Collateral Crisis a Pressing Challenge for Ethiopian Banks
As the Ethiopian government initiates a new corridor development plan, banks find themselves at the epicentre of a collateral crisis. However, it’s important to note that the banking sector in Ethiopia has shown remarkable resilience in the face of these challenges. Recent studies by the National Bank of Ethiopia (NBE) reveal that the industry heavily relies on securing immovable properties as collateral for loans. With the prevailing lending practice and the concentration of collaterals along main roads, banks often prioritize these properties for security.
Ethiopia’s banking sector, which has long operated in a relatively stable policy and regulatory environment, is now undergoing a seismic shift. This transformation, characterized by significant policy and regulatory changes, was set in motion in 2019 when the Ethiopian government introduced the first phase of the Home-Grown Economic Reform Program (HGER 1.0). These changes have ushered in a wave of economic policy changes across various sectors, including the banking business, and have significantly altered the operating landscape for banks in the country. The seismic shift includes changes in capital requirements, corporate governance, foreign exchange market liberalization, and a shift from a pegged to a market-based foreign currency regime, among others.
Regarding these policy and regulatory changes, the central bank has overseen the amendment or promulgation of more than 15 directives and has introduced a new monetary policy. Notably, the NBE has promulgated a foreign exchange directive, which has liberalized the foreign exchange market and lifted restrictions on the foreign exchange market. It has also obliged existing banks to raise their paid-up minimum capital requirement to five billion birr by June 30, 2026, and it has tightened its monitoring and supervision power by promulgating directives that oblige banks to adhere to corporate governance and the appointment of external auditors. Similarly, the NBE shifted the determination of the nation’s currency value from a pegged monetary policy to a new market-based foreign currency regime last July. It also introduced a credit cap growth cap of 14% for all commercial banks. This means that banks can disburse only 14% more than they have credited the previous year, significantly impacting their lending operations and profitability by limiting their ability to expand their loan portfolio and generate interest income.
With these policy and regulation shifts, the NBE aims to control inflation, promote economic stability, increase market efficiency, reduce exchange rate volatility, and improve transparency, accountability, and risk management. However, banks are already experiencing the impact of these changes, as restrictions on credit and foreign exchange risks have impacted revenues and assets, increased operation costs and raised concerns about the future of banks. It is bringing the financial sector mergers and acquisitions issues to the frontline.
In addition to these challenges, other pressing issues are also at the forefront. The new corridor development projects in Addis Ababa and other cities have presented new challenges, as immovable collateral properties have been subject to partial or complete demolition, leaving banks uncertain about the fate of their loans.
The profound practice of appropriation, which refers to taking private property by the state or government for a public purpose, has become common in the country. Ethiopia has a long history of government-led development initiatives. While these initiatives are well-intentioned, they have also resulted in the expropriation of lands. The Ethiopian Constitution grants land ownership to the Ethiopian Nation, Nationalities, Peoples, and government. This indicates that land is one of the most sought-after resources.
In support of this framework, the state has been given the sole right to transfer land through auction or allotment, which is the only method through which urban leaseholding rights can be asserted. Even though individuals or entities don’t own land, it is leased. These lease rights are protected by various legal frameworks that are in place to protect the rights of citizens affected by expropriation.
Lawmakers, aware of the impact of a takeover on citizens’ rights, have established a legal framework. To this end, Ethiopia has enacted legal frameworks such as the Constitution under Article 40 (7) and a Proclamation to Determine Expropriation of Landholdings for Public Purpose, Payments of Compensation, and Resettlement No. 1116/2019. These legal frameworks provide for a compensation scheme for landholders in cases of expropriation.
Moreover, the law provides, under the Civil Code Article 3069 (2), the right of mortgagees, such as banks, to claim compensation received by the borrower due to expropriation. This law, in particular, safeguards the interests of banks from expropriation and diminishes credit risk. These laws illustrate the government’s obligation to redress persons affected by expropriation. The consequence of expropriation makes the affected person eligible for monetary compensation, resettlement to a new location, or a combination of both. Such actions by the government are intended to redress persons affected by expropriation from financial loss.
While these legal frameworks and procedures provide a foundation to address the impact of takeover, banks are entangled in mounting challenges regarding compensation practices. Banks’ practical compensation challenges, specifically related to the corridor development that started in Addis Ababa and has now expanded throughout the country can be broadly categorized into two types. The first refers to valuation mismatch; in this regard, the government has formulated its system to value properties for compensation. However, these values usually show significant differences compared to the estimations of banks and market prices. Secondly, banks face nonpayment of compensation, which is particularly prevalent in regional cities, especially Sheger City, despite trends indicating that the Addis Ababa City Administration has attempted to settle compensation by the pertinent laws and procedures.
Both of these challenges pose significant implications for the banking industry. The most alarming is financial losses that will exacerbate the industry’s struggles, which are prevalent due to various internal and external factors. However, this is not the only impact, as banks expect increased credit risks, lengthy legal proceedings, and overall effects on the country’s financial stability.
Despite recent economic reforms and the ongoing corridor development projects, Ethiopia’s banks have grown significantly over the past decade. They are key players in the country’s financial stability and development. With the potential for further growth and development in the banking sector, there is a bright future to look forward to, which should instill optimism in all stakeholders.
Therefore, it’s crucial for banks to assess their situation and develop a formidable plan to mitigate regulatory risks effectively. However, the pressing issues related to the practical challenges and impacts of appropriation cannot be addressed by banks alone. The government and banks need to work together, emphasizing the importance of unity in addressing the sector’s challenges.
The government needs to ensure the implementation of the existing legal framework and promulgate new laws, if necessary, to uphold transparent, efficient and effective systems for redressing affected parties. On the other hand, banks need to strengthen internal and external risk mitigation processes and work closely with the government to address the underlying problems. This collaboration is crucial to narrow the gap between the existing legal frameworks and the practical challenges. The failure to act could have dire consequences for all affected parties, the financial sector, and the state’s overall economy.
Indeed, while promising, the Ethiopian government’s urban facelift initiative has posed significant challenges for banks and property owners. The widespread expropriation of properties, often at insufficient compensation rates, has created a complex financial landscape.
Banks frequently rely on property as loan collateral and are particularly vulnerable to these developments. The loss of valuable collateral, especially income-generating properties, could lead to substantial financial losses and potential defaults. To mitigate these risks, banks can implement several strategies. Firstly, they should strengthen their risk assessment and valuation processes to accurately assess the collateral value and potential risks associated with expropriation. Secondly, diversifying loan portfolios and reducing reliance on property as the sole collateral can help minimize exposure. Thirdly, exploring alternative forms of collateral, such as equipment or inventory, can provide additional security.
The government should implement transparent and equitable compensation mechanisms to prevent future crises. Adequate notice periods, fair market valuations, and timely compensation disbursement are crucial. Clear guidelines and regulations regarding expropriation procedures can mitigate uncertainty and provide legal recourse for affected property owners. By working collaboratively, the government and banks can find solutions that protect public interest and private property rights, ensuring sustainable urban development.
13th Year • December 2024 • No. 136