CHAPTER SIX

OVERVIEW OF ETHIOPIAN FINANCIAL

SYSTEM

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 Financial Markets and Institutions in Ethiopia
 The State Bank of Ethiopia operated as both a commercial
and central bank until 1963 when it was dissolved to
form the central bank, the National Bank of Ethiopia
(NBE), and the Commercial Bank of Ethiopia (CBE).
 A number of other private financial institutions were also
established during the 1960s.
 The structure of Ethiopia's financial system therefore
resembled that of other African countries at this time.
 All of this changed with the overthrow of the monarchy
of Haile Selassie in 1974.

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 Cont…
 Under the Derg (meaning the committee [of solders] in
Amharic) regime all privately owned financial institutions
including three commercial banks, thirteen insurance
companies and two non-bank financial intermediaries were
nationalized on 1 January1975.
 The NBE continued its functions as a central bank, although
the directives of the planning system now circumscribed its
activities.
 The NBE fixed both deposit and loan rates (both of which were
set at very low levels), administered the allocation of foreign
exchange (all of which had to be surrendered to NBE), and
directly financed the fiscal deficit (NBE 1996a).

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 Cont…
 NBE's bank supervision and regulation was largely
restricted to off-site inspection of a few bank branches.
 By allocating credit and foreign exchange in favor of the
state sector, NBE constituted a powerful tool for imposing
state-led development.
 Credit to the private sector fell from nearly 100 per cent
of total bank credit under the monarchy to only 40 per
cent under the Derg.
 The Agriculture and Industrial Development
Bank(known today as the Development Bank of Ethiopia)
allocated 68 per cent of its resources to State farms.

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 Economic transition and financial reform
 Economic reform began soon after the new government
took power.
 War and the Derg's policies had left a crippled economy
and an impoverished people.
 Fiscal policy aimed to raise revenue and to reduce the
fiscal deficit which became a source of inflation.
 Structural reforms concentrated on lifting most domestic
price controls, reducing import tariffs, and moving to a
market-based system of foreign exchange allocation.
 Exchange-rate reform, which was an essential first step
in achieving economic recovery, began in October 1992.
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 Cont…
 In 2016, the government is following a managed
floating exchange rate policy.
 Until recently, despite a significant gap between imports
and exports, where exports financing only 20% of
imports by 2016 – the parallel market premium
remained insignificant being about Birr 0.20- to 0.30
(1.5%).
 This premium has dramatically increased to about 5 Birr
(about 23 %) in January, 2017 –doubling from 14% in
November 2016.
 This has happened following the relapse to violent
conflict in the country after nearly a decade of relative
peace.
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 Cont…
 The economy has responded reasonably well to reform
despite the structural constraints characteristic of a
predominantly agrarian economy (large annual
fluctuations in GDP occur in response to weather
variations), terms of trade shocks (the decline in the
coffee price) and the 1998-2000 war with Eritrea.
 Inflation also became a major macro challenge since the
2005 violent election.
 Following this early period of post-reform Ethiopia in the
1990s, economic growth has been very good (extremely
good if we take the official statics which shows a double
digit growth for a decade.
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 The New Private Banks
 Financial reform began in earnest in 1994. NBE's role in
overseeing the commercial banks was codified.
 Sector-specific interest rates administered by NBE were also
ended, and replaced with a minimum deposit rate (10 per
cent) and a maximum lending rate (15 percent).
 The domestic private sector was permitted to enter the
banking and insurance business (foreign financial institutions
are not yet permitted to invest).
 The response to these reforms has been promising.
 There were 6 private banks at the initial stage of this reform
and this has grown to 19 by 2016.
 There were also 8 private insurance companies at the initial
stage of the reform. This has grown to 14 by 2016.
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 Cont…
 The market shares of the private banks, although growing,
still remain small relative to those of the publicly owned CBE.
 CBE dominates the deposit market (its share was 87.6 per cent
in 1995/96) a reflection of CBE's national coverage .
 However, CBE's dominance in the loan market has eroded, its
share having fallen to 56.3 per cent in 1997/ 98 from 83.9
per cent in 1995/96 and to 51.2 % in 2015.
 Another public institution, the Development Bank of Ethiopia,
has captured some of this share, but the new private banks
have raised their share to 17.3 per cent at this initial stage of
the reform.

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 Regulating the New Financial Sector
 Financial markets are inherently imperfect, characterized as
they are by asymmetric information in the relationship of
borrower to lender.
 In Ethiopia this imperfection is aggravated by the
institutional under-investment of the Derg era.
 It is after the fall of the Derg , the public and private banks
beg an developing the capacity to evaluate loan risks in the
context of a market economy and are yet to offer the full
range of financial instruments required by potential clients
(which vary from large commercial enterprises to micro-
entrepreneurs).

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 Cont…
 The supporting framework of commercial law and
accounting practice both essential to sound financial systems
are highly underdeveloped in Ethiopia.
 For these reasons, investment in NBE's capacity to regulate
the financial system in the public interest must get the
highest priority.
 Under the Derg, regulation consisted of enforcing interest-
rate controls and the allocation of credit and foreign
exchange according to the dictates of the planners.
 Thus, it was a must for NBE to learn the skills of prudential
regulation and supervision appropriate to a market-based
financial system

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 Cont…
 NBE's supervision consists of both off-site surveillance and
on-site examination.
 NBE's off-site surveillance mechanisms require banks to
submit key financial data such as the composition of lending
and the scale of non-performing loans on a regular basis in
order to identify all the risks to which each bank is exposed.
 To maintain further the stability of the financial sector the
NBE has also issued various directives.
 The NBE,
 first, stipulated the maximum outstanding loan relative to the
total capital not exceed 35 per cent of the total capital of the
commercial bank in question.

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 Cont…
 Second, to reduce ex-ante risks, it has issued a loan provision
directive that force banks to craft and work out Non-
Performing Loan (NPL) reduction plan.
 Third, the NBE has also issued various directives with the aim
of reducing other ex-ante risks.
 These includes: reserve requirements (15%), liquidity requirements
(25%), minimum capital adequacy ratio (of 12%), minimum paid
up capital (of 75 million Birr out of 500 million startup),
among others.

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 The Development, Policy and Regulation of the Banking,
Insurance and Microfinance Markets
• Ethiopia has conducted financial sector reform
following the change in government and economic
policy 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 through monetary, banking and
insurance supervision laws that are enacted in 1994
and amended in 2008.
• It has made inter-bank money and foreign exchange
markets operational as of 1998.
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 Cont…
• It has also introduced a regulatory regime for
microfinance, required the formal establishment of the
microfinance institutions within the financial system,
and required the NBE to promote development of the
traditional savings institutions of the society along with
the microfinance institutions and to encourage
participation of the banks and other financial
institutions in the provision of microfinance by a law
enacted in July 1996 and amended in 2009.
• It subjects the banks, insurers and microfinance
institutions to supervision laws that are similarly
fashioned and complementary to one another.
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 Cont…
• It also allows the transformation of the microfinance
institutions into formal banks and the direct engagement
of the formal banks and insurers in the provision of
microfinance.
• It has licensed twelve private banks, eleven private
insurers, thirty microfinance institutions and more than
one thousand insurance auxiliaries under this regime.
• There are also government owned three banks and one
insurer.

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 Cont…
• The country has not, however, achieved desirable level
of banking, insurance and microfinance services.
• All the services are at their beginning stage of
development and a substantial size of the Ethiopian
population still lives without them.
• The banks, insurers and microfinance institutions are
also weak in their fixed capitals, service types,
governance and competitiveness.
• They have not diversified, modernized, automated and
networked their services.

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 Cont…
• The banks, other than the Development Bank of
Ethiopia, also concentrate on short and medium
term trade finance while the insurers
concentrate on short term general insurance
making the total long-term insurance less than
six percent of the total insurance business in the
country.

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 The Development, Policy and Regulation of Securities
Market
• Ethiopia had a securities market in the 1960s and 70s.
• The market was closed because of change of policy in
1974.
• The country does not have a securities market currently.
• It has created only an agricultural commodity market
which is owned fully by the government and operated
outside the financial market.
• The creation of securities market is justified in the
country by the following functions:

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 Cont…
• providing long term finance which the banks are not
doing;
• meeting the growing need for domestic resource to
finance investment;
• providing market place and thereby enhancing the
transferability, liquidity and proprietary value of existing
securities;
• curing the excess reserve and liquidity positions of the
banks;
• enabling the NBE to enforce monetary and financial
policy objectives through indirect and open market
instruments;
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 Cont…
• encouraging the creation of institutional savers and
investors, diversifying the financial market and
increasing competition;
• motivating companies to go public and widen their
ownership bases;
• enhancing information flow and corporate
management, accounting and control;
• assisting individuals, households, business firms and the
financial institutions to diversify their income and
investment portfolios; and
• facilitating future privatization.
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The Development, Policy and Regulation of Private Pensions
• Ethiopia does not have comprehensive social security. It has
only occupational pension for government employees, some
provident fund scheme for private sector employees, and
some social assistance for the old, the destitute and the
needy.
• The occupational pension for the government employees
does not serve as universal basic system since it provides
only subsistent income to very small population of the
country.
• It does not also serve the functions of facilitating saving,
employment, investment, corporate finance and capital
market development since its benefit payments are small
and its resources are hardly invested.
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 Cont…
• The private sector provident funds and social assistances
do not also serve these functions since they are informal
and voluntary payments.
• The occupational benefits and severance pays in the
private sector are also piecemeal and negligible.
• The provision (and consumption) of life insurance and
pension annuity is also very negligible.
• The country needs to expand its pension coverage in
order to curb these problems and reduce retirement
poverty.

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 Cont…
• The country also needs to focus on two functions
which are important for the development of the
financial market:
a) forcing saving and
b) mobilizing the saving for investment.
• The Ethiopian households and individuals are reported
to have very limited saving due to both their
expenditure habits and the low levels of their incomes.

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 The Design of Means of Enforcement of Regulation
• Ethiopia makes the NBE regulator of all the financial
institutions, markets and auxiliaries and enforces the
existing regulations through banking, insurance and
microfinance supervision departments organized in it.
• It confers it with the powers of licensing, inspecting,
examining and sanctioning the financial institutions,
markets and auxiliaries.
• It also confers it with some discretion and autonomy from
the government.
• It also authorizes it to finance its regulatory functions by its
own funds except in cases where it has been fixed by law
that the funding has to be borne by the regulated
institutions.
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