Chapter 5

The Regulation of Financial Markets and Institutions

The nature of financial system regulation

The regulatory environment is changing to provide for changing economic conditions to improve the efficiency
and operation of organized financial market.

The purpose of regulation is to:

Provide the welfare for the general public.

For more than a century, American consumer and business person have called public policies which make
financial institutions competitive and sound. In response to the public demand the state and federal government
legislated standard of conduct and credit regulation agencies. Example: security exchange act of 1934 & 1975.

Remove barriers to competition

Faster the development of national security market system and national clearance and settlement
system.

Through the prohibition of undesired acts and promotion of competition and common objective regulation is
intended to improve the effectiveness and efficiency of financial institution and welfare.

Proposed changes in the structure of regulation are based on a set of general objective:

 Increasing competition
 Increasing the flexibility of financial institution to response to the changing need of individual and
businesses.
 Maintaining a base for effective monetary policy.
 Preserve a sound and resilient financial system.

These objectives are intended to promote a stable and growing standard of living.

The regulation is designed to increase confidence and stability i.e. confidence in the financial system
promotes to increase the flow of saving to investment.

The effect of regulation on institution management

Regulation changes the alternative action available to financial institutions management and consequently
become a factor in management decision.

Government regulation causes change in the:

 Investment portfolios
 Security issued
 Operation of financial institution

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The regulation of commercial banks

Due to their importance in the financial system, commercial banks are typically the most regulated financial
institution. Responsibility for the regulation of bank activity in US today is divided among the overlapping
three federal bank agencies.

1. Federal Reserve System

The Federal Reserve System is responsible for enhancing and supervising activities of all its member banks
related to:

 Merger and acquisition

 Establishing branch offices

It is responsible to supervise the US based international banking corporations for:

 Overseeing the operation of member banks in foreign countries

 Regulating the activity of foreign banks inside the US.

 It also fest the reserve requirement on deposit for all depository institutions.

2. Office of controller of currency (OCC)

It is administrator of national bank and the oldest regulatory agency in US.

It has the power to issue the federal charter for the creation of new international bank. Once they are chartered
are subject to an impressive array of regulation most of all which pertains the kind of loan and instruments that
are made and the amount.

All national banks are supervised periodically by the controller team and may be liquidated or consolidated
with another financial institution.

3. Federal Deposit insurance corporation

Insures the deposit of commercial banks, saving banks and saving and loan association.

Regulation of thrift institution

Credit unions

They are chartered and regulated at both federal and state government. They are closely regulated in the service
they provide to the public and the type of deposit they can sell.

Saving and loan associations

Are regulated by and can receive their charter of corporation from either federal or state government agency
who supervise their activity and regularly examine their books.

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Saving banks

It can also be chartered by either the state or federal government. State and federal government have to share
responsibility of furnishing saving banks and regulate closely a type of asset a saving bank is permitted to
acquire.

Arguments against or for financial regulation

 Arguments on the positive due

By economist George Stinger (1965) suggested that regulated industries are far from dreading regulation,
actually invite government intention expecting to benefit from it.

This is true because regulators may prevent entry into an industry; the firm involved may earn excess profit or
monopoly rent due to absence of competitors.

Therefore the listing of regulatory rules may bring about a decrease profit for financial institution

By Edward Kane (1981) suggested that regulation tends to increase public confidence in regulated industries.
Thus customers may trust their banks stability and reliability more because they are regulated increasing
customer loyalty and helping shelter from risk.

 Arguments on negative side

Regulations are costly and can reduce competitiveness of regulated institutions than less regulated. The costs
could be for the purpose of checking the compliance of the institution towards the rule.

Regulation is defined as the supply of regulatory and supervisory services . The concept of
deregulations is often confused with unregulated markets.

There are six distinctive arguments on regulation which need a special mention at this stage. These six
positions may be summarized as follows –

(1 ‘Free markets outperform regulated markets’, which is based on the fundamental theorem of welfare
economics which advocates competitive equilibrium as an optimum efficient outcome where marginal
revenue equals marginal cost, preventing discriminatory pricing and promoting service quality through
economies of scale.

(2) ‘Regulation is inefficient’ as it increases agency costs, distorting agency relationships. in unregulated
economy, management will voluntarily agree to supply shareholders with financial information to aid
monitoring because they can do so at a lower cost and because it provides evidence of contractual
undertakings not to transfer wealth.

(3) ‘The stock market is a fair game’ where information concerning companies is rapidly absorbed
making quoted prices unbiased estimates of the true market value. A stronger version of the efficient
market hypothesis supporting this view claims that investors cannot earn above average benefits
analyzing financial statements. Therefore regulation is unnecessary.

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 (4) ‘ That regulations of innovations in financial products and services can result in social costs’
which are the sum of administrative costs and the smaller of forfeited economies of scope and avoidance
and joint costs.

Moreover the regulation of innovation in financial services and product will inhibit the growth of
innovations and / or foster them if the benefits of joint production or economies of scope exceed
avoidance and joint costs.

(5) ‘Regulatory capture occurs as public or private groups manipulate regulations for their own
interests’. The origin of regulation, whether from public or private interests will determine whether and
how the regulator is captured. This is similar to the life cycle theory of regulation, where the regulatory
failure is seen as inevitable part of growth.

(6) ‘Experts should regulate themselves, as the free operations of ethics is more efficient and effective
than regulations’, therefore regulations of self regulatory professions is unnecessary. Such professions
use cancellations of membership as the ultimate sanction. As it may destroy a career and livelihood, it
should only be decided by the experts, the profession itself.

These six arguments can be summarized into two theorems –

1. Regulation is counterproductive in achieving its own economic goals of efficient resource allocation and its
social goal of protection of public and private interests ( arguments 2. 3, and 4)
2. The free market mechanisms include self regulation by experts and professional ethics will always produce
an outcome closer to optimality and more likely to promote the enforcement of agency relationships (
arguments 1, 5, and 6)
History of financial institutions in Ethiopia

Ethiopia felt the need for having formal banking only after establishment of Addis Ababa as its permanent
capital in 1886. It started it by establishing the Bank of Abyssinia on February 16 1906 in partnership with the
British owned National Bank of Egypt after a 50-years-concession agreement was signed in 1905 between
Emperor Minelik II and Mr. M. Gillivray (who represented the National Bank of Egypt). It established this
bank with powers of issuing bank notes and monitoring the legal tender as a central bank. It also required the
deposit of all government and public funds in the bank and the making of all payments by the bank to be in
cheque. The bank was, however, liquidated for replacement by the Bank of Ethiopia in 1931. The latter bank
was established in August 1931 with ownership of sixty percent of its capital by the government. It operated
only until invasion of the country by Italy in 1935.

The Italians then established branches of the Banca d’Italia, Banco di Roma, Banco di Napoli and Banca
Nazionale del lavoro and started operation in the main towns of Ethiopia as of that year.

In 1943 the country established the State Bank of Ethiopia which went operational on the 15th of April 1943. It
created it as central and principal commercial bank with powers to issue bank notes and coins as agent of the
Ministry of Finance of the time and to engage in all commercial banking activities. It also established the
Development Bank of Ethiopia by Imperial Charter of 1951.

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It separated the central and commercial banking functions of its banks for the first time by enacting a Monetary
and Banking Proclamation and a National Bank of Ethiopia Charter Order, and thereby dissolving the State
Bank of Ethiopia and creating the National Bank of Ethiopia as central bank and the Commercial Bank of
Ethiopia Share Company as commercial bank, in 1963. It also allowed the formation of private domestic banks
and the entry of foreign banks through joint ventures with maximum foreign ownership of forty nine percent.

 Modern insurance was also introduced in the country as far back as 1906 when the Bank of Abyssinia
transacted fire and marine insurance as agent of a European insurance company.

The country did not also have comprehensive monetary, banking and insurance regulation prior to enactment of
the Monetary and Banking Proclamation and the National Bank Charter Order in 1963 and the Insurance
Proclamation in 1970.

The country has reformed its financial sector following the economic policy change in 1991. It has re-
established the National Bank of Ethiopia (NBE) as central bank and financial market regulator and opened the
banking and insurance sectors for domestic private investment.

It has introduced a regulatory regime for microfinance institutions for the first time in its history and required
their formal establishment as financial companies under supervision of the NBE to cater for the credit needs of
small scale producers, service providers and peasant farmers by enacting a microfinance institutions supervision
law on the 5th of July 1996.

The NBE has, accordingly, licensed twelve private banks, eleven private insurers, thirty microfinance
institutions and more than one thousand insurance auxiliaries along with the hitherto existing government
owned three banks and one insurer until June 2010.

Regulatory frame of Ethiopia

Ethiopia did not define the reasons and objectives of its banking and insurance laws prior to enactment of the
Monetary and Banking Proclamation of 1963, the NBE Charter Order of 1963, and the Insurance Proclamation
of 1970. Only these laws included objectives. The Monetary and Banking Proclamation and the Charter Order
made it clear that the purpose of the NBE was fostering monetary stability and credit and exchange conditions
that are conducive to the balanced growth of the economy of the country.

Regulation on Number and Nationality

Ethiopia does not currently have limits on the number of banks, insurers and microfinance institutions that have
to be licensed. It, however, prohibits the ownership of these institutions by foreign natural and foreign owned
juridical persons.

Regulation on Location and Registration

Ethiopia has not decentralized the formation and regulation of its financial institutions. It establishes the
government banks and insurer by laws of the Federal Government.

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Regulation on Legal Form

Ethiopia allows only share companies (besides the government enterprises) to undertake the banking, insurance
and microfinance businesses.

Regulation on Initial Capital

Ethiopia requires the banking, insurance and microfinance companies to have fully subscribed and partly paid
up share capital before commencement of business and to maintain unimpaired minimum capital throughout
their life after commencement of business.

Regulation on Ownership Spreading

Ethiopia spreads the shareholding in the banking, insurance and microfinance institutions by prohibiting all
persons from holding more than five percent (more than twenty percent in the case of the insurers) of the total
shares of the institutions on their own as well as jointly with their spouses and persons below the age of
eighteen years who are related to them by consanguinity in the first degree.

Regulation on Business Plan, Organizational Structure and Disclosure

Ethiopia requires the applicants for banking, insurance and microfinance business license to provide the NBE
with information on their formation costs and liabilities, feasibility studies, projected financial statements,
proposed organizational structures and functions, curriculum vitae (of chief executive(s), founders and
directors), ownership certificates and evidences (for their paid up capitals, valuations of contributions in kind
and insurance coverage’s, if any)

Regulation on Management and Ownership Quality

Ethiopia authorizes the NBE to enact qualification, fitness and propriety criteria for influential shareholders of
the banks and the directors and chief executives of the banks, insurers and microfinance institutions.

Regulation on the Rules on Granting and Termination of License

The National Bank of Ethiopia is required by law to issue and renew the banking, insurance and microfinance
licenses on annual basis. It has to respond to the applicants for license and for branching permit within a period
of ninety (sixty for microfinance) and thirty days, respectively, from the date of its receipt of the applications.

Regulation on Capital Adequacy, Reserving and Provisioning Requirements

It requires the banks and microfinance institutions to maintain capital adequacy (i.e. unimpaired minimum
capital) that shall not be less than a minimum amount that will be determined by the NBE.

The reserves and statutory (cash) deposits of the banks, insurers and microfinance institutions are meant to
serve the purposes of maintaining the integrity of their capitals and guaranteeing their liabilities.

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Regulation on Accounting, Balance Sheet and Valuation Rules

Ethiopia requires the banks, insurers and microfinance institutions to keep books of accounts following
generally accepted accounting principles; to have all their assets, whether forming part of their capital or not,
valued by experts acceptable or approved by the government; to have their books of accounts audited by
independent auditors to be appointed under approval of the NBE and their supervising bodies; and to report the
state of their financial activities and affairs to the NBE and to the bodies responsible to supervise them.

The Ethiopia Commodity Exchange (ECX)

There is no formal organized stock exchange in Ethiopia. However efforts are in place to establish a stock
exchange very soon. So far the Ethiopian economy was successful in establishing a commodities exchange.

The Ethiopia Commodity Exchange (ECX) is a new initiative for Ethiopia and the first of its kind in Africa.
The vision of ECX is to revolutionize Ethiopia’s tradition bound agriculture through creating a new
marketplace that serves all market actors, from farmers to traders to processors to exporters to consumers. The
ECX is a unique partnership of market actors, the Members of the Exchange, and its main promoter, the
Government of Ethiopia. ECX represents the future of Ethiopia, bringing integrity, security, and efficiency to
the market. ECX creates opportunities for unparalleled growth in the commodity sector and linked industries,
such as transport and logistics, banking and financial services, and others. The Ethiopia Commodity Exchange
(ECX) commenced trading operations in April 2008. ECX has invited membership of the agricultural and trade
industry. ECX assures all commodity market players the security they need in the market through providing a
secure and reliable End-to-End system for handling, grading, and storing commodities, matching offers and
bids for commodity transactions, and a risk-free payment and goods delivery system to settle transactions,
while serving all fairly and efficiently.

The Ethiopian Commodity Exchange was started to benefit and modernize the way Ethiopia was trading its
most valuable assets, its commodities. Ethiopia needed a change from the traditional means of trading to better
support the needs of all those involved in the trading and production.

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