A New Era for Financial Inclusion

Ethiopia’s Growing Interest-Free Banking Brings Transformative Change

Ethiopia’s financial sector is undergoing a significant transformation, with Islamic banking emerging as a critical driver of inclusion and economic empowerment. This surge responds directly to the substantial Muslim population’s demand for Sharia-compliant financial instruments.

Previously absent, interest-free banking gained a foothold in 2011 through designated windows within conventional banks. Recognising its immense potential, Ethiopia took a bold step in 2020, permitting full-fledged Islamic financial institutions to be established. This regulatory shift opened doors for a broader range of Sharia-compliant products, fostering financial inclusion for unbanked Ethiopians.

The impact extends beyond individual empowerment. Islamic banking principles, built on profit-sharing and risk-sharing mechanisms, encourage entrepreneurship and business growth. Interest-free banks act as catalysts for job creation and economic diversification by financing ventures based on shared success.

EBR’s Eden Teshome’s exploration delves deeper into this compelling story. Her analysis sheds light on the specific financial products offered, the reach of Islamic banking in different regions, and its measurable contribution to Ethiopia’s economic development. Examining success stories of individuals and businesses that have thrived under this evolving system will further illuminate the transformative power of Islamic banking in Ethiopia.

Ethiopia, home to a substantial Muslim population, recognised the importance of integrating Islamic finance into its financial system a little more than a decade ago. Islam is the second-largest religion in the country, with approximately 31.3 to 35.9 % of the country’s total population of around 120 million people following the faith (according to various statistics). In response to this significant demography, the Ethiopian government took a proactive step in 2011 by developing a policy introducing interest-free banking. This move enabled commercial banks to offer services that align with Islamic principles. The National Bank of Ethiopia (NBE) issued a directive to regulate and authorise these interest-free banking operations. Subsequently, several banks obtained licenses from the NBE and established interest-free banking windows, catering to the needs of the Muslim population and others seeking ethical financial solutions.

Some Muslim depositors in Ethiopia have placed their funds in conventional banks without earning interest. They intend to avoid participating in interest-based transactions dictated by Sharia principles. However, this approach inadvertently results in their funds being utilised for interest-generating activities, contradicting their original intent.

But after NBE started giving licenses to these banks, they have since been able to mobilise funds from the unbanked Muslim population and individuals who already hold deposit accounts with conventional banks, despite their choice because they were left without options. While some authorised banks have yet to commence offering interest-free banking services, this delay primarily stems from the need to ensure liquidity and effectively manage associated risks.

It is important to note that these authorised banks may enter into time or saving Mudarabah, an Islamic finance arrangement that functions like a profit-sharing partnership, deposit contracts with customers, introducing liquidity risks and potential challenges in meeting withdrawal requests. Managing these risks is crucial for smoothly operating interest-free banking windows or savings accounts.

In the bustling streets of Addis Ababa, we spoke with Ahmed and Aisha, a young couple who recently decided to switch to interest-free banking options offered by a local bank. Their story sheds light on the motivations and experiences of individuals who choose Islamic banking and its impact on their financial well-being.

Ahmed, a successful entrepreneur, and Aisha, a talented designer, were initially drawn to interest-free banking due to their strong adherence to Islamic principles. They were determined to align their financial practices with their faith, seeking an alternative to conventional banking that would allow them to avoid interest-based transactions.

As we sat down in a cosy café, Ahmed shared his perspective on their decision. “Islamic banking resonated with our values and beliefs. We wanted our money to be kept and used in line with Sharia principles, and interest-free banking offered us that opportunity,” he explained. Aisha nodded in agreement, mentioning how important it was for them to maintain financial integrity while pursuing their dreams.

The couple’s experience with interest-free banking has been overwhelmingly positive. They found that the bank’s offerings, such as savings accounts and Mudarabah deposit contracts, provided them with viable alternatives to conventional banking services. These options allowed them to save and grow their money without compromising their religious convictions.

Moreover, Ahmed highlighted the impact of interest-free banking on their financial well-being. “It’s liberating to know that our hard-earned money is being utilised ethically,” he said with a smile. “We no longer have to worry about whether our savings are inadvertently supporting interest-based activities that go against our beliefs and values.”

In addition to personal banking, Ahmed and Aisha accessed credit facilities provided by the bank to support their business expansion. Through a Sharia-compliant financing product called Murabaha, essentially a cost-plus sale agreement that adheres to Sharia law, they could secure funds for purchasing raw materials and expanding their artistic endeavours. The couple expressed gratitude for the availability of credit options that respected their religious values and contributed to their entrepreneurial growth.

Ahmed and Aisha’s story is just one example of the positive impact interest-free banking has had on individuals and businesses in Ethiopia. Their journey showcases financial freedom and peace of mind when banking aligns with personal beliefs and values.

While conventional banking remains dominant, the growth of interest-free banking in Ethiopia has been remarkable, with these services proving financially viable. It is worth noting that interest-free banking services are practised parallel to conventional banking in most jurisdictions. However, in certain countries with a Muslim majority, Islamic banking is the sole form of banking permitted.

Compared to the long-standing history of conventional banking, Islamic banking is a relatively recent development, dating back only a few decades. It has gained significant traction in many Muslim-majority countries and has become an integral part of their financial systems. The global Islamic finance market is predicted to register a compounded average growth rate (CAGR) of 10.2% from 2024 to 2029, and the global market size is expected to grow from USD 2.46 trillion in 2024 to USD 3.99 trillion by 2029.

According to an independent economic analyst, “the advent of interest-free banking in Ethiopia has brought about profound economic and social implications. From an economic perspective, interest-free banking promotes resource allocation efficiency by encouraging productive investments and discouraging speculative activities driven by interest-based returns. By focusing on shared risk and equity-based financing, interest-free banking channels funds towards sectors that have real economic value, fostering sustainable growth and development.”

“In terms of social implications, interest-free banking in Ethiopia has the potential to enhance financial inclusion and reduce income inequality. By providing access to financial services that align with cultural and religious beliefs, interest-free banking caters to previously underserved segments of the population. This inclusivity empowers individuals and businesses to participate fully in the formal economy, fostering entrepreneurship, job creation, and poverty reduction.”

He further discloses, “Various academic institutions and research organisations are actively exploring the impact of interest-free banking in Ethiopia. These studies delve into areas such as the effectiveness of Islamic financial instruments, the role of interest-free banking in promoting economic stability, and the socio-economic outcomes of interest-free banking for different segments of the population. Ongoing research aims to deepen our understanding of the sector, identify potential challenges, and propose strategies to maximise the benefits of interest-free banking.”

“The fast growth of interest-free banking in Ethiopia is a testament to the demand for alternative financial solutions that align with religious and cultural values. This growth can be attributed to a combination of factors, including increasing awareness and acceptance of interest-free banking principles, supportive regulatory frameworks, and the proactive involvement of financial institutions. The fast-paced expansion of interest-free banking showcases its potential to become an integral part of the overall financial system in Ethiopia, contributing to a more inclusive and sustainable financial sector. “

Regarding further growth and integration, the economist explains that “the potential for interest-free banking in Ethiopia is significant and untapped. As the sector continues to expand, it is crucial to strengthen regulatory frameworks, enhance consumer education, and develop the necessary infrastructure to support its growth. Collaboration between financial institutions, policymakers, and stakeholders is essential to ensure a smooth integration of interest-free banking into the broader financial system. By harnessing this potential, Ethiopia can unlock new avenues for economic growth, financial inclusion, and sustainable development.”

Ethiopia’s banking sector comprises 32 banks, including four fully-fledged interest-free banks. Many other private banks, including the prominent Commercial Bank of Ethiopia, offer interest-free banking services through dedicated windows and branches. Among the four fully-fledged interest-free banks, Shabelle initially operated as a microfinance institution in 2011 but acquired a banking license to provide enhanced ethical financial products. ZamZam Bank, on the other hand, is the first bank in Ethiopia to receive a permit from the National Bank of Ethiopia to operate as a full-fledged interest-free bank. Notably, ZamZam Bank began preparations for establishing itself as an interest-free bank in 2008, following the signing of a proclamation allowing such banks. Lastly, Hijra Bank is a fully compliant Sharia-based interest-free bank. It utilises a core banking solution accredited by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), making it the sole bank with this distinction.

According to Melika Bedri Mohammed, the CEO of ZamZam Bank, the journey to its establishment wasn’t without challenges: “We faced unique challenges as the first full-fledged interest-free bank in Ethiopia. With no prior experience to draw from, we had to develop our business model from scratch, taking inspiration from international banks. However, we have managed to overcome these challenges and achieve profitability.”

Melika further explains that Ethiopia’s interest-free banking market remains largely untapped, presenting significant opportunities. She further emphasised that “It’s important to note that interest-free banking is not exclusive to Muslims; it is an inclusive model. ZamZam Bank has successfully addressed the challenges and embraced the opportunities associated with operating under Sharia-compliant financial principles.”

Interest-free banking plays a crucial role in a country’s economy by fostering financial stability, promoting equitable growth, and addressing the needs of diverse segments of society, thereby contributing to financial inclusion. Interest-free banking encourages productive investments and discourages speculative activities. This promotes resource allocation efficiency and reduces the risk of financial bubbles. Moreover, it provides an inclusive financial system catering to individuals and businesses with cultural, religious, or principle preferences prohibiting interest-based transactions.

Countries like Malaysia have emerged as shining examples of how Islamic finance, with its core principle of interest-free banking, can be a powerful economic tool. Malaysia’s Islamic banking sector has grown tremendously, contributing significantly to the country’s overall economic development. This success story highlights the potential benefits of adopting a similar system for nations like Ethiopia.

One key takeaway from Malaysia’s experience is that it positively impacts financial inclusion. Islamic banking products cater to a broader range of people, including those who may be excluded from conventional banking due to religious restrictions on interest.

This fosters a more inclusive financial system, allowing a more significant portion of the population to participate in the economy. With a significant unbanked population, Ethiopia can leverage Islamic finance to bring more people into the financial fold.

Furthermore, Islamic finance promotes alternative financial instruments that drive economic growth. Profit-sharing models like Mudarabah incentivise investment and entrepreneurship. This can be particularly beneficial for Ethiopia, a nation with a burgeoning entrepreneurial spirit. By providing Sharia-compliant financing options, Islamic banks can fuel business creation and economic activity.

Finally, Malaysia’s success in Islamic finance has made it a magnet for investors seeking Sharia-compliant investment opportunities. This has led to increased foreign direct investment, a crucial factor for economic development. In striving to attract foreign capital, Ethiopia can use Islamic finance to tap into this vast pool of investors.

However, it’s important to remember that successful implementation requires adaptation. Malaysia’s Islamic banking system co-exists with a conventional system. Ethiopia should carefully consider its own economic and social context when designing its approach.

Regulatory frameworks and a well-trained workforce versed in Islamic finance principles will be crucial for a smooth transition.

By learning from Malaysia’s experience and adapting the model to its specific needs, Ethiopia has the potential to unlock the significant economic and social benefits that Islamic finance can offer. EBR

12th Year • April 2024 • No. 128

Eden Teshome

Editor-in-Chief of Ethiopian Business Review (EBR). She can be reached at eden.teshome@ethiopianbusinessreview.net

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