Sanctions on Iran may have been partially lifted in January, but the country’s troubled banking sector has hardly felt the benefits of the nuclear deal yet. That is because the US continues to impose financial sanctions on Tehran for sponsoring terrorism and for money laundering, threatening hefty fines against any banks with operations in the US that does business with Tehran, which include most of Europe’s largest banks.

After three frustrating months trying to access international financing and to retrieve its $100bn in frozen assets from abroad with limited success, the Iranian authorities are beginning to fire back. During a rare visit to Washington to attend the World Bank and International Monetary Fund meetings, the central bank governor, Valiollah Seif, warned on April 15 that the nuclear deal would “break up under its own terms” if the US does not “do whatever is needed to honour their commitments”. US officials deny that they are blocking Iran’s access to foreign capital and that they would not stand in the way of entities doing legitimate business with Iran.

A step forward in reconnecting Iran’s Islamic banks to international markets is that, starting in January, global payment processer Swift has been gradually reconnecting Iranian banks to its system after a four-year hiatus, which will enable them to process international payments. Furthermore, Tehran has begun to take modest steps to tackle some of the problem areas, such as ratifying a law to combat financing terrorism in March.

But based on the slow post-sanctions start for Iranian banks, it will take some time for them to become liquid enough to finance developments in infrastructure, manufacturing and construction, despite the urgency with which large investments are needed in these key sectors. And time is a precious commodity for the administration of the moderate Iranian President Hassan Rouhani, who has repeatedly come under fire from conservative politicians and clergy in recent months for insufficient economic growth since the sanctions started being lifted.

Without a functional banking sector, the Iranian economy and its moderate political establishment are looking at an uncertain future.

In his Washington speech, Seif conveniently left out the domestic problems plaguing Iranian banks, such as low liquidity and poor asset quality caused by the faulty economic policies of the previous administration of Mahmoud Ahmadinejad.

After being forced to give out loans to all types of economic projects in the 2000s without much in the way of due diligence, Iran’s 28 Islamic banks are now paying the price for policies they never asked for. The official rate of non-performing loans (NPLs), which stood at 12% in March 2015, the latest official figure available, is considered to be a gross underestimation of the extent of the problem. Observers believe NPLs range from $60bn to $120bn. Senior officials like Akbar Torkan, chief adviser to President Hassan Rouhani, placed the figure at the lower end of the spectrum – $80.5bn out of a total loan portfolio of $240bn – in January 2015.

As a result, banks suffer weak asset quality and very low capital buffers – major problems that are exacerbated by the lack of a system to assess credit risk effectively, Oliver Coleman, the Middle East and North Africa analyst for global risk consultancy Maplecroft, argues. “Distortions in the banking sector have also taken a toll on the real economy; over the past few years, cash-strapped banks competing to attract capital from savers have set exorbitantly high deposit interest rates. The peak was in early 2015, when interest rates of over 25% were common,” Coleman writes in a recent report.

The Central Bank of Iran (CBI) is working to reduce interest rates by establishing a ceiling of 18% in February 2016, but bringing them down to more sustainable levels will take time.

High deposit rates have resulted in equally inflated loan rates, which, compounded with the high rate of NPLs, means that businesses have a hard time financing new investments. When they do take out loans at such prohibitive interest rates, it is normally to refinance previous loans. According to financial columnist Morteza Mirmohammadi, as much as 80% of the loans given out in the March 2014-March 2015 financial year were used to refinance previous loans. “The CBI has tried to force banks to lower interest rates, but its efforts have been in vain because banks are borrowing at high rates, so they have to lend at high rates as well,” he tells bne IntelliNews.

The prospects for corporate banking might be modest, but consumer finance is even less likely to take off in the near future, Mirmohammadi contends, as US-based Visa and MasterCard continue to be banned from offering their services to Iranian banks by the American authorities.

The way out

Unfortunately for the Rouhani administration, there is no quick fix for Iran’s banking woes, Coleman contends; instead, Tehran should look for long-term solutions in the form of a comprehensive reform of the sector. One of the solutions that Tehran is considering is the establishment of an asset management company that could absorb the banks’ bad assets, allowing them to start over with clean balance sheets. But in the longer term Coleman believes that reforms have to tackle the numerous shortcomings in the governance of the banking sector.

While the CBI is pushing banks to implement Basel III recommendations to improve supervision, regulation and risk management in the sector, Tehran also would do well to look at ways to increase the autonomy of banks and limit political influence over them. The majority of Iran’s banks – 20 out of 28 – are ostensibly private, but they remain affiliated to public institutions that interfere in their management.

Worryingly, the Revolutionary Guard – the armed militia tasked with protecting the Islamic revolution – controls big parts of the economy, including some banks, and are the target for many US sanctions against the country. Ansar Bank, for instance, is known as being under Revolutionary Guard control. But instead of acknowledging the problem of state control, officials like Seif have limited themselves to advising foreign companies to “know who their partner is” when entering the Iranian market.

In turn, Washington needs to clarify the terms of its financial sanctions on Iran, and the possible repercussions for European banks that trade with the country. After being fined some $15bn for violating sanctions in 2009-2015 by US authorities, Europe’s largest banks – BNP Paribas, HSBC, Standard Chartered, ING, Credit Suisse, Commerzbank – are understandably wary of financing Iranian companies and banks or European companies that want to do business there.

Some of the smaller banks on the continent like Belgium-based KBC and Germany’s DZ Bank have begun to process transactions on behalf of European companies that do business in Iran, the Financial Times reports. And pressure has been mounting for larger banks to follow suit, and for Washington to allow them to do so. If the US is truly in favour of allowing “legitimate business with Iran” in order to meet “not just the letter, but the spirit of our agreement”, as State Department spokesman Alan Eyre has said, now would be a good time to prove it.