Are Iraqi Banks Too Liquid?

By Mark DeWeaver.

Fund managers visiting Iraq for the first time are often surprised by the large amounts of cash Iraqi banks typically hold. While the Central Bank of Iraq (CBI) requires lenders to hold 15% of their deposits in the form of vault cash and central bank reserves, most hold well over 50%. (See Chart.) “Cash in hand and at bank,” rather than loans, is usually a bank’s single biggest asset.

Bank managers will tell you that they need cash to meet unexpected large withdrawals by depositors. But this is true of banks everywhere. Why should Iraqi lenders be so much more liquid than their counterparts in other countries? Aren’t they being overly cautious?

Their behavior doesn’t seem so strange when you consider the fact that Iraq lacks an interbank market. Ordinarily, banks with a cash shortfall at the end of the day can borrow overnight from those with a surplus. As long as the public’s demand for banknotes is unchanged, withdrawals from bank A end up as deposits at bank B, ensuring that A’s demand for short-term money can usually be easily met.

In Iraq, a bank that ends up with a cash shortfall will be forced to borrow from the CBI, which offers seven-day facilities for this purpose. This is a much less attractive alternative than borrowing from another commercial bank.

Foreign institutions that are perceived to be in trouble may still be able to access funds in the interbank market provided that they are willing to pay a large enough premium over LIBOR. The central bank, however, is both lender and regulator. It is certainly not going to provide liquidity to the highest bidder regardless of the circumstances. (In fact, CBI facilities are available at a fixed rate—two percentage points above the CBI’s policy rate.)

It is thus not surprising that Iraqi banks choose to rely on their own funds. Their high levels of liquidity are not a sign of risk-aversion or incompetence, as is sometimes suggested. In the absence of an interbank market, liquidity risk is the biggest risk they face. They need to be ready not only for ordinary levels of withdrawals but for worst-case scenarios as well.

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