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January 13, 2004

A Short Note on Credit Market in Iran
Borghan Nezami  [info|posts]

I should thank Ali Meli's post for opening the discussion about credit market in Iran. However, I think it is very misleading and, as an economist, I have to clarify it.

The most important underlying assumptions in his discussion are:

1) Checks are always being accepted as mean of payment (which is obviously not true);

2) Interest rate on debts which are secured by check is almost zero! (in contrary, they're very high, since lenders always take to account the highest possible risk of default, calculating the expected interest rate plus the the highest risk of default, and then asking for that amount as future payment);

3) Banks are responsible for paying for overdrawn checks (which is incorrect: banks just freeze the account observing the first overdrawn check; in contrast to most of checking accounts in North America, where the bank honors its check and pays it, and just charges a penalty to drafter);

4) There is no punishment for default (Actually if you default in the US, you can file for bankruptcy and it'll only lower your credit score, but in Iran you'll be jailed!);

5) Banks easily lend to individual at low interest rate (please name a bank which charges less than %25 interest rate for individual loans. Given the average %13 inflation in Iran, this means %12 net interest, one of the highest in the world);

Given these assumption, Ali concludes, the amount of outstanding debt is relatively high in Iran.

But quite opposite, it's very low; The outstanding non-governmental debt to banking system, which is mostly firms' debt to banking system and not housholds' debt, is less than %30 of Iran's GDP; Just to have an idea, morgage debts are about %60 of US GDP!

Due to lack of something like "Bureau of Credit”, which should keep track of people's credit worthiness, there is huge moral hazard and adverse selection going on in Iran’s credit market, causing less lending and therefore less borrowing. (There is a very tiny market for mortgage and no market for unsecured credit, i.e. credit card, in Iran).

I think it's incorrect to think the reason for real estate bubble is high outstanding debt; quite opposite: since people can’t invest their saving in an efficient credit market, by lending to those who want to borrow, they have to use other markets like real estate, car market and etc. for keeping their savings.

However, the cure will be exactly what has been mentioned in Ali Meli's post: Establishing Bureau of Credit, which keep track of people’s credit history and its data can be used for computing their credit worthiness; then different people with different default risk will be treated differently, lowering adverse selection and moral hazard, leading to more efficient credit market.

*Adverse Selection: When there are different types, and one cannot distinguish between them and treat them similarly, it's called "Adverse Selection"; for example, when banks can not determine whether a borrower is high risk or low risk, they can't assign different interest rates, to compensate for different default risks, and they have to treat both types similarly; obviously, this causes inefficiency

** Moral Hazard: Again, when types cannot be determined, when two different treatments are proposed, one type can pretend to be one of the other types and enjoy the better treatment. For example, if two different interest rates being proposed, obviously high risk borrowers will pretend to be low risk and enjoy the lower interest rate.

Sorry for short discussion and lack of sufficient statistics; I'll try to post a more elaborated version within a week.

Comments
Mehdi Y. at January 13, 2004 06:09 PM [permalink]:

I think what both posts are missing are outgoing links to some concrete statistics on what is going on in Iran in this regard. Such a statistics might not exist but I don't think the authors have attempted to do some research to find it.

Nanas at January 15, 2004 12:12 PM [permalink]:

Wow! What a great (and basically obvious) solutions! But please consider the Islamic Banking Schema that governs the whole banking system in your solutions too. Though from a borrower view banks really exploit customers by their 10+ percent premiums (Inflation is around 16.5 and profit - no interests!!! - rates are varying from 24 to 29) and almost grant nothing to depositors (From %7-short to at most %16-long-5Y) but the Islamic scheme differences from a conventional banking system causes the Iranian - Islamic Banking - to eliminate some very useful and widely used banking instruments. The major problem resides in "Islamization" e.g. overdrafts from a current account which in turn can cover a credit schema for individuals and result in a credit card service is NOT Islamic and then is abolished. I think the problem is basically government's having a normative look in an economic issue like banking, and so it can't be resolved by purely technical solutions.

azam asayesh at April 11, 2004 02:20 PM [permalink]:

i nead mor enformation ebout iran;s economy