VATICAN CITY (Reuters) - The Vatican bank is likely to close all accounts held by foreign embassies, following concerns about large cash deposits and withdrawals by the missions of Iran, Iraq and Indonesia, according to people with knowledge of the situation.

The Vatican's financial watchdog, which examined the transactions in 2011, believed the embassies' justifications for the transactions were too vague or disproportionate to the amounts — up to 500,000 euros at a time — these people said. In one case, a large cash withdrawal was said to be for "refurbishment", one person added.

Now the bank and the watchdog want to reduce the possibility that the Institute for Religious Works (IOR), as the bank is called, could be an unwitting vehicle for money laundering and other illicit finances.

Four people with knowledge of the matter said the closure of the accounts was likely to be a key recommendation of a broad review that Pope Francis has ordered of the bank, whose scandal-tainted history has long been an embarrassment for the Holy See.

The review is set to be completed by the end of the year.

It is the thorniest part of nascent efforts by the world's smallest state to open itself up to more outside scrutiny. The process ostensibly began under the former Pope Benedict, but was thwarted by conflicts among Vatican officials and an Italian money-laundering investigation.

The IOR is a private bank - currently with about 7.1 billion euros in assets under management - whose stated goal is to hold and manage funds for religious orders of priests and nuns, Catholic charities, Vatican employees, and other Catholic institutions. But the number of account holders has swelled to 19,000 over the years and diversified beyond the original categories with the right to hold accounts.

Fewer than two dozen of the 180 countries accredited to the Vatican have accounts at the IOR; many Western states such as the United States and Britain do not.

Reuters has learned that the Financial Information Authority (AIF), the Holy See's financial watchdog, wrote to the IOR in the second half of 2011 expressing its concern over several cash withdrawals and deposits by the embassies of Iran, Iraq and Indonesia, according to the people with knowledge of the situation.

The transactions - which were registered at the Vatican border in line with Vatican and European Union requirements that amounts of more than 10,000 euros in cash or equivalent be declared at customs - caught the eye of the AIF because of their origin, frequency and amounts. Iran, Iraq and Indonesia are classified by international institutions and governance bodies as countries at high risk of financial crimes. The Holy See's regulators also thought the justifications for the withdrawals, including one that simply said "personnel", were vague, these people said. It was not clear where the money for the cash deposits came from.

The Iranian and Iraqi embassies to the Vatican said they had no comment on the cash movements or the concerns raised by regulators.

The Indonesian ambassador to the Vatican, Bahar Budiarman, said that his embassy takes out up to 10,000 euros at a time from its IOR account and that the money is destined for personal use and petty cash. For bigger amounts, wire transfers are used, said Budiarman, who has been ambassador since early 2012.

An IOR spokesman stated in emails that the bank does not comment on matters concerning the AIF and that the IOR had no comment on the possible closure of embassy accounts.

The AIF said that "it does not give details about cases it investigates and does not comment on the....review of the bank".

The review of the IOR has gained momentum under Pope Francis, who became pontiff in March this year. In June, he created a special commission to advise him on how to reform the bank, and has not ruled out closing it altogether.

"If pulls off a restructuring of the IOR and gives it real oversight and transparency, it would go a long way towards convincing people that he's serious about reform," said John Thavis, longtime Vatican analyst and author of The Vatican Diaries.

IMPROVING STANDARDS

The Vatican moved to improve its financial transparency in 2010. That effort immediately hit a stumbling block when Rome magistrates investigating possible money laundering froze 23 million euros held by the IOR in two Italian banks. The IOR said it had been transferring its own funds between accounts in other countries. IOR officials told Italian magistrates at the time the money would be used to buy German securities, back then a safer bet than Italian securities, according to prosecutor's documents seen by Reuters. The magistrates later unfroze the funds, though the investigation continues.

Separately, AIF officials noticed in the summer of 2011 that large sums of money were moving several times a month in and out of the bank accounts held by the embassies of Iran, Iraq and Indonesia, according to the people with direct knowledge of the situation.

Withdrawing and depositing cash is not illegal, and embassies may legitimately transfer money in and out of the Vatican provided they offer sufficient details on the origin of the money and purpose of the transaction.

But international financial standards require banks to carry out thorough checks on the origin of large cash transfers and on the effective beneficiaries to rule out the possibility of money laundering, tax evasion and other financial crimes. Checks are heightened if the transactions involve countries, such as Iran and Iraq, considered by international regulators to be at high risk for financial crimes, and if high-level diplomats are involved.

Regulators working at the AIF at the time pressed the IOR for details about the transactions. The IOR replied, but referenced only the Iranian transfers and did not provide any further details about them, according to the people with knowledge of the situation. It did not mention the other two countries.

The AIF dropped its inquiries, according to these people. One top Vatican official briefed about the situation says the response was "silly" and that the AIF should have tried to follow up. The AIF management has since changed.

Earlier this year, Ernst Von Freyberg - a German lawyer hired in February to run the IOR - told colleagues that embassy accounts were potentially dangerous, and that he wanted to close them, according to a person with knowledge of the event. But the proposal was blocked by the Vatican's powerful Secretariat of State, whose officials feared the move might hurt diplomatic relations, this person said.

A report by Moneyval, the Council of Europe's anti-money laundering committee, said last year that while the Holy See had taken steps to improve standards, more needed to be done. The committee, which carried out the review at the Vatican's request, is due to conduct a new assessment later this year.

The bank is also coming clean on possible illicit financial activities. The Vatican has said it detected six possible attempts to use the IOR to launder money last year, and at least seven in the first half of this year. In one case, a prelate who had close ties to the IOR was arrested in June on suspicion of plotting to smuggle 20 million euros in cash into Italy from Switzerland to give to rich friends in southern Italy. The prelate, who will be tried in December, says he was not acting for personal gain.

(Edited by Alessandra Galloni, Simon Robinson and Philippa Fletcher)