations includes basic rules on internal audit, internal control and corporate governance. Banks are required to have an internal audit department, commensurate to the size and nature of its organization and activities. It reports to the Board s Audit Committee. The Internal Audit Department shall evaluate the financial statements, audit compliance with rules and regulations of external parties, as well as review the quality of, and compliance with the bank s own rules. The corporate governance and internal control regulations issued by the CBI do not seem to impose 47. Regulations issued addressed licensing of banks and non-bank financial institutions, voluntary liquidation, mergers and acquisitions, credit classification and provisioning, large exposures, lending to connected parties, credit practices, investments by banks in Iraq and abroad, investments in Iraqi banks, capital adequacy, liquidity, liquidity risk management, operational risk management, market risk, general risk management, interest rate risk management, foreign exchange positions, internal audit, governance, internal control, and disclosure.

159 ANNEXES 135 obligations on banks directly, but have the nature of a description and explanation rather than of a regulation. The CBI may need to take a more prescriptive approach, and verify that banks have implemented satisfactory systems. However, the legal basis for this regulation is unclear. 49. The regulation on loan classification and provisioning distinguishes five categories: good, requiring no provisions, average : overdue more than 30, but less than 90 days, and other criteria, also requiring no provisions; below average, overdue more than 90 but less than 180 days, requiring 20 percent provisions; doubtful, requiring a provision of 50 percent, and bad, requiring a 100 percent provision. The exposures are calculated on a net basis, i.e. after deduction of security or collateral. Critical in this context is that the collateral or other form of security is conservatively valued. This represents an additional challenge to on-site inspectors. The criteria for classification include the traditional days overdue criterion, but also other, more judgment based elements 50. The CBI states that it has authority to override the decisions taken by the banks with regard to the classification of credits, but the text of the regulation does not confirm this. It would be advisable to include this discretionary power explicitly in the regulation. The zero provisioning for average loans does not seem justified, given the nature of the criteria for this classification, e.g. unclear financial statements that do not reflect the real financial condition of the borrower, slowdown in the sector of the borrower, defective management, requests to restructure the loan, insufficiently strong guarantees. A provision of 10 percent would seem appropriate. 51. For large exposures between 10 and 15 percent of the bank s capital, CBI permission is required, and the total of large exposures may not exceed 400 percent of the bank s capital. The regulation does not clearly say that exposures over 15 percent are prohibited. The 15 percent and 400 percent criteria are relatively conservative. On the other hand enforcement seems to be weak. Banks do not seem to be required to unwind large exposures that exceed the limits. In particular the state owned banks take excessive positions with impunity. 52. The Board of a bank as well as the CBI must give permission for connected lending, defined as credit to related companies, relatives or key officials in the bank, and these credits may not exceed 5 percent of capital, with the overall total of such credits limited to 15 percent of capital. Security must be given for at least 30 percent of the value of the credit, and the terms must be on a commercial basis. Banks are required to report connected lending to the CBI. Given a tradition of connected lending, this aspect will require firm enforcement policies and actions from the CBI. 53. Credit files of a bank must include customer identification information, financial information, a feasibility study of the project for which the loan is to be used. Also information needs to be provided on other funding sources for the project, cash flow of the project, credit risk mitigation documentation, and the correspondence between the bank and the borrower, including e.g. information on meetings between the bank and the customer, records of any loan enforcement actions against the customer, and extensive client information.

160 136 Supervisory approach, reporting and supervisory practices (BCP 19-21) 54. The current high risk banking environment is extremely challenging for the CBI, also taking into account that, also for relatively small banks, high vigilance, remedial action, conservatorship and mergers require a disproportionate effort on the part of the supervisory authorities. At this stage of development of the banking system, it is critical that the CBI maintain the public confidence in the banks. This requires a higher than average level of supervisory resource allocation in the medium term. 55. Prudential reporting and off-site analysis: The CBI has strong general authority to collect information and data from banks, but does not seem able to provide quick and reliable off-site information. Article 4 (1)(g) of the Law on the Central Bank of Iraq states that the CBI shall compile and publish data on the banking and financial system. Article 41 of the Banking Law specifically addresses prudential reporting: each bank shall furnish the CBI at relevant intervals (i.e. quarterly) statements showing assets and liabilities, foreign currency exposures, reserve position, liquid assets, large exposures, and credit to related persons. Also information shall be provided on deposits, credit lines, credit plans, and off balance sheet commitments. Article 41(1) of the Law on the Central Bank of Iraq states that, at the request of the CBI, banks shall provide the CBI with such information or data that reflect the risk position of banks. Article 40 of the Banking Law states that the CBI has the authority to require banks and their subsidiaries to provide all such information as the CBI may request regarding the bank s affairs. Banks are required to submit annually their balance sheets and income statements. 56. Banks also need to report, separately or consolidated, on the activities of their branches. However, Iraqi accounting standards do not require consolidation of accounts. The CBI has recently re-issued instructions to banks to verify financial information from borrowers and their guarantors, cancelling unused credit commitments or commitment to corporate clients that do not provide their financial statements, or when borrowers become delinquent on their debts. Banks are instructed to start collection proceedings in the latter cases. 57. The Banking Supervision Department has a Bureau for Studies and Research, which performs the off-site analysis function. Moreover the CBI has a special bureau for the collection of prudential returns, which also independently flags discrepancies and contacts the banks for clarification. Also a type of credit bureau function exists within the Banking Supervision Department, which tracks connected lending and guarantees across the banking system. This function is expected to be automated by the end of The CBI applies a CAMELS bank rating system, scoring banks on a range between 1 (good) and 5 (bad). The CBI publicly discloses the ratings. The CBI has also issued guidelines for the classification of banks in the CAMELS system: Approved Controls for Assessing Private Banks. The ratings actually given run across the whole range, indicating an appropriately individualized approach to the assessment of banks and their risk profiles. Currently a number of banks are rated 3-5. Keen vigilance is required for the 3-rated banks in the current environment to prevent further slippage, and the 4 and 5- rated banks are under conservatorship or are candidates for takeover by a strategic partner. However, it has been rumored that on occasion the CAMELS rating process has been open to corruption.

161 ANNEXES On-site inspections: Article 53 Banking Law authorizes the CBI to conduct on-site examinations, and the CBI has recently issued a Manual for Effective Banking Supervision, which provides more detailed guidelines for on-site inspections. It sets out the objectives of on-site inspections, which, however, are still strongly compliance oriented, referring explicitly to laws regulations and Basel principles, rather than allowing more judgment-based criteria of safety and soundness. This does not preclude that inspectors do apply such criteria, and the manual should explicitly allow this approach. The Manual sets out the minimum size of an inspection team (two CBI staff; in practice teams may comprise between three and seven staff members). Other topics covered by the Manual, although in a very schematic way, include preparing an inventory of cash and currencies, checking balances with CBI and other banks, investments, credits including reviewing the appropriateness of loan classification and provisioning -, fixed assets, expenses, deposits, amounts due to other banks and the CBI, contingent liabilities and commitments, equity and reserves. 60. Inspections take place according to an inspection plan, prepared annually, which takes account of the relative strengths and weaknesses of each bank. On average, banks are inspected once per year. A Terms of Reference for the inspection is prepared, taking into account past reports, and information from other bureaus of the Banking Supervision Department, and e.g. NPL-data. A letter is sent to the bank by the CBI to announce the inspection, and the names of the staff who will be conducting the inspection. The topics of the inspection are not mentioned. 61. At the end of the inspection, which can take up to 30 days to complete, the team leader discusses the draft inspection report with the bank s CEO and signs the draft report. The bank has 30 days to respond to the report, after which the CBI finalizes the report. The head of the Banking Supervision Department subsequently sends a letter to the bank, instructing it to correct any adverse findings of the inspection team. The mission could not ascertain how the CBI follows up on the banks actual implementation of the inspectors findings. The CBI also has at its disposal special Urgent Action teams, which can be deployed for periods of one to two weeks to respond rapidly to critical issues in banks. Accounting, audit, internal audit/controls, disclosure (BCP 17, 22) 62. Article 42(1)(a) of the Banking Law states that banks shall maintain proper books and records. Article 42(1)(b) requires banks to apply International Financial Reporting Standards (IFRS) including full accrual accounting, to which the CBI can add special requirements. IFRS shall also be applied to the preparation of the banks annual financial statements. 63. However, the mission s counterparts stated that (IFRS) are not fully implemented in Iraq, and that significant differences exist with Iraqi accounting standards, even though the latter are said to be based on IFRS. Differences are for instance the lack of a requirement in Iraqi accounting standards to consolidate accounts, although Article 43(1) Banking Law requires banks to consolidate financial statements. There are also no guidelines for the valuation of financial instruments, e.g. mark-tomarket requirements. No clear guidance exists on revaluation of fixed assets. 64. The CBI has requested banks to start preparing parallel accounts, according to Iraqi accounting standards as well as IFRS. The state owned banks have significant

162 138 problems in using IFRS, and different accounting systems are used for the state owned banks than for the private banks. Under the former regime, there was no difference between bank accounting and commercial enterprise accounting. It is also not clear whether a CBIprescribed chart of accounts exists for banks compiling their financial records. Without a proper chart of accounts with explanations, the risk is very high that banks interpret accounting standards in different ways, and that information becomes inconsistent across banks and difficult to interpret. External auditors of banks may be required to report significant issues to the CBI, including issues of safety and soundness of the bank. 65. The accounting profession is properly regulated, but the availability of accountants and auditors sufficiently qualified to work in banks is limited. There are several levels of accountancy training in Iraq: a two year course, a more intensive four year course, a four-year university accounting curriculum, and a PhD level course at the Higher Institute for Accounting and Legal Studies, which produces accountants at the level of a public chartered accountant. Also an Arab Institute for Accounting exists, which offers a three year curriculum and requires a thesis. The CBI needs to agree to the appointment of an external auditor by a bank, which must be rotated every 5 years at minimum. The CBI can waive the rotation requirement. A Commission of Supervision of the Accounting Profession oversees the quality of the accounting profession. 66. The tasks of the bank s external auditor are listed extensively in Article 46 BL, and include assisting the bank in maintaining proper accounting systems and procedures, as well as proper financial control and risk management systems and procedures, the preparation of an audit report for the Board and an opinion on the annual statements. The auditor is also required to comment on the adequacy and performance of management, make recommendations to management (comparable to the management letter), attest to the accuracy of the periodic prudential returns sent to the CBI report on the loan classification and provisioning system, as well as on any deficiencies in provisioning, and whether adequate AML/CFT measures are implemented in the bank. 67. Neither the Law on the Central Bank of Iraq nor the Banking Law provides a general provision requiring internal audit and internal controls in banks, although Article 24 Banking Law requires banks to form an Audit Committee. However, the January 2011 issue of regulations includes regulations on internal audit and internal control. According to the regulation, each bank must have an internal audit unit, charged with the evaluation of the financial statements, and the supervision of compliance with the bank s internal controls and procedures, e.g. those on connected lending. The internal audit unit must be allowed to communicate directly with any staff member of the bank and with the Board. Staff of the unit must have had appropriate training, and follow additional training as needed. 68. A specific regulation on governance stipulates that banks Boards must have an audit committee, a risk management committee, and a compensation and remuneration committee. The Internal Control Regulation mentioned above is more descriptive than prescriptive, and does not in so many words oblige the bank to have an internal control system. The regulation states as the goals of internal controls matching of internal processes and procedures to the rules and regulations, internal as well as external; assuring the accuracy of accounting and financial information, and assuring the quality of communication and information systems. The regulation also describes in broad terms the role of a compliance officer in the bank.

163 ANNEXES Disclosure of banks financial statements to the shareholders, CBI and the general public is regulated in general terms in Articles 43 and 44 BL, which require publication of audited financial statements in two general newspapers within four months after the closing of the book-year. The CBI is to receive the financial statements no later than four months after the closing of the book-year (January 1-December 31). The annual report should be received by the CBI within 30 days after it becomes available, and no later than 6 months after the closing of the book-year. Banks reports may only be published after approval of the CBI. 70. A specific regulation on disclosure to the shareholders, stakeholders and customers of the bank has also been issued in January The information specified in the regulation must be included in the annual report and any published reports as required by the Iraqi stock exchange authorities. Required disclosures include the shares of the major shareholders, as well as their names, corporate governance policies, remuneration policies, large credits, fair market value of derivatives, provisions, the liquidity position, the income statement showing specific items as enumerated in the regulation, credit risk, potential losses and risk management policies. Also information needs to be provided on banks related entities, such as subsidiaries, holdings etc. Abuse of financial services (BCP 18) 71. Article 4(2) of the Law on the Central Bank of Iraq stipulates that the CBI is authorized to take any action it considers necessary to counter money laundering and the financing of terrorism. Under Article 47(1) (a), the CBI may impose on an external auditor a duty to certify whether or not adequate measures have been taken by the bank to prevent money laundering or the financing of terrorism, and that these have been implemented in accordance with regulations and orders or guidelines issued by the CBI. Money laundering-sensitive operations such as money transfer offices and exchange bureaus are under the supervision of the CBI. According to Article 35 of the BL, banks have an obligation to report to an appropriate official or judicial authority any banking transaction or the receipt or payment of any amount which may relate to a criminal or illegal act. The CBI is to be informed on a monthly basis of such reports. Submission of such reports by banks is not considered by law to be a breach of contractual confidentiality. 72. The general anti-money laundering and anti-financing of terrorism framework is laid down in the Anti-Money Laundering Act of Currently, a new law is being drafted. The role of Financial Intelligence unit is performed by the Money Laundering Reporting Office (MLRO), administratively located under the CBI, but which enjoys operational independence, as well as separate funding and staffing. The MLRO notifies the prosecuting and investigative authorities of any transactions it considers connected to illegal activities, money laundering, or the financing of crime. Banks may approach the MLRO for guidance when confronted with a suspected illegal transaction. The CBI and MLRO may exchange information with domestic and foreign agencies involved in Iraq in AML/CFT. Banks are required to apply know-your-customer practices and retain records of customers identities, as well as maintain transaction records for at least seven years. Banks must match customer information against a list of suspicious persons maintained by the CBI. 73. The CBI has been given a central role in the implementation of the AML/CFT framework. It supervises compliance by financial institutions of the AML/CFT rules.

164 140 It shall inform the institutions of their obligations under the law, and issue regulations. The mission did not see these regulations. According to the law, regulations shall require that all financial institutions establish internal policies, procedures and controls, as well as adequate training programs for staff. A compliance officer shall be designated, and an independent audit function created to test the institution s AML/CFT program. The AML/CFT systems in banks are the object of inspections by the MLRO, sometimes jointly with the Banking Supervision Department. The FATF-MENA list of uncooperative jurisdictions is applied, and transactions with those jurisdictions are prohibited. However, no list of types of suspicious transactions is in place to guide the banks. Reporting forms for suspicious transactions and large cash transactions are in place. 74. However, notwithstanding the existence of important elements of a legal, regulatory and institutional AML/CFT framework, external observers note that the implementation of the AML/CFT framework in Iraq is extremely weak. No FATF-MENA AML/CFT assessment has been conducted to date, but an assessment has been tentatively scheduled for Much work will still need to be done, in particular in implementation, to achieve a reasonable level of compliance by Iraq. The new AML/CFT draft law envisages the creation of an AML Council, with membership of the governor of the CBI or his deputy, the director of the Anti-Money Laundering and Terrorism Finance Bureau in the CBI, a judge, representatives of the Ministries of the Interior, Finance and Trade, representatives of the Commission for Integrity, the Securities Commission, the Commission on Iraqi Antiquities, and the Non-governmental Organizations Department. The draft law has a much more extensive section on penalties than the existing law. Corrective and remedial powers of the CBI (BCP 23) 75. Section 10 of the Banking Law provides the CBI with a range of options for enforcement action and penalties against breaches of prudential standards and the unsafe and /or unsound conduct of banking business. Under Article 56 BL, the CBI may send written warnings to a bank, give orders, request the bank to submit a program of corrective action, cease and desist orders, impose restrictions on certain credits, require the placing of deposits with the CBI, and/or request that the CEO or Board Chairman personally take responsibility for the implementation of remedial action. The CBI may also request the suspension of any manager, or remove the chairman or Board members, dissolve the Board and appoint a conservator, impose a penalty, or revoke the bank s license. 76. When using its enforcement tools, the CBI first informs the bank of its findings, as well as of the measures it intends to impose, and requests a written response from the bank within two weeks. The bank may request a hearing, which the CBI shall grant within two weeks. After the response of the bank or the hearing, the CBI decides on the course of action. In urgent cases, this procedure does not need to be followed. 77. The CBI has the discretion to appoint or not appoint a conservator when capital has declined to below 75 percent of the minimum level, or the bank fails to carry out a CBI order, or an administrator of the bank has engaged, or is reasonably suspected to engage, in criminal activities. The CBI is obliged to appoint a conservator when it determines that capital of the bank has decreased below 50 percent of the required minimum, has become illiquid or a petition for bankruptcy

165 ANNEXES 141 has been filed. When capital falls below 25 percent of the minimum, liquidation becomes mandatory. This implies an appropriate form of prompt corrective action, where the CBI has no option but to appoint a conservator or initiate liquidation. The appointment of the conservator terminates when his term of office expires and is not/may not be extended, the CBI or Financial Services Tribunal decides to terminate the conservator s work, or when a receiver is appointed in bankruptcy. 78. The CBI may impose a moratorium with regard to a bank for which a conservator has been appointed, including a ban on further deposits in the bank. 79. The conservator shall attempt to rehabilitate the bank if the Minister of Finance has decided that this worthwhile, given concerns for the stability of the financial system. The recommendation of the CBI to rehabilitate a bank shall be accompanied by a time-bound plan for the implementation of corrective measures. Currently, two banks are under conservatorship, and one bank is negotiating a takeover by a strategic partner, under CBI oversight. 80. The Banking Law also envisages forced liquidation of a bank when the CBI decides that capital has declined to below 25 percent of the minimum, deposits or other liabilities are not being repaid, or the CBI determines that the bank is insolvent (assets, liabilities). A receiver is then appointed by a court of law to conduct the liquidation proceedings, under court supervision. 81. The Law on the Central Bank of Iraq provides for the establishment and functioning of a Financial Services Tribunal, which is responsible for conducting the bankruptcy of banks, according to the rules set out in the Law on the Central Bank of Iraq and the Banking Law. The Tribunal also functions as a court of appeals against CBI decisions, e.g. on refusal of a license, imposition of enforcement measures or penalties, the term of office of a conservator, etc. Consolidated supervision (BCP 24) 82. Although the law and regulations require consolidation of accounts and consolidated reporting in several places, the counterparts of the mission stated that there are no rules under the Iraqi accounting system that require consolidation of accounts. This remains one of the major differences between Iraqi accounting standards and IFRS. For effective banking supervision it is essential that this lacuna be filled as soon as possible, either through an ad-hoc addition to Iraqi accounting standards, with an explanation how consolidation of accounts is conducted or through expedient introduction of new Iraqi bank accounting standards that are fully consistent with IFRS. Moreover, a chart of accounts for banks, with detailed explanations, setting out how the accounts of banks need to be structured in order to produce IFRS consistent statements, is urgently needed. Home-host relations (BCP 25) 83. Although the CBI contacts home supervisors with regard to licensing of foreign institutions, through ad-hoc contacts via , letters and/ or information packages, there is no system of formal MoUs or other institutionalized contacts. Currently, six foreign banks have establishments in

166 142 Iraq, either through joint ventures, branches or subsidiaries. There are many pending applications.. There are no mutual on-site inspections, or regular exchanges of information. The CBI does not participate in supervisory colleges. In the case of Dar es Salaam Bank, a joint venture with HSBC, officials from HSBC visited the CBI in Baghdad. In the context of the licensing process, home supervisors of foreign banks, and the CBI, ask for ratings, inspection reports and performance indicators. In case of concerns with regard to foreign establishments, the CBI will discuss the matter with their colleagues in the home central bank or supervisory agency.

167 ANNEXES 143 ANNEX 8: IOSCO OBJECTIVES AND PRINCIPLES OF SECURITIES REGULATION: INFORMAL ASSESSMENT A formal assessment using the IOSCO Methodology was not undertaken for two reasons. The first was the expectation, based on a preliminary review of available laws and regulations that a very high number of the Principles would be assessed as not implemented. The second was the lack of comprehensive documentation and data and the inability to assess the operations of the regulator on site. Merely rating a jurisdiction as performing poorly does not provide a catalyst for setting in train a process of improvement. Rather it can act as a disincentive to the authorities given the apparently overwhelming scope of the problem. Furthermore, for a newly emerging market the challenge should not be to aim for a high benchmarking score taken in isolation but to seek, over a realistic time period, to emulate the performance of emerging markets at a somewhat more advanced state of development, especially those in the same region. A 2007 IMF Working Paper 48 reported a high correlation between the level of income in a jurisdiction and the level of implementation of the Principles. Low-income jurisdictions had levels of implementation below 50 percent, lower-middle income jurisdictions had levels of implementation around 50 percent, upper-middle income jurisdictions had levels of implementation around 60 percent, while high-income countries had levels of implementation above 70 percent. Assessment of implementation of the IOSCO Principles operates by seeking answers to three questions. First, does the jurisdiction have the necessary laws, including the provision of sufficient powers to the regulator to enforce those laws? Second, is there a comprehensive body of regulations, rules and enforceable guidance capable of providing the regulator with practical tools to enforce the laws and providing entities subject to the laws with a structure by which they can run their businesses in a compliant manner? Third, is the regulator properly accountable and does it enforce the law, regulations, rules and enforceable guidance in a way which is fair, transparent, effective and credible? For the purposes of the analysis in this section, the weaknesses in the preconditions for effective regulation of securities markets have been disregarded in some cases and dealt with under comments on particular sections of the Principles where directly relevant. In order to reach conclusions about the comprehensiveness and probable effectiveness of the draft permanent Securities Law it is necessary to examine the rules and regulations which support it. The draft Law is generally drafted at as high level of generality and contains within it over 80 provisions which require rules to be made by the ISC for their implementation. The reviewer team was told that when the draft law was prepared in 2008 a parallel set of regulations were also drafted. These have not been made public nor, despite a request, have they been provided to the reviewer. It has not therefore been possible to reach conclusions, or to make definitive recommendations for improvement as to the totality of the proposed legal and regulatory framework in many areas. 48. Strengths and Weaknesses in Securities Market Regulation: A Global Analysis, Ana Carvajal and Jennifer Elliott

168 144 Legal and Regulatory Framework There are two legislative Acts which currently govern the operation and regulation of the securities market in Iraq and companies which seek to issue or have issued shares to the public. These are the Coalition Provisional Authority (CPA) Order No. 74, Interim Law on Securities Markets issued in 2004 and Company Law No. 21 issued in 1997 and amended by CPA Order No 64 in The current Law No 74 was a stop gap measure which has served its purpose of providing a basic legal framework for the creation and operation of a stock exchange (ISX) in the private sector, with recognizable self regulatory functions, and the establishment of an independent, interim, statutory securities commission (ISC). Under Law No 74 the interim ISC has a range of powers over the ISX, (including approval of its rules), the securities depository, licensed brokers and dealers, investment advisors, and companies which issue shares to the public and their major shareholders. The objectives of the second ( No 21 ) are stated as to provide for the organization of companies, the protection of creditors from fraud and shareholders from abuse by majority owners, company officials etc, and to promote the provision of full information to owners in connection with decisions affecting their investments in the company. Amended Law No 21 has provided a basic framework within which private companies have been able to raise equity capital from the public and shareholders, other than insiders or those in a position of control, have been given some of the rights and benefits of ownership. However, both laws have many limitations and the reviewer believes that it would be more useful for the Iraqi authorities for the analysis herein to be forward looking and focus on the draft permanent Securities Law which it is hoped will be passed by Parliament and brought into force in the near future. Law No 74 on Securities Markets will in due course be replaced by a permanent Securities Law and the Interim ISC will become a permanent Securities Commission. A draft permanent law was prepared in 2008 by a team including persons from the US SEC with the objective of creating a law which will meet the requirements, at the legislative level, of the IOSCO Principles. It is publicly available in Arabic and English. Following an extended period of consultation it is currently under consideration within government. It is drafted at a relatively high level of generality and grants extensive rule making and enforcement powers to the permanent ISC. Its effectiveness will therefore depend to a very large degree on decisions to be made by the permanent ISC as to the rules and regulations it will introduce and the effectiveness and credibility with which it will carry out its supervisory tasks. Recommendation: discussions on the Permanent Securities Law should be concluded as a matter of high priority during which the Authorities should consider making the amendments to the draft Permanent Securities Law as recommended in this Review; the draft should forthwith be presented to Parliament within a procedural framework that provides for adequate discussion and a speedy passage. As a consequence, and given that the current interim Law is brief and clearly fails to meet most of the IOSCO Principles, the informal assessment versus the Principles has been carried out on the basis of the draft permanent Securities Law and highlights significant gaps in the powers and processes the permanent ISC will need in each of the various sections into which the Principles are divided. These include the powers, independence and resources of the regulator,

169 ANNEXES 145 international cooperation, enforcement, supervision of issuers and the licensing and regulation of intermediaries and stock exchanges. Company Law No 21 governs the type of companies permitted in Iraq as well as their formation, governance, management and dissolution. Four main types of company are permitted although for capital market development purposes only one is significant, the joint stock company. This can have five or more shareholders which permits public participation. The liability of each shareholder is limited to the nominal value of his share. It is intended that Chapter 3 Section 3 Public Subscriptions in the Capital will be replaced by Chapter 3 of the permanent Securities Law, Public Offer of Securities. Mixed companies, where the State holds at least 25 percent of the voting shares are subject to this law and not the State Companies Law No 22. Within Law No 21 there are extensive provisions about the General Assembly (defined as all the members of the company). It requires there to be an annual meeting of the General Assembly. (AGM), preceded by sufficient and timely notification of the date, time and place etc of the AGM. It sets out the powers of the General Assembly which include the power to appoint shareholder directors to the Board, to appoint the accounts controller (external auditor), to discuss and approve the final accounts etc. There are gaps and ambiguities in Law No 21 which need to be addressed given that it is intended that this Law will continue to operate alongside the Permanent Securities Law and elements of it will be enforced by the ISC. Some gaps, such as the absence of rules governing takeovers, are to be dealt with in the Permanent Law (although the current draft has weaknesses in this area (see Section IV: Principles relating to Issuers). Others have not been addressed. These include provisions to ensure the payment of dividends and other entitlements; a procedure by which shareholders (holding e.g. 5 percent of the votes) may submit, in advance, resolutions for vote at the AGM and a provision whereby shareholders (owning e.g. 10 percent of the votes) can demand an Extraordinary General Meeting and hold same if the board refuses. The rules governing the need for a quorum at the AGM lack clarity. Company Law No 21 also gives an important role to the Registrar of Companies and it is unclear how his role will interface with that of the ISC when the Permanent Securities Law is in place. The Registration of Companies Department of the Ministry of Trade administers several provisions of Law No 21 and other elements of the Commercial law framework. In particular its responsibilities include registering all business entities (ISX is specifically exempted from this requirement, or oversight by the Registrar, under Law No 74) approving documents of incorporation, monitoring and keeping records of company activities, inspecting company accounts and records and directing company dissolutions where appropriate. Specific obligations include the presence of a representative of the Registrar at an AGM to confirm that a quorum is present and acting as an appeal mechanism should 5 percent of shareholders object to decisions taken at the AGM. The Registrar also has the power to appoint inspectors to investigate whether a company has violated the provisions of Law No 21, its own constitution or decisions of the General Assembly. ISC has similar powers over listed companies in the current and prospective securities laws accompanied by stronger sanctioning powers. Recommendation: The authorities should consider subjecting Company Law No 21 to detailed analysis by an international expert in the field with a view to updating it to reflect current standards of corporate governance and shareholder rights and clarifying the roles of ISC and the Registrar.

170 146 As to the current and prospective operational effectiveness of the ISC it has not been possible to make more than the most tentative of assessments as the ISC did not engage with the Review. Neither has it been possible to discuss with the ISC how it intends to meet the significantly enhanced role envisaged for it under the draft permanent Law. Also, for operational reasons, it was not possible to seek out the views and experiences of a range of stakeholders such as current and potential issuers of shares to the public, brokers and dealers, institutional fund managers, lawyers and accountants. The analysis which follows should be read in light of these reservations. Principles relating to the regulator These Principles are intended to provide the foundation of the regulatory system. They require clarity of the law under which the regulator operates to minimize the risks of disputes over vires. They require that the law secures the independence of the regulator from political and commercial pressures while providing effective accountability for its actions. They recognize the need for the law to provide the regulator with adequate powers and for adequate and stable funding sufficient to enable the regulator to meet its responsibilities. Finally they require the regulator itself to operate to high standards of integrity, fairness, competence, transparency and due process; they recognize that the law has an important role to play here too. There is much in the draft law which make a positive contribution to achieving these objectives. For example: Article 6.B states that the the Commission shall be an independent government commission with the exclusive responsibility and authority to administer this law. Article 6.F states that No Commissioner, employee or agent of the Commission, shall be personally liable for any act or omission taken in the discharge of his or her official functions within the scope of his or her authority under this law and the rules of the Commission, absent a finding of malice and intentional abuse of office. Article 9.C states that The Prime Minister may only remove a Commissioner (prior to the expiration of his or her term) for: criminal misconduct, conviction of a violation of this or another law, (other than minor infractions), substantial violations of ethics provisions; repeated and inexcusable absence from duty; or if physically unable to perform the duties of a Commissioner. Article 12 sets out the ethical responsibilities of Commissioners and employees when carrying out their functions. Article 13 gives the ISC the power to set and charge fees for a broad range of regulatory activities and to retain them as an offset to funds otherwise provided by the Government as part of the State budgetary process. Although IOSCO does not have a view on whether there is a preferred funding model, this mix of state and industry funding can be viewed as minimizing the risk of the ISC being inappropriately influenced from either political or commercial quarters. Article 15 requires the ISC to publish new rules for consultation and to provide feedback when bringing them into force.

171 ANNEXES 147 Articles provide that people about to be sanctioned by ISC may offer to reach a settlement, or have a Hearing before an ISC Tribunal and ultimately may appeal to the courts a decision of the ISC which adversely affects them. However, the operational independence from Government is not as well defined as it should be. There should be an explicit provision in the law which prevents a Minister from interfering in an investigation in any way, such as by, for example, demanding that papers relating to the case be sent to his office, or that he be notified in advance of prospective searches of premises or questioning of individuals, whether nor not under oath, or that his permission be obtained before any such actions are undertaken. Recommendation: amend the draft Permanent Securities Law to better secure the independence of the ISC. Principles relating to Self Regulation The provision in the Law which permits the Iraq Association of Securities Dealers (or any other securities association) to apply for SRO status will, if passed, in due course require careful handling by the ISC. Delegation of certain of ISC s powers over licensed securities firms etc should not take place until the ISC is certain that the IASD has either given up its trade association representational functions or has satisfied the ISC that these are adequately ring-fenced from its SRO functions. For a discussion on the policy framework to use in employing self-regulation in capital markets see World Bank working paper Self-regulation in Securities Markets by John Carson and Clemente del Valle; Principles relating to Enforcement The draft law provides the ISC with comprehensive inspection, investigation and surveillance and enforcement powers. On a US dollar basis the maximum fines, ID 25 million for an individual and ID 50 million for a company are too low. Principles relating to Cooperation Although Article 16 of the draft permanent Securities Law is broadly drafted as regards empowering the ISC to collect information and provide assistance to a foreign regulator it has several weaknesses which should be corrected in the final version. The provisions should include the power to cooperate with domestic regulators such as the Central Bank and judicial authorities. The Law should clearly state that the power of the ISC to share information and to cooperate with a domestic or foreign regulatory authority does not require the consent of any other Government department or other authority The drafting of the no Iraqi interest provision requires redrafting (at least in the English translation) to be properly effective. The wording Such assistance may be provided to the foreign authority with respect to a violation of its law even though a violation of law may not have occurred in Iraq should be replaced with Such assistance may be provided to the foreign authority with respect to a violation of its law regardless of whether the ISC has an independent interest in the matter.

172 148 There should be an explicit power in the Law enabling the ISC to enter into Memoranda of Understanding with domestic and foreign regulatory authorities. There should be an explicit obligation in the Law that the ISC treats information received with appropriate level of confidentiality. Before finalizing Article 16 the authorities should establish if there are bank secrecy, confidentiality or blocking statutes which would prevent the ISC from adequately responding to a request for information or cooperation from a foreign regulatory authority. If such obstructions exist the authorities should take steps to create appropriate gateways though which information can be acquired by ISC and passed on. Recommendation: the powers of the ISC to assist and share information with domestic and foreign regulators under Article 16 should be clarified Principles relating to Issuers Four issues in particular arise from a comparison of the Iraq legislation and the IOSCO Principles; these are prospectus issuance, accounting and auditing standards, takeovers and corporate governance/shareholder rights. Once the draft permanent Securities Law is in place it appears that regulation of companies which sell securities to the public and list on ISX will be carried out via a combination of the permanent Securities Law and Company Law No 21. The main responsibility will fall to ISC but ISX will also have a responsibility to enforce its own listing rules the extent that they differ from the Commission s. Under the legal and regulatory framework the Registration of Companies Department of the Ministry of Trade administers several provisions of Law No 21 and other elements of the commercial law framework. In some areas these functions and powers overlap with those intended to be exercised by ISC. Their respective roles should be clarified. Article 20 of the draft permanent Securities Law sets out the basic contents a prospectus must include and gives ISC powers to write rules requiring specific information. In order to provide prospective investors, their advisors and other financial market commentators with sufficient information to fully evaluate the offering the ISC should, by use of its rulemaking power, add significantly to the amount of information a prospectus will be required to contain. Annex 9 sets out a possible model. It is taken from the requirements of the European Union Prospectus Directive 49. Clear and comprehensive prospectus contents requirements, rigorously enforced by ISC, will be an essential element of investor protection as the privatization program develops, particularly as these issuers will have no public track record as commercially driven, for profit entities and their historic accounting records will have been drawn up to meet the needs of one owner, the State, rather than those of large groups of private investors. Recommendation: the ISC should set out in greater detail the content of prospectuses for issues of securities to the public and for listing on ISX based on a globally recognized standard such as is found in the EU Prospectus Directive 49. Directive 2003/71/EC on the prospectus to be published when securities are offered to the public or admitted to trading.

173 ANNEXES 149 The value of prospectuses, and continuous disclosure by listed and other publicly owned issuers such as via annual and other periodic reports is, to a very large degree, dependent on the quality of the accounting records and the abilities and independence of those responsible for their composition, namely the external auditors. Accounting and auditing standards appear to be weak. There is a Government body, the Audit Advisory Board, which organizes and licenses the auditing and accounting professions in the private sector. There is also a professional association, the Iraq Union of Accountants and Auditors. This is affiliated to IFAC and should therefore have exposure to IFAC s International Standards on Auditing (ISA). It has not been possible to meet with either of these bodies to discuss the current situation. There is some evidence (from the internet) that in 2007 the Union worked with several universities in Iraq to provide students with training in modern standards of accounting and auditing but it is not known whether that process is ongoing. The Board of Supreme Audit audits government departments and state owned and mixed companies. Recommendation: The authorities should seek to work with the profession to improve accounting and auditing standards such that they can be recognized internationally as acceptable. Article 35 of the draft permanent Law sets out a regime for regulating tender offers and takeovers. It seeks to provide for equal treatment for all shareholders and requires that a person who acquires more than 50 percent of the publicly held shares of a company shall offer to purchase all of the outstanding shares of the company (a mandatory bid rule).. There are a number of changes which should be made to Article 35 as drafted. It should begin with a statement of general principles governing the behavior of persons participating in a takeover bid situation. These would serve two purposes. First they would provide the basis in the Law for detailed rules to be drawn up by the ISC. Second, and subject to the principles of Iraqi commercial law, they should provide a broad basis for the use of ISC s sanctioning powers if a particular course of action by a participant was undesirable but fell within the detailed rules. General principles might include the following: All target shareholders of the same class must be afforded equal treatment; If a person acquires control of a company, the other holders of securities must be protected. Target shareholders must have sufficient time and information to enable them to reach a properly informed decision on the bid When advising its shareholders, the target board must give its views on the effect of the bid on employment, conditions of employment and location of place of business of the target. The target board must act in the interests of the company as a whole and must not deny shareholders the opportunity to decide on the merits of a bid. A bidder must announce a bid only after taking all reasonable measures to secure the implementation in full of the consideration offered. A target company must not be hindered in the conduct of its business by a bid for its shares for longer than is reasonable.

174 150 Other required changes to Article 35 are set out below The reference to Any person in A35.B does not take account of the possibility of two or more persons working in concert to take control of the company. It should be redrafted to say A person or a group of persons acting together who acquire more than 10 percent of the voting power of the publicly held securities of an issuer This concept is used elsewhere in the draft Law. See Article 3.U which defines a major shareholder as a person or a group of persons acting together who have control or beneficial ownership of 10 percent or more of a class of voting securities of an issuer or licensee. The 50 percent trigger for a mandatory bid is high by international standards. 30 percent is a more typical number since a shareholder or group of shareholders working together with 30 percent of the voting shares of a company are likely to be in position to exert significant control over the affairs of the company. The unfettered power of the ISC to exempt a person or persons from making a mandatory bid should be constrained by the insertion of specific criteria, such as when it considers that the interests of shareholders in the companies concerned would be better served by the bid not proceeding. A35 needs to provide clarity as to what happens if a person or persons refuse to make a mandatory bid as required by the law and in the absence of an exemption by ISC. The sanctions and remedies set out in A74 and not appropriate. In some cases (eg delisting of the company) they will damage the interests of the shareholders without a controlling interest. The maximum fines set out in A75 (ID 25 million for an individual and ID 50 million for a company) are unlikely to be a deterrent. The power of the ISC to make rules to ensure that the remaining security holders receive a fair price is necessary but is too narrowly defined given the limited conditions and other requirements set out in Article 35. The rule making powers of the ISC need to be broader. Article 35 should at a minimum ensure that ISC can write and enforce rules which achieve the following in order to secure adequate protection for all shareholders and to preserve the integrity of the market: The price offered in the mandatory bid must at least equal the maximum price the bidder has paid to any person to acquire voting shares in the nine months prior to making the mandatory bid. Shareholders must be given a reasonable time in which to consider the proposal and must be supplied with adequate information to enable them to make a properly informed decision on the merits of the proposal. Shareholders must be given reasonable and equitable opportunities to participate in the bid The board of the company the shares of which are the object of the mandatory bid (the target ) must act in the interests of the company as a whole and must not deny shareholders the opportunity to decide on the merits of a bid or take action which may frustrate a bid without prior shareholder approval. The bidder must not place itself in a position where a mandatory bid is required without (in the case of a bid to be funded all or part in cash) having first secured adequate financing for the bid and reasonably believing that the cash will be available during the life of the bid.

175 ANNEXES 151 Successful bidders who acquire 95 percent of the shares shall be entitled to acquire remaining shares compulsorily at the mandatory bid price (the squeeze out rule). It shall be an offence to create false markets in the shares of the bidder, the target, or any other company involved in the bid, such that the price of the securities concerned artificially rises or falls and the normal functioning of the markets is distorted. A mandatory bid must be time limited depending on the circumstances. The decision taking principle as to what is proportionate is that a target company must not be hindered in the conduct of its business by a bid for its shares for longer than is reasonable. Recommendation: Article 35 should be amended to reinforce the provisions governing takeover bid and extend the scope of the powers of the ISC to make and enforce rules in this area Corporate governance and shareholder rights are dealt with extensively in Company Law No 21 although there are gaps and ambiguities in the provisions which need to be addressed. These elements, found in Chapters IV and V of the current law, are intended to have continuing effect after the bringing into force of the permanent Securities Law. They cover the role of the General Assembly and set requirements for timeliness and notification of the Annual General Meeting (AGM). The conduct of the AGM is set out as are its powers. The formation, role, and responsibilities of the board of directors are also elaborated as is the requirement that the accounts of a public company (ie neither State-owned or mixed) must be subject to an external audit, by an auditor appointed by the general assembly. Mixed companies must be audited by the Financial Control Bureau, part of the Board of Supreme Audit. Readily identifiable gaps include the following. There do not appear to be provisions to ensure the payment of dividends and other entitlements; a procedure by which shareholders (holding eg 5 percent of the votes) may submit, in advance, resolutions for vote at the AGM and a provision whereby shareholders (owning eg 10 percent of the votes) can demand an Extraordinary General Meeting and hold same if the board refuses. Ambiguities include the rules governing the need for a quorum at the AGM. On one level they appear to follow international good practice in seeking, on the one hand, to prevent manipulation of the voting process by the board or controlling shareholders and on the other, to prevent a minority (or even a majority) of shareholders preventing the company from taking important decisions. It may be however that their effect is the opposite given that there are no provisions governing the rights of shareholders who are not physically present to vote on matters on the agenda. Although there is a provision permitting shareholders to appoint a proxy it appears that the proxy holder also has to be physically present at the AGM to cast the votes as instructed. Principles relating to Collective Investment Schemes and Hedge Funds Collective investment schemes (CIS) and specialized forms of such schemes such as hedge funds do not currently exist in Iraq and there is no law or regulation which could govern their operation. As discussed In the Review under Capital market development CIS can play a very important role in capital markets. Before

176 152 permitting the development of a CIS industry it will be important that the appropriate law and regulation is developed and brought into force Recommendation: Establish the appropriate legal and regulatory framework to enable the foundation and operation of a CIS industry Principles relating to market intermediaries Although the Law governing the licensing and ongoing supervision of broker dealers and other licensees is comprehensive it appears that its implementation requires greater specificity than is currently in the regulations and rules to which licensees are subject. Responsibility under the law, currently and under the draft permanent Securities Law, is shared by the ISC and ISX as regards members of the exchange. In practice, according to ISX, ongoing supervision of its members is carried out largely by the exchange. This is consistent with its self-regulatory role under the law. Its resources to supervise its members and conduct market surveillance are however very limited, amounting to just five persons. Although ISX imposes a risk based capital regime on its members this is set out only in basic terms and does not have precise quantitative criteria. Trading by ISX members on the exchange currently appears to be simple, low risk, agency brokerage business, trading rules regarding cash and securities are restrictive, and the central depository (IDC) tracks trades in the process of settlement and appears well integrated with ISX s own member monitoring systems. This position can change rapidly however. For example, members may begin to acquire substantial positions for their own proprietary trading purposes or to facilitate the execution of client orders. When privatization of state owned companies begins, competitive pressures on brokers to move to a higher risk business model will intensify. Currently the capital rules of ISX or ISC are not adequate although they appear based on the Net Capital Rule used by the US SEC and other regulators such as in Canada and Japan.. Internationally, many securities regulators, including in emerging markets, have begun to adopt the capital regime developed by the Basel Committee, originally for the banking business of banks, but increasing adapted to apply to banks carrying on securities market business on their own balance sheets and securities firms, whether part of banking groups or free-standing. Recommendation: ISC and ISX should cooperate in developing a risk based capital regime for licensees based on the appropriate internationally applied quantitative and qualitative criteria More broadly, although the permanent Securities Law sets out initial and ongoing regulatory requirements there are significant gaps and a lack of specificity which should be covered by the rules of ISX and ISC. These are particularly apparent in areas such as compliance, risk management and controls. Furthermore, although the draft permanent Securities Law (Article 55) gives the ISC the right to intervene in the bankruptcy or insolvency of a licensee, and seeks to preserve the claims of clients to their assets held by such a licensee over competing claims by its creditors, it is not clear whether the courts would uphold these provisions given the uncertainty which surrounds the structure and operation of bankruptcy law in Iraq. Recommendation: ISC, ISX and IDC should assess their rules and procedures regarding the bankruptcy or insolvency of a licensee by reference to Article 55

177 ANNEXES 153 of the draft permanent Securities Law and IOSCO Principle 32 and make any necessary amendments (or seek legal clarity) to secure protection of investors when doing business with licensees which is consistent with international standards. Principles relating to secondary markets, clearing and settlement The current and draft permanent Laws contain extensive provisions regarding the licensing and ongoing supervision by ISC of securities exchanges. Currently there is only one stock exchange, ISX. In practice the effectiveness of the oversight function will depend on the relationship between ISC and ISX. That was not capable of being assessed as part of the current Review. Similar conditionality applies to the relationship of ISC to the IDC which was recently spun off from ISX but which will continue to share the same board of directors until the permanent Securities Law is brought into force. It is functionally integrated with ISX and is from the same supplier NASDAQ OMX. Although the current Securities Law permits the creation of a settlement guarantee fund, this has not been done though one is under consideration. It has not been possible to review the risk profile of IDC to establish whether such a fund is necessary, or whether other risk mitigation mechanisms (such as margin requirements) are necessary at the current time. Recommendation: Three additional issues should be kept under review by ISC and ISX Whether there is scope to enhance the transparency of trading now that the new electronic platform is fully operational Whether the provisions prohibiting insider trading and other forms of market abuse as set out in Chapter 10 of the draft permanent Law, and the maximum level of fines may, in the light of experience, need updating as to scope, specificity and severity. Whether the capacity of the trading, clearing and settlement systems and the financial; resources of the IDC may, in due course, need enhancing if daily trading volumes build.

178 154

179 ANNEXES 155 ANNEX 9: AN EXAMPLE OF MINIMUM DISCLOSURE REQUIREMENTS FOR A PROSPECTUS (TAKEN FROM EU PROSPECTUS DIRECTIVE: DIRECTIVE 2003/71/EC ON THE PROSPECTUS TO BE PUBLISHED WHEN SECURITIES ARE OFFERED TO THE PUBLIC OR ADMITTED TO TRADING) Adoption of these detailed requirements does not require a change in the draft permanent Securities Law. Article 20 sets out minimum requirements and empowers the ISC, by rule, to mandate additional information which a Prospectus must contain. 1. Persons Responsible 1.1. All persons responsible for the information given in the Registration Document and, as the case may be, for certain parts of it, with, in the latter case, an indication of such parts. In the case of natural persons including members of the issuer s administrative, management or supervisory bodies indicate the name and function of the person; in case of legal persons indicate the name and registered office A declaration by those responsible for the registration document that, having taken all reasonable care to ensure that such is the case, the information contained in the registration document is, to the best of their knowledge, in accordance with the facts and contains no omission likely to affect its import. As the case may be, a declaration by those responsible for certain parts of the registration document that, having taken all reasonable care to ensure that such is the case, the information contained in the part of the registration document for which they are responsible is, to the best of their knowledge, in accordance with the facts and contains no omission likely to affect its import. 2. Statutory Auditors 2.1. Names and addresses of the issuer s auditors for the period covered by the historical financial information (together with their membership in a professional body) If auditors have resigned, been removed or not been re-appointed during the period covered by the historical financial information, indicate details if material. 3. Selected Financial Information 3.1. Selected historical financial information regarding the issuer, presented for each financial year for the period covered by the historical financial information, and any subsequent interim financial period, in the same currency as the financial information. The selected historical financial information must provide the key figures that summarise the financial condition of the issuer If selected financial information for interim periods is provided, comparative data from the same period in the prior financial year must also be provided, except that the requirement for comparative balance sheet information is satisfied by presenting the year end balance sheet information. 4. Risk Factors Prominent disclosure of risk factors that are specific to the issuer or its industry in a section headed Risk Factors. 5. Information about the Issuer 5.1. History and Development of the Issuer the legal and commercial name of the issuer; the place of registration of the issuer and its registration number; the date of incorporation and the length of life of the issuer, except where

180 156 indefinite; the domicile and legal form of the issuer, the legislation under which the issuer operates, its country of incorporation, and the address and telephone number of its registered office (or principal place of business if different from its registered office); the important events in the development of the issuer s business Investments A description, (including the amount) of the issuer s principal investments for each financial year for the period covered by the historical financial information up to the date of the registration document; A description of the issuer s principal investments that are in progress, including the geographic distribution of these investments (home and abroad) and the method of financing (internal or external); Information concerning the issuer s principal future investments on which its management bodies have already made firm commitments. 6. Business Overview 6.1. Principal Activities A description of, and key factors relating to, the nature of the issuer s operations and its principal activities, stating the main categories of products sold and/or services performed for each financial year for the period covered by the historical financial information; and An indication of any significant new products and/or services that have been introduced and, to the extent the development of new products or services has been publicly disclosed, give the status of development Principal Markets A description of the principal markets in which the issuer competes, including a breakdown of total revenues by category of activity and geographic market for each financial year for the period covered by the historical financial information Where the information given pursuant to items 6.1. and 6.2. has been influenced by exceptional factors, mention that fact If material to the issuer s business or profitability, a summary information regarding the extent to which the issuer is dependent, on patents or licences, industrial, commercial or financial contracts or new manufacturing processes The basis for any statements made by the issuer regarding its competitive position. 7. Organizational Structure 7.1. If the issuer is part of a group, a brief description of the group and the issuer s position within the group A list of the issuer s significant subsidiaries, including name, country of incorporation or residence, proportion of ownership interest and, if different, proportion of voting power held. 8. Property, Plants and Equipment 8.1. Information regarding any existing or planned material tangible fixed assets, including leased properties, and any major encumbrances thereon A description of any environmental issues that may affect the issuer s utilisation of the tangible fixed assets. 9. Operating and Financial Review 9.1. Financial Condition. To the extent not covered elsewhere in the registration document, provide a description of the issuer s financial condition, changes in

181 ANNEXES 157 financial condition and results of operations for each year and interim period, for which historical financial information is required, including the causes of material changes from year to year in the financial information to the extent necessary for an understanding of the issuer s business as a whole Operating Results Information regarding significant factors, including unusual or infrequent events or new developments, materially affecting the issuer s income from operations, indicating the extent to which income was so affected Where the financial statements disclose material changes in net sales or revenues, provide a narrative discussion of the reasons for such changes Information regarding any governmental, economic, fiscal, monetary or political policies or factors that have materially affected, or could materially affect, directly or indirectly, the issuer s operations. 10. Capital Resources Information concerning the issuer s capital resources (both short and long term); An explanation of the sources and amounts of and a narrative description of the issuer s cash flows; Information on the borrowing requirements and funding structure of the issuer; Information regarding any restrictions on the use of capital resources that have materially affected, or could materially affect, directly or indirectly, the issuer s operations Information regarding the anticipated sources of funds needed to fulfil commitments referred to in items and Research and Development, Patents and Licenses Where material, provide a description of the issuer s research and development policies for each financial year for the period covered by the historical financial information, including the amount spent on issuer-sponsored research and development activities. 12. Trend Information The most significant recent trends in production, sales and inventory, and costs and selling prices since the end of the last financial year to the date of the registration document Information on any known trends, uncertainties, demands, commitments or events that are reasonably likely to have a material effect on the issuer s prospects for at least the current financial year. 13. Profit Forecasts or Estimates If an issuer chooses to include a profit forecast or a profit estimate the registration document must contain the information set out in items 13.1 and 13.2: A statement setting out the principal assumptions upon which the issuer has based its forecast, or estimate. There must be a clear distinction between assumptions about factors which the members of the administrative, management or supervisory bodies can influence and assumptions about factors which are exclusively outside the influence of the members of the administrative, management or supervisory bodies; the assumptions must be readily understandable by investors, be specific and precise and not relate to the general accuracy of the estimates underlying the forecast.

182 A report prepared by independent accountants or auditors stating that in the opinion of the independent accountants or auditors the forecast or estimate has been properly compiled on the basis stated and that the basis of accounting used for the profit forecast or estimate is consistent with the accounting policies of the issuer The profit forecast or estimate must be prepared on a basis comparable with the historical financial information If a profit forecast in a prospectus has been published which is still outstanding, then provide a statement setting out whether or not that forecast is still correct as at the time of the registration document, and an explanation of why such forecast is no longer valid if that is the case. 14. Administrative, Management and Supervisory Bodies and Senior Management Names, business addresses and functions in the issuer of the following persons and an indication of the principal activities performed by them outside that issuer where these are significant with respect to that issuer: a) members of the administrative, management or supervisory bodies; b) founders, if the issuer has been established for fewer than five years; and c) any senior manager who is relevant to establishing that the issuer has the appropriate expertise and experience for the management of the issuer s business. The nature of any family relationship between any of those persons. In the case of each member of the administrative, management or supervisory bodies of the issuer and of each person mentioned in points (b) and (d) of the first subparagraph, details of that person s relevant management expertise and experience and the following information: (a) the names of all companies and partnerships of which such person has been a member of the administrative, management or supervisory bodies or partner at any time in the previous five years, indicating whether or not the individual is still a member of the administrative, management or supervisory bodies or partner. It is not necessary to list all the subsidiaries of an issuer of which the person is also a member of the administrative, management or supervisory bodies; (b) any convictions in relation to fraudulent offences for at least the previous five years; (c) details of any bankruptcies, receiverships or liquidations with which a person described in (a) and (d) of the first subparagraph who was acting in the capacity of any of the positions set out in (a) and(d) of the first subparagraph was associated for at least the previous five years; (d) details of any official public incrimination and/or sanctions of such person by statutory or regulatory authorities (including designated professional bodies) and whether such person has ever been disqualified by a court from acting as a member of the administrative, management or supervisory bodies of an issuer or from acting in the management or conduct of the affairs of any issuer for at least the previous five years. If there is no such information to be disclosed, a statement to that effect is to be made Administrative, Management, and Supervisory bodies and Senior Management conflicts of interests. Potential conflicts of interests between any duties to the issuer, of the persons referred to in item 14.1., and their private interests and or other duties must be clearly stated. In the event that there are no such conflicts, a statement to that effect must be made. Any arrangement or understanding with major shareholders, customers, suppliers

183 ANNEXES 159 or others, pursuant to which any person referred to in item 14.1 was selected as a member of the administrative, management or supervisory bodies or member of senior management. Details of any restrictions agreed by the persons referred to in item 14.1 on the disposal within a certain period of time of their holdings in the issuer s securities. 15. Remuneration and Benefits In relation to the last full financial year for those persons referred to in points (a) and (d) of the first subparagraph of item 14.1.: The amount of remuneration paid (including any contingent or deferred compensation), and benefits in kind granted to such persons by the issuer and its subsidiaries for services in all capacities to the issuer and its subsidiaries by any person. That information must be provided on an individual basis unless individual disclosure is not required in the issuer s home country and is not otherwise publicly disclosed by the issuer The total amounts set aside or accrued by the issuer or its subsidiaries to provide pension, retirement or similar benefits. 16. Board Practices In relation to the issuer s last completed financial year, and unless otherwise specified, with respect to those persons referred to in point (a) of the first subparagraph of : Date of expiration of the current term of office, if applicable, and the period during which the person has served in that office Information about members of the administrative, management or supervisory bodies service contracts with the issuer or any of its subsidiaries providing for benefits upon termination of employment, or an appropriate negative statement Information about the issuer s audit committee and remuneration committee, including the names of committee members and a summary of the terms of reference under which the committee operates A statement as to whether or not the issuer complies with its country s of incorporation corporate governance regime(s). In the event that the issuer does not comply with such a regime, a statement to that effect must be included together with an explanation regarding why the issuer does not comply with such regime. 17. Employees Either the number of employees at the end of the period or the average for each financial year for the period covered by the historical financial information up to the date of the registration document (and changes in such numbers, if material) and, if possible and material, a breakdown of persons employed by main category of activity and geographic location. If the issuer employs a significant number of temporary employees, include disclosure of the number of temporary employees on average during the most recent financial year Shareholdings and stock options With respect to each person referred to in points (a) and (d) of the first subparagraph of item14.1. provide information as to their share ownership and any options over such shares in the issuer as of the most recent practicable date Description of any arrangements for involving the employees in the capital of the issuer. 18. Major Shareholders In so far as is known to the issuer, the name of any person other than a member of

184 160 the administrative, management or supervisory bodies who, directly or indirectly, has an interest in the issuer s capital or voting rights which is notifiable under the issuer s national law, together with the amount of each such person s interest or, if there are no such persons, an appropriate negative statement Whether the issuer s major shareholders have different voting rights, or an appropriate negative statement To the extent known to the issuer, state whether the issuer is directly or indirectly owned or controlled and by whom and describe the nature of such control and describe the measures in place to ensure that such control is not abused A description of any arrangements, known to the issuer, the operation of which may at a subsequent date result in a change in control of the issuer. 19. Related Party Transactions The issuer must disclose: a) The nature and extent of any transactions which are - as a single transaction or in their entirety - material to the issuer. Where such related party transactions are not concluded at arm s length provide an explanation of why these transactions were not concluded at arms length. In the case of outstanding loans including guarantees of any kind indicate the amount outstanding. b) The amount or the percentage to which related party transactions form part of the turnover of the issuer. 20. Financial Information concerning the issuer s Assets and Liabilities, Financial Position and Profits and Losses Historical Financial Information Audited historical financial information covering the latest 3 financial years (or such shorter period that the issuer has been in operation), and the audit report in respect of each year. Such financial information must be prepared according to IFRS or national accounting standards. It must be set out in a form consistent with that which will be adopted in the issuer s next published annual financial statements having regard to accounting standards and policies and legislation applicable to such annual financial statements. If the issuer has been operating in its current sphere of economic activity for less than one year, the audited historical financial information covering that period must be prepared in accordance with IFRS. If the audited financial information is prepared according to national accounting standards, the financial information required under this heading must include at least: (a) balance sheet; (b) income statement; (c) a statement showing either all changes in equity or changes in equity other than those arising from capital transactions with owners and distributions to owners; (d) cash flow statement; (e) accounting policies and explanatory notes The historical annual financial information must be independently audited or reported on as to whether or not, for the purposes of the registration document, it gives a true and fair view, in accordance with applicable auditing standards Pro forma financial information In the case of a significant gross change, a description of how the transaction might have affected the assets and liabilities and earnings of the issuer, had the transaction been undertaken at the commencement of the period being reported on or at the date reported.

185 ANNEXES 161 This requirement will normally be satisfied by the inclusion of pro forma financial information. This pro forma financial information is to be presented as set out in Annex X and must include the information indicated therein. Pro forma financial information must be accompanied by a report prepared by independent accountants or auditors Financial statements If the issuer prepares both own and consolidated annual financial statements, include at least the consolidated annual financial statements in the registration document Auditing of historical annual financial information A statement that the historical financial information has been audited. If audit reports on the historical financial information have been refused by the statutory auditors or if they contain qualifications or disclaimers, such refusal or such qualifications or disclaimers must be reproduced in full and the reasons given Indication of other information in the registration document which has been audited by the auditors Where financial data in the registration document is not extracted from the issuer s audited financial statements state the source of the data and state that the data is unaudited Age of latest financial information The last year of audited financial information may not be older than one of the following: (a)18 months from the date of the registration document if the issuer includes audited interim financial statements in the registration document; (b)15 months from the date of the registration document if the issuer includes unaudited interim financial statements in the registration document Interim and other financial information If the issuer has published quarterly or half yearly financial information since the date of its last audited financial statements, these must be included in the registration document. If the quarterly or half yearly financial information has been reviewed or audited, the audit or review report must also be included. If the quarterly or half yearly financial information is unaudited or has not been reviewed state that fact If the registration document is dated more than nine months after the end of the last audited financial year, it must contain interim financial information, which may be unaudited (in which case that fact must be stated) covering at least the first six months of the financial year. The interim financial information must include comparative statements for the same period in the prior financial year, except that the requirement for comparative balance sheet information may be satisfied by presenting the years end balance sheet Dividend policy A description of the issuer s policy on dividend distributions and any restrictions thereon The amount of the dividend per share for each financial year for the period covered by the historical financial information adjusted, where the number of shares in the issuer has changed, to make it comparable Legal and arbitration proceedings Information on any governmental, legal or arbitration proceedings (including any such proceedings which are pending or threatened of which the issuer is aware), during a period covering at least the previous 12 months which may have, or have had in the recent past significant effects on the issuer and/or group s financial position or profitability, or provide an appropriate negative statement Significant change in the issuer s financial or trading position A description of any significant change in the financial or trading position of the group

186 162 which has occurred since the end of the last financial period for which either audited financial information or interim financial information have been published, or provide an appropriate negative statement. 21. Additional Information Share Capital The following information as of the date of the most recent balance sheet included in the historical financial information: The amount of issued capital, and for each class of share capital: (a) the number of shares authorised; (b) the number of shares issued and fully paid and issued but not fully paid; (c) the par value per share, or that the shares have no par value; and (d) a reconciliation of the number of shares outstanding at the beginning and end of the year. If more than 10 percent of capital has been paid for with assets other than cash within the period covered by the historical financial information, state that fact If there are shares not representing capital, state the number and main characteristics of such shares The number, book value and face value of shares in the issuer held by or on behalf of the issuer itself or by subsidiaries of the issuer The amount of any convertible securities, exchangeable securities or securities with warrants, with an indication of the conditions governing and the procedures for conversion, exchange or subscription Information about and terms of any acquisition rights and or obligations over authorised but unissued capital or an undertaking to increase the capital Information about any capital of any member of the group which is under option or agreed conditionally or unconditionally to be put under option and details of such options including those persons to whom such options relate A history of share capital, highlighting information about any changes, for the period covered by the historical financial information Memorandum and Articles of Association A description of the issuer s objects and purposes and where they can be found in the memorandum and articles of association A summary of any provisions of the issuer s articles of association, statutes, charter or bylaws with respect to the members of the administrative, management and supervisory bodies A description of the rights, preferences and restrictions attaching to each class of the existing shares A description of what action is necessary to change the rights of holders of the shares, indicating where the conditions are more significant than is required by law A description of the conditions governing the manner in which annual general meetings and extraordinary general meetings of shareholders are called including the conditions of admission A brief description of any provision of the issuer s articles of association, statutes, charter or bylaws that would have an effect of delaying, deferring or preventing a change in control of the issuer An indication of the articles of association, statutes, charter or bylaw provisions, if any, governing the ownership threshold above which shareholder ownership must be disclosed A description of the conditions imposed by the memorandum and articles of association statutes, charter or bylaw governing changes in the capital, where such

187 ANNEXES 163 conditions are more stringent than is required by law. 22. Material Contracts A summary of each material contract, other than contracts entered into in the ordinary course of business, to which the issuer or any member of the group is a party, for the two years immediately preceding publication of the registration document. A summary of any other contract (not being a contract entered into in the ordinary course of business) entered into by any member of the group which contains any provision under which any member of the group has any obligation or entitlement which is material to the group as at the date of the registration document. 23. Third Party Information and Statement by Experts and Declarations of Any Interests Where a statement or report attributed to a person as an expert is included in the Prospectus, provide such person s name, business address, qualifications and material interest if any in the issuer. If the report has been produced at the issuer s request a statement to the effect that such statement or report is included, in the form and context in which it is included, with the consent of the person who has authorised the contents of that part of the Prospectus Where information has been sourced from a third party, provide a confirmation that this information has been accurately reproduced and that as far as the issuer is aware and is able to ascertain from information published by that third party, no facts have been omitted which would render the reproduced information inaccurate or misleading. In addition, identify the source(s) of the information. 24. Documents on Display A statement that for the life of the registration document the following documents (or copies thereof), where applicable, may be inspected: (a) the memorandum and articles of association of the issuer; (b) all reports, letters, and other documents, historical financial information, valuations and statements prepared by any expert at the issuer s request any part of which is included or referred to in the registration document; (c) the historical financial information of the issuer or, in the case of a group, the historical financial information for the issuer and its subsidiary undertakings for each of the two financial years preceding the publication of the registration document. An indication of where the documents on display may be inspected, by physical or electronic means. 25. Information on Holdings Information relating to the undertakings in which the issuer holds a proportion of the capital likely to have a significant effect on the assessment of its own assets and liabilities, financial position or profits and losses.

188 164

189 ANNEXES 165 ANNEX 10: INFORMAL ASSESSMENT OF THE IAIS CORE PRINCIPLES FOR EFFECTIVE INSURANCE SUPERVISION Part on Conditions for Effective Insurance Supervision Principle on Conditions for effective insurance supervision: Insurance supervision relies upon a policy, institutional and legal framework for financial sector supervision, a well developed and effective financial market infrastructure and efficient financial markets. The government has made an attempt to establish a framework aimed at ensuring financial stability, including the provision of effective financial sector supervision covering the insurance. Insurance legislation (the Insurance Business Regulation Act was March 2005) has been passed and an insurance supervisor has been established. Likewise banking, securities and pension laws have been passed. A banking supervisor and a securities supervisor have been established. The overall quality of the legal framework is not as good as it could be, but it is well published by being posted in Iraqi and English on the website of the supervisors. It does not presently seem to be a reliable, effective, efficient and fair legal and court system whose decisions are enforceable. Neither is there an alternative dispute mechanism that operates within an appropriate legal framework. The accounting, actuarial and auditing standards are not comprehensive, documented, transparent and consistent with international standards. Presently most of the institutions including financial sector are applying the Iraqi accounting standards (the Iraqi Unified Accounting Systems) that do not comply with international accounting and auditing standards. The Iraqi Unified Accounting System is not comparable to IFRS. The insurance companies are not required to use the IFRS and with the possible exemption of the foreign own insurers do not apply the IFRS. The accounting and actuarial standards are not applied and disclosed in a manner that allows current and prospective policyholders, investors, intermediaries, creditors and supervisors to properly evaluate the financial condition of insurers. Accountants, actuaries and auditors are generally not qualified to apply the IFRS standards. Some of the big international auditing firms such as Ernst & Young are established in Baghdad, but it was estimated by representatives from these firms that 99% of the local auditors are not skilled in applying the IFRS A professional body The Iraqi Insurance and Reinsurance Association is established but the Law explicitly states the association shall not have any regulatory role or responsibilities (article 84). Basic economic, financial and social statistics are not available to the supervisory authority, the industry and the public, and data is not available to establish the premium paid to the insurance companies. A well-functioning money and securities markets to support the availability of both longterm and short-term investment opportunities, is not established and it is difficult to find assets in which to invest for the insurance companies.

190 166 Part on the Supervisory System Principle on Supervisory objectives The principal objectives of insurance supervision are clearly defined. The Law identifies the Insurance Diwan as the authority responsible for the supervision of insurance entities (article 6) and the Law clearly defines the objectives of insurance supervision (article 6). It identifies as the key objectives of supervision to promote the maintenance of efficient, fair, safe and stable insurance markets for the benefit and protection of policyholders. Principle on Supervisory authority The supervisory authority: has adequate powers, legal protection and financial resources to exercise its functions and powers; is operationally independent and accountable in the exercise of its functions and powers; hires, trains and maintains sufficient staff with high professional standards; and treats confidential information appropriately. There are explicit procedures regarding the appointment and dismissal of the president of the supervisor. The president of the Diwan can only be dismissed based on a decision by the Prime Minister and approved by the Presidents Council. A justified reason needs to be provided for dismissing the president of the Diwan prior to the end of the tenure (article 7). The Diwan is founded by fees collected from the supervised entities (article 9). This provides the supervisory authority with financing in a manner that does not undermine its independence from political, governmental or industry bodies. The Law includes conflict of interest rules to employees of the Diwan such as imposing a prohibition on dealing in shares and investing in the companies they supervise (article 91). The supervisory authority has the authority to hire, contract or retain the services of external specialists through contracts or outsourcing arrangements if necessary (articles 8 and 54). The Law includes an unclear provision that requires the President of the Diwan to issue a number of regulations within 90 days of being appointed (article 12). This is probably meant to be a to-do list for the first President of the Diwan, but since it is in the Law it means that each new President will have to reissue these regulations within 90 days of being appointed. The legislation should instead give the supervisor the power to issue and enforce regulations within the whole area they are responsible for supervising. The Law does not grant sufficient powers to the Diwan for effective discharge of its supervisory responsibilities; it is particularly serious that the Law does not explicitly give the supervisor the power to conduct on-site inspections. The Law s wording is unclear in relation to the supervisor s right to carry a surplus from one year over to the next (article 10). The Law seems to say that the supervisor can carry over to the next year a surplus in an amount similar to 2/3 of its expenditures and transfer the remainder to the public treasury. This provision makes it difficult to plan forward and will lead to the absurd result that to be able to take on a big project in the coming year the supervisor needs to have large expenses during the ongoing year. The

191 ANNEXES 167 supervisor should instead have full freedom to allocate its resources in accordance with its mandate and objectives and the risks it perceives. There is an organizational chart shoving the structure of the supervisor on the Diwan s web page. This structure does, however, not exist in real life. The supervisor is now staffed by the chairman and two secretaries. The supervisory authority and its staff are organized under the Ministry of Finance and subject to the Minster s direction. It is consequently not free from undue political and governmental interference in the performance of supervisory responsibilities. There does not seem to be any activity going on at the supervisor at present so it is not possible to assess whether processes are transparent, decisions consistent, whether its supervisory practices are normally subject to prior consultations with market participants or whether the supervisory authority and its staff, observe the highest professional standards, or have the appropriate levels of skills and experience. The supervisor does not publish audited financial statements on a regular basis. The Law does not provide the supervisor s staff with the necessary legal protection to protect them against lawsuits for actions taken in good faith while discharging their duties and the Law does not adequately protect the supervisory authority and is staff against the costs of defending their actions while discharging their duties. Principle on Supervisory process The supervisory authority conducts its functions in a transparent and accountable manner. The Law requires the supervisor publishes a report annually on the conduct of its policy and describs its performance in pursuing its objectives (article 11). Also the administrative decisions by the supervisor to deny a license can be subject to substantive judicial review (article 19). There are no indications that the supervisor applies a clear, transparent and consistent regulatory and supervisory process. The supervisor s has, however, made some information available of its website but this information is unfortunately not updated and now very dated. The supervisor does not seem to publish a regular report, annually or otherwise, explaining its objectives and describing its performance in pursuing its objectives. The indications are that the supervisor is not free to make independent decisions but must await clearance by the Ministry of Finance and that will prevents it from taking immediately action in the case of an emergency situation. Principle on Supervisory cooperation and information sharing The supervisory authority cooperates and shares information with other relevant supervisors subject to confidentiality requirements. The supervisor has entered into a MoU with the Insurance Association but not otherwise entered into any MoU with other supervisors or anyone else. The Law does not explicitly allow the supervisor to exchange information or provide assistance to other supervisors.

192 168 Part on the Supervised Entity Principle on Licensing An insurer must be licensed before it can operate within a jurisdiction. The requirements for licensing are clear, objective and public. The Law requires that the applicant for a license is provided with an explanation if the application is denied (article 19). The Law should but does not include a definition of insurers. The Law does require licensing of insurers (article 14) but the exemptions are so significant that the licensing requirement is almost meaningless. The President of the Diwan can allow foreign insurers or insurers affiliated with a foreign insurer to operate with a license provided they come from country that apply the IAIS core principles for insurance. Insurers that hold an old license can also continue operating under the old license and are not required to apply to be license in accordance with the requirements under the Law. The Law does not properly define the permissible legal forms of insurers. The Law allows a wide array of company types to conduct insurance business. An insurer can in accordance with the Law be organized as a public company, a private company, a mixed shareholding company (mix of owners from state sector and non-state sectors), a takaful and a retakaful company. There are five types of private companies of which three have unlimited liability (the joint liability company, the sole owner enterprise, and the simple owner company). Also takaful and retakaful companies do not follow the legal structure of a joint stock company. In addition, an insurer or reinsurer that the President of the Diwan considers to be qualified and financially capable can conduct insurance business (article 13). Furthermore, the Law is on this point in conflict with Company Law No. 21 of 1997 as amended which requires that insurance and reinsurance companies must be organized as joint-stock company (article 10). There is also some confusion in the Law s handling of branches when the Law seems to allow for withdrawing the licensee in relation to one or several branches (article 23 and 24). A license is given to a company and to different parts of the company so it is not possible to withdraw the license in relation to certain parts or branches of the company. The Law does not include licensing criteria (article 15) and regulation with licensing criteria has not been issued. Contrary to best practice the Law allows an insurer to underwrite both life and nonlife insurance business without any requirements to keeping the businesses separate, provided it conducted this combined business before the Law came into effect. Principle on Suitability of persons The significant owners, board members, senior management, auditors and actuaries of an insurer are fit and proper to fulfill their roles. This requires that they possess the appropriate integrity, competency, experience and qualifications. The Law does not include clear, objective and public licensing criteria to the applicant s significant owners, auditor and actuary requiring that they individually and collectively are fit and proper. The Law does on the other side contain requirements to the board members and key functionaries professional experience while the requirements to their integrity are insufficient, making a criminal conviction or a serial violation of the Law or the corporate law as the only barrier to not being considered fit and proper (article 42). The

193 ANNEXES 169 Law also precludes persons who have previous experience in a failed institution, but that indicator is too broad because it does not consider the applications part in the failure. The Law does not stipulate that the supervisor shall assess the qualification of auditors and actuaries of an insurer as part of the licensing procedure or later. Instead the Law requires that the shareholder committee select an independent accountant to examine the financial information of the insurer and notify the Diwan, if it is found that the insurer is unable to cover its financial obligations, meet the law s capital adequacy requirement or that the accounting practice of the insurer does not conform to legal framework s requirement to acceptable accounting practice (article 36). Principle on Changes in control and portfolio transfers The supervisory authority approves or rejects proposals to acquire significant ownership or any other interest in an insurer that results in that person, directly or indirectly, alone or with an associate, exercising control over the insurer. The supervisory authority approves the portfolio transfer or merger of insurance business. The Law requires that an insurer obtains the supervisor s approval before it transfers all or any part of its insurance business (articles 48 and 50) and it requires that the interests of the policyholders of both the transferee and transferor be protected when insurance business is transferred (articles 48 and 50). The Law does not include a definition of the term Control that address: (i) holding of a defined number or percentage of issued shares or specified financial instruments (such as compulsory convertible debentures) above a designated threshold in an insurer or its intermediate or ultimate beneficial owner; (ii) voting rights attached to the aforementioned shares or financial instruments; and (iii) power to appoint or remove directors to the board and other executive committees. The supervisory authority should: (i) approve any increase, significant or other in shareholdings in an insurer; (ii) check whether those seeking control meet fit and proper criteria; and (iii) require that the structures of the financial groups containing potential controlling owners of insurers be sufficiently transparent so that supervision of the insurance group will not be hindered. Principle on Internal control The supervisory authority requires insurers to have in place internal controls that are adequate for the nature and scale of the business. The oversight and reporting systems allow the board and management to monitor and control the operations. The supervisor should review the insurers internal controls and checks their adequacy to the nature and the scale of the business and requires strengthening of these controls where necessary. Part on Ongoing Supervision Principle on Reporting to supervisors and off-site monitoring The supervisory authority receives necessary information to conduct effective off-site monitoring and to evaluate the condition of each insurer as well as the insurance market.

194 170 The Law requires the insurer annually to provide an audit opinion, with its annual report and final annual financial account (article 38) and the Law gives the supervisor the power to set the requirements for the submission of regular and systematic financial and statistical information, actuarial reports and other information from all insurers. Furthermore, the Law gives the Diwan the power to define the scope and frequency of those reports and information, including any requirement that reports and information be audited (article 37). Principle on On-site inspection The supervisory authority carries out on-site inspections to examine the business of an insurer and its compliance with legislation and supervisory requirements. The supervisor should start conducting off-site monitoring to evaluate the conditions of each insurer as well as the insurance market. The Law should also be amended so the supervisor can start conducting on-site inspections to examine the business of the insurer and their compliance with legislation and the supervisory requirements. Principle on Preventive and Corrective Measures The supervisory authority takes preventive and corrective measures that are timely, suitable and necessary to achieve the objectives of insurance supervision. The Law provides the supervisor with the power to take preventive and corrective measures if an insurer fails to operate in a manner that is consistent with sound business practices or regulatory requirements (articles 47 and 51). The Law does, however, not allow the supervisor to take these measures in a timely fashion, but instead requires that the insurer has violated the law, regulations or instructions before the action can be taken (article 47 and 51). The Law should allow the Diwan to impose preventive and corrective measures at a much earlier time when the chance for saving the insurer is much better. Principle on Enforcement or sanctions The supervisory authority enforces corrective action and, where needed, imposes sanctions based on clear and objective criteria that are publicly disclosed. The supervisor has the power to replace the board of an insurer (article 51) and in that way address management problems. The insurance legislation provides for sanctions by way of fines against individuals and insurers where the provisions of the legislation are breached (article ). The Law also provides for sanctions against individuals who withhold information from the supervisory authority, provide information that is intended to mislead the supervisory authority or fail to provide information to the supervisory authority in a timely fashion (article 98) and the Law gives the supervisor the power to take action to withdraw the license of an insurer where appropriate (article 23). The Law does not but should allow the supervisor to issue formal directions to companies to (i) take particular actions or to desist from taking particular actions; (ii) give the supervisor the power to prevent the insurer issuing new policies, (iii) provide the supervisor with the authority to arrange for compulsory transfer of the obligations under the policies from a failing insurer to another insurer that accepts this transfer; (iv) give the supervisor the power to require capital levels to be increased, restrict or suspend dividend or other payments to shareholders, restrict asset transfers and restrict an insurer s purchase of its own shares; give the supervisor the power to bar an individual from acting in responsible capacities in

195 ANNEXES 171 the future; and (v) give the supervisor the powers to protect one or more insurers within its jurisdiction that belong to a group from the financial difficulties in other parts of the group. Principle on Winding-up and exit from the market The legal and regulatory framework defines a range of options for the orderly exit of insurers from the marketplace. It defines insolvency and establishes the criteria and procedure for dealing with insolvency. In the event of winding-up proceedings, the legal framework gives priority to the protection of policyholders. The Law should include the definition of the point at which it is no longer permissible for an insurer to continue its business (articles 51 to 74). The Law contains several articles (articles 51-74) regulating rehabilitation and liquidation procedure, but they do set forth a procedures for dealing with insolvency and the winding-up of the insurer that is sufficiently clear and comprehensive covering such areas how to conduct a run-off by paying claims after it closes and ceases its operation. Principle on Group-wide supervision The supervisory authority supervises its insurers on a solo and a group-wide basis. The Law should include a definition of what constitutes an insurance group and financial conglomerate and the supervisor does not conduct group-wide or any other type of supervision. Part on Prudential Requirements Principle on Risk assessment and management The supervisory authority requires insurers to recognize the range of risks that they face and to assess and manage them effectively The Law should require that the insurer recognize the range of risks that it faces, assess the risks and manage the risks effectively, and the supervisor should ensure that insurers have in place comprehensive risk management policies and systems capable of promptly identifying, measuring, assessing, reporting and controlling their risks. The Law should require that the insurer must evaluate and manage the risks it underwrites, in particular through reinsurance, and to have the tools to establish an adequate level of premiums. Principle on Insurance activity Since insurance is a risk taking activity, the supervisory authority requires insurers to evaluate and manage the risks that they underwrite, in particular through reinsurance, and to have the tools to establish an adequate level of premiums. The Law does not require that the insurer must evaluate and manage the risks it underwrites, in particular through reinsurance, and to have the tools to establish an adequate level of premiums. Principle on Liabilities The supervisory authority requires insurers to comply with standards for establishing adequate technical provisions and other liabilities, and making allowance for reinsurance recoverables. The supervisory authority has both the authority and the ability to assess the adequacy of the technical provisions and to require that these provisions be increased, if necessary.

196 172 The Law includes provisions requiring that the insurer establish technical provisions (article 32), but these provisions are quite rudimentary and not based on sound accounting and actuarial principles. The Law provides that the insurer shall make reserve provision in a sum similar to 40% of net premium and 25% of net insurance premium for marine insurance. Plus a sum equal to 100% of outstanding clams, plus a sum proportionate to the amount of incurred but not reported claims. There is probably a mistake when the Law requires a sum proportionate to the sum incurred but not reported claims to be included in the technical reserves. There should not be a deduction as indicated by the word proportionate when calculating the amount of incurred but not reported claims. Principle on Investments The supervisory authority requires insurers to comply with standards on investment activities. These standards include requirements on investment policy, asset mix, valuation, diversification, asset-liability matching, and risk management. Requirements should be established that requires that insurers comply with standards on investment activity. The Law anticipates that the supervisor shall issue instruction regarding insurer s investments (article 12) but such instructions have not been issued. Principle on Derivatives and similar commitments The supervisory authority requires insurers to comply with standards on the use of derivatives and similar commitments. These standards address restrictions in their use and disclosure requirements, as well as internal controls and monitoring of the related positions. Requirements regarding the use of derivatives are not been established in the law or in supervisory rules. Principle on Capital adequacy and solvency The supervisory authority requires insurers to comply with the prescribed solvency regime. This regime includes capital adequacy requirements and requires suitable forms of capital that enable the insurer to absorb significant unforeseen losses. The Law (article 12) delegates to the supervisor to issue regulation regarding solvency margin and minimum guarantee fund. Regulation relating to solvency margin has not been issued. Regulation relating to minimum guarantee fund has been issued but this is an old fashion way of monitoring solvency that should be replaced with the more up to date prudential supervision. Regulation relating to technical reserves as required by the Law (article 32) has been issued, but regulation relating to allowable investments, matching of assets and liabilities, and suitable forms of capital should also be issued. Part on Markets and consumers Principle on Intermediaries The supervisory authority sets requirements, directly or through the supervision of insurers, for the conduct of intermediaries. The Law includes requirements that the Diwan license or register intermediaries (articles 75, 76, and 77), but the law does not include requirements to the intermediary to handle client s money with sufficient safeguards to protect these funds. The Law should also

197 ANNEXES 173 require intermediaries to give customers information on their status, specifically whether they are independent or associated with particular insurance companies and whether they are authorized to conclude insurance contracts on behalf of an insurer or not. Principle on Consumer protection The supervisory authority sets minimum requirements for insurers and intermediaries in dealing with consumers in its jurisdiction, including foreign insurers selling products on a cross-border basis. The requirements include provision of timely, complete and relevant information to consumers both before a contract is entered into through to the point at which all obligations under a contract have been satisfied. The Law includes provisions aimed at preventing conflict interest situation, but the scope of these provisions are too limited both in terms of the persons it reaches (only board members, managing director and principle employees) and situations it prohibits (only where the person is competing against the insurer it is hired by) (article 48). The supervisor should require that insurers and intermediaries (i) act with due skill, care and diligence in their dealing with consumers; (ii) requires that insurers and intermediaries have policies on how to treat consumers fairly and to have systems and provide training to ensure compliance with those policies by their employees and other sales collaborators; and (iii) require that insurers and intermediaries seek the information from their consumers in order to assess their insurance needs, before giving advice or concluding a contract. The supervisor should also require that insurers and intermediaries deal with claims and complaints effectively and fairly through a simple, easily accessible and equitable process. Principle on Information, disclosure & transparency towards the market The supervisory authority requires insurers to disclose relevant information on a timely basis in order to give stakeholders a clear view of their business activities and financial position and to facilitate the understanding of the risks to which they are exposed. Insurers are required by the Law to report on their financial position and the risks they are facing (article 38) and these requirements should be enforced by the supervisor. The Law requires insurers to prepare and provide their annual report to the supervisor (article 38), but they are not required to provide it to other stakeholders. Principle on Fraud The supervisory authority requires that insurers and intermediaries take the necessary measures to prevent, detect and remedy insurance fraud. The Law should address insurance fraud and require that insurers and intermediaries take the necessary measures to prevent, detect and remedy insurance fraud. Part on Anti-money laundering, combating the financing of terrorism Part on Anti-money laundering, combating the financing of terrorism Principle on Anti-money laundering, combating the financing of terrorism (AML/CFT) The supervisory authority requires insurers and intermediaries to take effective measures to deter, detect and report money laundering and the financing of terrorism.

198 174 The Law includes provisions to prevent money laundering (article 35) but the provisions does not conform with the criteria specified by FATF, such as conducting Customer Due Diligence; monitoring complex, unusual large transactions; and reporting suspicious transactions to the Financial Intelligence Unit. The supervisor should also require that insurers and intermediaries, and in particular insurers and intermediaries offering life insurance products or other investment related insurance, comply with AML/CFT requirements.

199 ANNEXES 175 ANNEX 11: CONSOLIDATED STATEMENT OF BANKS (2010) (Million ID) Assets Liabilities End Of Period Reserves Currency Current Deposits with CBI Foreign Assets Claims on Govt. Private Sector & Others Bank Premises Other Assets Total Assets or Liabilities Deposits ( Private & Others ) Sector Current Time & Saving Deposits Vs. Guarante es & L / C Govt. Foreign Liabilities Credit from CBI Capital Reserves & Provisions Other Liabilities Total Assets or Liabilities Rafidain 1,479,418 15,004,459 1,569,801 3,466,098 3,358, , ,854, ,888,424 14,405,104 2,917,721 6,473 4,487,854 1,160, , ,456, ,888,424 Rasheed 1,133,434 5,731, ,473 2,444,976 2,045,355 46,731 1,378,110 13,522,889 7,211,764 1,833,973 6,144 1,639, , ,658 1,621,419 13,522,889 Trade Bank 81,523 6,622,306 8,950,580 1,228, ,725 30, ,555 17,804,797 2,585,086 94, ,096 11,950, ,899, ,803 17,804,797 Agricultural 53, , ,842 57,547 9,478 74,779 1,398,982 32,424 82, , , ,007 1,398,982 Real Estate 30, , , ,118 2,312 17,448 1,147,158 54,345 7, , , ,068 1,147,158 Industrial 7, ,520 2, ,927 2,993 43, ,640 42,271 1, , , , ,640 Iraq Bank 1,639 31, ,214 1, ,315 1,734 8, ,639 29,896 41,315 Warka 4,989 27,009 9, ,373 62,199 54, , , ,927 95,991 4,304 1, ,162 71, ,399 Baghdad 68, , , , ,646 33,336 20, , , ,074 11, ,448 2, ,786 Basrah 2,263 8, ,567 26, , ,778 75,390 20,272 29, , , ,778 AlBilad Islamic 9,764 81,619 57, , ,112 55, ,800 84, ,741 47, , , , ,800 Iraqi Middle East 17, , , ,661 61,243 20, , , ,991 13,185 11, ,130 21, ,954 North Bank 48, ,527 63, ,135 28,968 39, , , , ,199 2, ,661 54, ,987 United Bank 1, ,176 6, ,052 11,364 23, , ,392 51, , ,707 19, ,754 Dar Alsalam 10, ,255 82, ,000 19,009 11,092 3, , , ,056 60, ,432 1, ,150 Credit Bank 18, ,954 43, ,840 25,654 4,589 4, , ,229 83,050 5, , ,073 10, ,893 Kurdistan 51,073 91, , ,201 26,348 15, , ,317 70,320 86,802 3, ,554 23, ,441 AL-Huda 4, ,960 2, ,189 1,747 2, ,050 80,413 3,662 42, ,333 24, ,050 Mousel 28,451 35,553 16,521-66,336 8,795 19, , ,262 16,969 22,247 7, ,730 (42,093) 175,040 Gulf 12,585 30,640 23, ,000 53,599 20,991 18, ,740 61, ,927 18, ,031 (1,909) 260,740 Investment 9,689 82,861 83,217 89,415 10,446 7, ,487 48,792 74,467 14, ,446 43, ,487 Commercial Bank 6,193 34,660 50, ,000 13,845 9,477 1, ,780 50,900 26, ,676 20, ,780 Economic 11,793 24,768 64, ,396 27,296 22, , ,831 43,278 28, ,798 33, ,514

200 176 Babylon k 7, ,605 5, ,138 20,640 4, ,133 38,905 90, , ,978 (6,242) 193,133 Ashur 7, ,251 3, ,150 7,624 1, ,232 31,011 14,253 9, ,225 3, ,232 Dijah&Furat 7,597 63,627 13, ,338 22,406 8, ,337 35,656 20,888 13, ,266 66, ,337 Mansour 6,555 39,277 27,167 56,500 37,135 4,044 1, ,015 28,741 43,310 10, ,723 3, ,015 Islamic Regional 16,734 69,350 23, ,774 14,652 4, ,470 33,867 29,237 4, ,876 2, ,470 Cooperation Union Bank 3,216 34,683 9, ,300 9,381 6, ,264 12,042 11,915 18, ,772 (1,507) 105,264 National Bank of 4,448 34,725 3,958 9,348 43,144 4,646 3, ,074 21,458 27, ,856 (1,599) 104,074 Iraq Summer 1,465 20,971 32, ,845 8,898 2, ,170 11,622 19,940 1,850-2, ,939 1, ,170 Islamic 7,045 26,540 6,315 18,296 6,588 6,918 71,702 12,194 9,629 1,298 54,546 (5,965) 71,702 Elaf 7,731 66,526 13,345 34,243 20,532 54, ,874 24,619 3,166 5, ,099 88, ,874 Trans Iraq Bank 3,462 13,789 67,162 2,679 1, ,108 13,004 2, ,394 4,897 89,108 Bank Melli Iran ,484 2, , ,527 3, , ,012 (11,055) 26,527 Islamic National Bank 1,118 36,564 2, ,785 3,657 18,343 81,795 29, , ,940 (6,468) 81,795 Arab Banking 0 0 1, ,215 9, , , ,744 Corporation Ziraat Bank 201 4,838 2, , ,313 2, , , ,313 Byblos Bank 1,973 46,598 21,962 12,533 7,748 13,943 19, , ,300 6,493 11, , ,349 (39,168) 124,003 Gehan Bank 5,079 72,195 18,945 50,485 2,778 5, ,223 22,417 11,110 2,055 58,070 61, ,223 Intercontinantal Bank ,321 26, , ,486 37,595 3, ,978 (661) 49,486 Erbal Bank 233 6,509 56, ,250 1, ,188 14,225-1, ,856 (373) 116,188 Total 3,175,691 31,942,775 12,693,755 8,319,189 9,385, , ,622, ,056,416 27,421,430 6,841,076 1,704,603 19,041,455 1,762,523-6,249, ,035, ,056,416 Source: Monetary and Statistics Division

201 ANNEXES 177 ANNEX 12: CONSOLIDATED STATEMENT OF STATE-OWNED BANKS (2010) (Million ID) Assets Reserves Claims on End Of Period Current Foreign Private Bank Other Total Assets Currency Deposits Assets Govt. Sector & Premises Assets or with CBI Others Liabilities Rafidain 1,479,418 15,004,459 1,569,801 3,466,098 3,358, , ,854, ,888,424 Rasheed 1,133,434 5,731, ,473 2,444,976 2,045,355 46,731 1,378,110 13,522,889 Trade Bank 81,523 6,622,306 8,950,580 1,228, ,725 30, ,555 17,804,797 Agricultural 53, , ,842 57,547 9,478 74,779 1,398,982 Real Estate 30, , , ,118 2,312 17,448 1,147,158 Industrial 7, ,520 2, ,927 2,993 43, ,640 Iraq Bank 1,639 31, ,214 1, ,315 Total State-owned 2,786,868 28,933,976 11,265,633 7,667,828 6,500, , ,955, ,360,205 End Of Period Liabilities Deposits ( Private & Others ) Sector Current Source: Monetary and Statistics Division Time & Saving Deposits Vs. Guarantees & L / C Govt. Foreign Liabilities Credit from CBI Capital Reserves & Provisions Other Liabilities Total Assets or Liabilities 2010 Rafidain 14,405,104 2,917,721 6,473 4,487,854 1,160, , ,456, ,888,424 Rasheed 7,211,764 1,833,973 6,144 1,639, , ,658 1,621,419 13,522,889 Trade Bank 2,585,086 94, ,096 11,950, ,899, ,803 17,804,797 Agricultural 32,424 82, , , ,007 1,398,982 Real Estate 54,345 7, , , ,068 1,147,158 Industrial 42,271 1, , , , ,640 Iraq Bank 1,734 8, ,639 29,896 41,315 Total Governmental 24,332,728 4,945, ,806 19,003,507 1,724,153-3,231, ,226, ,360,205

202 178

203 ANNEXES 179 ANNEX 13: CONSOLIDATED STATEMENTS OF COMMERCIAL BANKS (2010) (Million ID) Assets Liabilities End Of Period Reserves Currency Current Deposits with CBI Foreign Assets Claims on Govt. Private Sector & Others Bank Premises Other Assets Total Assets or Liabilities Deposits ( Private & Others ) Sector Current Time & Saving Deposits Vs. Guarantees & L / C Govt. Foreign Liabilities Cred it from CBI Capital Reserves & Provisions Other Liabilities Total Assets or Liabilities Warka 4,989 27,009 9, ,373 62,199 54, , , ,927 95,991 4,304 1, ,162 71, ,399 Baghdad 68, , , , ,646 33,336 20, , , ,074 11, ,448 2, ,786 Basrah 2,263 8, ,567 26, , ,778 75,390 20,272 29, , , ,778 AlBilad Islamic 9,764 81,619 57, , ,112 55, ,800 84, ,741 47, , , , ,800 Iraqi Middle East 17, , , ,661 61,243 20, , , ,991 13,185 11, ,130 21, ,954 North Bank 48, ,527 63, ,135 28,968 39, , , , ,199 2, ,661 54, ,987 United Bank 1, ,176 6, ,052 11,364 23, , ,392 51, , ,707 19, ,754 Dar Alsalam 10, ,255 82, ,000 19,009 11,092 3, , , ,056 60, ,432 1, ,150 Credit Bank 18, ,954 43, ,840 25,654 4,589 4, , ,229 83,050 5, , ,073 10, ,893 Kurdistan 51,073 91, , ,201 26,348 15, , ,317 70,320 86,802 3, ,554 23, ,441 AL-Huda 4, ,960 2, ,189 1,747 2, ,050 80,413 3,662 42, ,333 24, ,050 Mousel 28,451 35,553 16,521-66,336 8,795 19, , ,262 16,969 22,247 7, ,730 (42,093) 175,040 Gulf 12,585 30,640 23, ,000 53,599 20,991 18, ,740 61, ,927 18, ,031 (1,909) 260,740 Investment 9,689 82,861 83,217 89,415 10,446 7, ,487 48,792 74,467 14, ,446 43, ,487 Commercial Bank 6,193 34,660 50, ,000 13,845 9,477 1, ,780 50,900 26, ,676 20, ,780 Economic 11,793 24,768 64, ,396 27,296 22, , ,831 43,278 28, ,798 33, ,514 Babylon k 7, ,605 5, ,138 20,640 4, ,133 38,905 90, , ,978 (6,242) 193,133 Ashur 7, ,251 3, ,150 7,624 1, ,232 31,011 14,253 9, ,225 3, ,232 Dijah&Furat 7,597 63,627 13, ,338 22,406 8, ,337 35,656 20,888 13, ,266 66, ,337 Mansour 6,555 39,277 27,167 56,500 37,135 4,044 1, ,015 28,741 43,310 10, ,723 3, ,015

204 180 Islamic Regional 16,734 69,350 23, ,774 14,652 4, ,470 33,867 29,237 4, ,876 2, ,470 Cooperation Union Bank 3,216 34,683 9, ,300 9,381 6, ,264 12,042 11,915 18, ,772 (1,507) 105,264 National Bank of Iraq 4,448 34,725 3,958 9,348 43,144 4,646 3, ,074 21,458 27, ,856 (1,599) 104,074 Summer 1,465 20,971 32, ,845 8,898 2, ,170 11,622 19,940 1,850-2, ,939 1, ,170 Islamic 7,045 26,540 6,315 18,296 6,588 6,918 71,702 12,194 9,629 1,298 54,546 (5,965) 71,702 Elaf 7,731 66,526 13,345 34,243 20,532 54, ,874 24,619 3,166 5, ,099 88, ,874 Trans Iraq Bank 3,462 13,789 67,162 2,679 1, ,108 13,004 2, ,394 4,897 89,108 Bank Melli Iran ,484 2, , ,527 3, , ,012 (11,055) 26,527 Islamic National Bank 1,118 36,564 2, ,785 3,657 18,343 81,795 29, , ,940 (6,468) 81,795 Arab Banking Corporati 0 0 1, ,215 9, , , ,744 Ziraat Bank 201 4,838 2, , ,313 2, , , ,313 Byblos Bank 1,973 46,598 21,962 12,533 7,748 13,943 19, , ,300 6,493 11, , ,349 (39,168) 124,003 Gehan Bank 5,079 72,195 18,945 50,485 2,778 5, ,223 22,417 11,110 2,055 58,070 61, ,223 Intercontinantal Bank ,321 26, , ,486 37,595 3, ,978 (661) 49,486 Erbal Bank 233 6,509 56, ,250 1, ,188 14,225-1, ,856 (373) 116,188 Total Private 388,823 3,008,799 1,428, ,361 2,884, , ,263 9,696,211 3,088,702 1,895, ,797 37,948 38,370-3,018, ,438 9,696,211 Source: Monetary and Statistics Division

205 ANNEXES 181 ANNEX 14: CONSOLIDATED STATEMENTS OF COMMERCIAL BANKS WITHOUT ISLAMIC BANKS (2010) (Million ID) End Of Period Assets Reserves Currency Current Deposits with CBI Foreign Assets Claims on Govt. Private Sector & Others Bank Premises Other Assets Total Assets or Liabilities Liabilities Deposits ( Private & Others ) Sector Current Time & Saving Deposits Vs. Guarantees & L / C Govt. Foreign Liabilities Credit from CBI Capital Reserves & Provisions Other Liabilities Total Assets or Liabilities Warka 4,989 27,009 9, ,373 62,199 54, , , ,927 95,991 4,304 1, ,162 71, ,399 Baghdad 68, , , , ,646 33,336 20, , , ,074 11, ,448 2, ,786 Basrah 2,263 8, ,567 26, , ,778 75,390 20,272 29, , , ,778 Iraqi Middle East 17, , , ,661 61,243 20, , , ,991 13,185 11, ,130 21, ,954 North Bank 48, ,527 63, ,135 28,968 39, , , , ,199 2, ,661 54, ,987 United Bank 1, ,176 6, ,052 11,364 23, , ,392 51, , ,707 19, ,754 Dar Alsalam 10, ,255 82, ,000 19,009 11,092 3, , , ,056 60, ,432 1, ,150 Credit Bank 18, ,954 43, ,840 25,654 4,589 4, , ,229 83,050 5, , ,073 10, ,893 AL-Huda 4, ,960 2, ,189 1,747 2, ,050 80,413 3,662 42, ,333 24, ,050 Mousel 28,451 35,553 16,521-66,336 8,795 19, , ,262 16,969 22,247 7, ,730 (42,093) 175,040 Gulf 12,585 30,640 23, ,000 53,599 20,991 18, ,740 61, ,927 18, ,031 (1,909) 260,740 Investment 9,689 82,861 83,217 89,415 10,446 7, ,487 48,792 74,467 14, ,446 43, ,487 Commercial Bank 6,193 34,660 50, ,000 13,845 9,477 1, ,780 50,900 26, ,676 20, ,780 Economic 11,793 24,768 64, ,396 27,296 22, , ,831 43,278 28, ,798 33, ,514 Babylon k 7, ,605 5, ,138 20,640 4, ,133 38,905 90, , ,978 (6,242) 193,133 Ashur 7, ,251 3, ,150 7,624 1, ,232 31,011 14,253 9, ,225 3, ,232 Mansour 6,555 39,277 27,167 56,500 37,135 4,044 1, ,015 28,741 43,310 10, ,723 3, ,015 Union Bank 3,216 34,683 9, ,300 9,381 6, ,264 12,042 11,915 18, ,772 (1,507) 105,264 National Bank of Iraq 4,448 34,725 3,958 9,348 43,144 4,646 3, ,074 21,458 27, ,856 (1,599) 104,074 Summer 1,465 20,971 32, ,845 8,898 2, ,170 11,622 19,940 1,850-2, ,939 1, ,170 Trans Iraq Bank 3,462 13,789 67,162 2,679 1, ,108 13,004 2, ,394 4,897 89,108 Bank Melli Iran ,484 2, , ,527 3, , ,012 (11,055) 26,527 Arab Banking 0 0 1, ,215 9, , , ,744 Corporation Ziraat Bank 201 4,838 2, , ,313 2, , , ,313 Byblos Bank 1,973 46,598 21,962 12,533 7,748 13,943 19, , ,300 6,493 11, , ,349 (39,168) 124,003 Intercontinantal ,321 26, , ,486 37,595 3, ,978 (661) 49,486 Bank Erbal Bank 233 6,509 56, ,250 1, ,188 14,225-1, ,856 (373) 116,188 Total Private Non Islamic 282,682 2,501,364 1,079, ,361 2,311, , ,176 7,717,569 2,683,295 1,616, ,427 34,016 31,369-2,292, ,376 7,717,569

206 182

207 ANNEXES 183 ANNEX 15: CONSOLIDATED STATEMENTS OF ISLAMIC BANKS (2010) (Million ID) End of Period Assets Reserves Currency Current Deposits with CBI Foreign Assets Claims on Govt. Private Sector & Others Bank Premises Other Assets Total Assets or Liabilities Kurdistan 51,073 91, , ,201 26,348 15, ,441 Dijah&Furat 7,597 63,627 13, ,338 22,406 8, ,337 Islamic Regional 16,734 69,350 23, ,774 14,652 4, ,470 Cooperation Islamic 7,045 26,540 6,315 18,296 6,588 6,918 71,702 Elaf 7,731 66,526 13,345 34,243 20,532 54, ,874 Islamic National Bank 1,118 36,564 2, ,785 3,657 18,343 81,795 AlBilad Islamic 9,764 81,619 57, , ,112 55, ,800 Gehan Bank 5,079 72,195 18,945 50,485 2,778 5, ,223 Total Islamic 106, , , , , ,087 1,978,642 End of Period Liabilities Deposits ( Private & Others ) Sector Current Time & Saving Deposits Vs. Guarantees & L / C Govt. Foreign Liabilities Credit from CBI Capital Reserves & Provisions Other Liabilities Total Assets or Liabilities Kurdistan 162,317 70,320 86,802 3, ,554 23, ,441 Dijah&Furat 35,656 20,888 13, ,266 66, ,337 Islamic Regional 33,867 29,237 4, ,876 2, ,470 Cooperation Islamic 12,194 9,629 1,298 54,546 (5,965) 71,702 Elaf 24,619 3,166 5, ,099 88, ,874 Islamic National Bank 29, , ,940 (6,468) 81,795 AlBilad Islamic 84, ,741 47, , , , ,800 Gehan Bank 22,417 11,110 2,055 58,070 61, ,223 Total Islamic 405, , ,370 3,932 7, , ,062 1,978,642 Source: Monetary and Statistics Division

208 184

209 ANNEXES 185 ANNEX 16: BANKING RATIOS (2010) (Percentage) End of Period Assets Reserves Currency Current Deposits with CBI Foreign Assets Claims on Govt. Private Sector & Others Bank Premises Other Assets Total Assets or Liabilities Islamic Banks to Total Banks Islamic Banks to Private Banks Islamic Banks to Private Non Islamic Banks Islamic Banks to State-owned Banks Private Banks to State-owned Banks Private Banks to Total Banks State-owned Banks to Total Banks End of Period Liabilities Deposits Private & Others Sector Current Time & Saving Deposits Vs. Guarante es & L / C Govt. Foreign Liabilities Credit from CBI Capital Reserves & Provisions Islamic Banks to Total Banks Islamic Banks to Private Banks Islamic Banks to Private Non Islamic Banks Islamic Banks to State-owned Banks Private Banks to State-owned Banks Private Banks to Total Banks State-owned Banks to Total Banks Other Liabilities Total Assets or Liabilities

210 186

211 ANNEXES 187 ANNEX 17: BANKING INDICATORS Table 1: Banking Basic Information 2009* No. Bank s Name Branches No. Establishment Date Total Assets or Liabilities (Million ID) Paid Up Capital (Million ID) 1 Rafidain Bank ,723,148 25,000 2 Rasheed Bank ,800,308 2,000 3 Trade Bank Of Iraq ,833, ,000 4 Agricultural Cooperation Bank ,591, Real Estate Bank ,055,993 50,000 6 Industrial Bank of Iraq ,990 25,000 7 Iraq Bank ,059 1,000 Total of State. Banks ,562, ,600 1 Warka Bank for Investment & Finance ,671 75,000 2 Bank of Baghdad ,729 85,200 3 Basrah International Bank for Investment 4 Al-Bilad Islamic Bank for Investment & Finance 5 Iraqi Middle East Bank for Investment 6 North Bank for Finance & Investment 7 United Bank for Investment 8 Dar Alsalam Investment Bank ,058 55, , , ,093 55, , , , , ,351 67,000 9 Credit Bank of Iraq ,758 85, Kurdistan International Bank for Investment & Development ,904 50, AL-Huda Bank ,920 25, Mousel Bank for Development & Investment ,375 50, Gulf Commercial Bank ,493 50, Investment Bank of Iraq 15 Commercial Bank of Iraq ,216 50, ,928 60,000

212 Economic Bank for Investment & Finance ,939 70, Babylon Bank ,479 50, Ashur International Bank for Investment 19 Dijah & Furat Bank for Development & Investment 20 Mansour Bank for Investment 21 Islamic Regional Cooperation Bank for Development & Investment ,233 57, ,475 50, ,009 75, ,656 50, Union Bank of Iraq ,108 50, National Bank of Iraq ,581 50, Summer Commercial Bank 25 Iraqi Islamic Bank for Investment & Development ,039 50, ,754 51, Elaf Islamic Bank ,331 20, Trans Iraq Bank ,240 56, Bank Melli Iran - Baghdad ,356 28, Islamic National Bank ,215 25, Arab Banking Corporation ,421 8, Ziraat Bank-Baghdad ,642 8, **Byblos Bank of Lebanon , **Emerlard Bank , **Gehan Bank for Investment & Islamic Finance 35 **Bank of Beirut & the Arab Countries 36 **Intercontinental Bank , , ,379 Total of Private Banks 383 8,674,834 1,833,466 Grand Total ,236,902 2,437,066 Source: Central Bank of Iraq * Banks were arranged according to their Financial Position ** Banks within Kurdistan Territory

213 ANNEXES 189 Table 2: Averages of Interest Rates at the Central Bank and Banks Details CBI Policy Rate Primary Credit Secondary Credit Lender of Last Resort Deposits Facilities ID Overnight deposits 8.17 ID 7 day deposits ID 14 day deposits ID 30 day deposits USD Overnight deposits 2.60 USD 7 day deposits USD 30 day deposits USD 90 day deposits Licensed Banks 1- In Iraqi Diner a- Interest Paid Savings Deposits Time Deposits for 6 months Time Deposits for 1 year Time Deposits for 2 years b- Interest Charge Current Account (overdraft ) Discounted Bills Short Term Loans Medium Term Loans Long Term Loans In Foreign Currency a- Interest Paid Savings Deposits Time Deposits for 6 months Time Deposits for 1 year Time Deposits for 2 years b- Interest Charge Short Term Loans Medium Term Loans Long Term Loans

214 190 Table 3: Iraq Monetary Survey, (In billions of Iraqi dinars, unless otherwise indicated) December December March June September December Est. Net foreign assets 59,113 55,173 54,004 46,459 59,787 62,570 Of which:cbi 58,841 49,794 49,341 46,459 54,408 57,191 Net domestic assets -22,238-8,439-3,465 4,222-8,043-7,331 Domestic claims -26,391-13,230-6,367-9,577-4,413-5,424 Net claims on general government Claims on general movement Less: liabilities to general govt. Claims on other sectors Other Item Net (OIN) -30,791-18,367-13,834-17,189-11,880-12,825 6,807 7,367 13,298 10,149 13, ,598-25,734-27,132-27,338-25, ,400 5,136 7,467 7,612 7,467 7,402 4,153 4,791 2,902 13,799-3,629-1,907 Broad money 36,875 46,734 50,539 50,679 51,745 55,239 Currency outside banks Transferrable deposits 18,492 21,776 22,681 23,895 23,891 22,993 13,264 18,615 21,395 20,379 21,391 24,185 Other deposits 5,119 6,343 6,463 6,405 6,463 8,062 Memorandum items Broad money (percentage growth) M2 velocity (ratio) Credit to the economy (percentage growth) Credit to the economy (as a percentage of non-oil GDP) Source: Iraqi authorities; and IMF staff estimates

215 ANNEXES 191 Table 4: Non Performing Loans by Sector for All Banks (In millions of ID) 2009 Agriculture, Forestry, Hunting & Fishing 26,023 Mining & Quarrying - Manufacturing Industry 33,719 Eelectricity &Ggas 453 Wholesale, RetailTtrade &Hotels 136,846 Transport, Communications & Storage 5,060 Finance, Insurance, Real Estate & Business services 8,045 Social services 15,191 Eexternal world 21 Building & Construction 13,255 Total 238,613 Table 5: Loans to Non Financial Enterprises, 2009 (In millions of Iraqi Dinars) Table 6: Iraq Income and Expense Statement for Banks, (In billions of ID) State banks Private banks All banks Interest Income Interest Expense Net interest income Non interest income Gross income Non interest expenses Personnel costs Other expenses Provisions Net income