Development Banking in Ethiopia

Explicating Some Misconceptions

Agenda 2063 is Africa’s strategic framework for inclusive economic growth and structural transformation. The continent is planned in detail on how to achieve this vision over a period of 50 years from 2013 to 2063; goals are also set. This Agenda packed with seven aspirations and twenty goals, which are aligned with the United Nations’ sustainable development goals that combine the social, ecological, and economic sustainability pillars. For a number of reasons, agriculture and African development are intertwined. One of the Agenda 2063 goals commits “to increase modern agricultural production and productivity,” implying agricultural growth is decisive for Africa’s transformation. However, the low agricultural development in the continent is linked to inadequate investments on the sector to stimulate sustained growth. The structural adjustment measures adopted to cut public spending at the end of the 20th century led to a decline in state-led agricultural initiatives in Africa. Policymakers are correcting the mistakes in the past, “Africa will take full responsibility for financing its own development,” as one of the 20 goals noted. Accordingly, it is imperative to emphasize the need for development-oriented financial institutions that support initiatives that have crucial developmental impacts. This article is mainly to explicate misconceptions regarding the roles played by public development banks, in general, and to provide evidence-based performance indicators on the success of current strategic reform plan of the Development Bank of Ethiopia (DBE), a reform plan aimed to strengthen the provision of cutting-edge development banking services Ethiopia.

Development banks are specialized financial institutions that provide medium- and long-term finance to address economic development and policy objectives. These banks help to achieve economic, social and environmental aims in the provision of counter-cyclical finance, encourages structural transformation, mobilizes funds to support infrastructure financing, and promotes environmental sustainability by adopting social cost-benefit principles in the appraisal of investment projects. Development banking is a risky public policy initiative to achieve development policy goals by facilitating access to long-term investment capital with subsidized interest rates to projects that are deemed to generate positive externalities and hence would be underfinanced by the profit-oriented financial sector. The reason for development banking is due to the gap between credit allocations operations of the commercial sector (highly risk-averse and operating as short-term lenders) and the financial requirements for rapid and sustained economic growth.

In general, the role and impacts of development banks has been a recurring theme in various high-level forums, mainly since the beginning of the new millennium. Hence, development banks were the center of discussions in the successive United Nations organized “Financing for Development” summits that were held in Monterrey, Mexico (2002), Doha, Qatar (2008), and the third International Conference that was held in Addis Ababa in 2015. Development banks mentioned 30 times in the 61-page declaration of the Addis Ababa Action Agenda (AAAA) and hence the participant governments acknowledged that: “…development banks play a valuable countercyclical role, especially during financial crises when private sector entities become highly risk-averse” and called on “national and regional development banks to expand their contributions” and “urge relevant international public and private actors to support these specialized banks in developing countries” (Paragraph 33). Moreover, the Finance in Commons Summit (FiCS), which has been held every year since 2020, provides an opportunity to highlight key roles of public development banks in supporting the transformation of economies and financial systems towards a climate-resilient sustainable development.

The 2008 global financial crisis has reinvigorated a renewed interest in the role development banks play in resolving counter-cyclical credit problems and has led to a focus on expanding public financial institutions. It is noted that the cause of the financial crisis was the weaknesses in the global governance of the financial system in identifying risks in a timely manner to mobilize international economic cooperation, regulatory frameworks, and macroeconomic coordination. This has prompted governments to reconsider their role in the modern financial system to resolve market failure problems. The causes and responses to the crisis were the center of discussions for participants in “Financing for Development ‘’ and this led to the initiation of policy reforms to mitigate the impacts of crises and prevent similar incidents from happening again.

The existence of widespread market failure that hampered economic growth and development in developing countries has also sparked debates in recent years over the role played by governments in the financial sector. In this regard, development banks are believed to address key credit constraints for those growth-oriented entrepreneurs such as the small and medium enterprises (SMEs) with long-term growth potential given that the collateral-tailored commercial sector is in short supply for a socially optimal investment. The lack of attractive and SME-friendly financial products is one of the key challenges facing SMEs in many developing countries. This gives rise to the – “missing middle phenomenon” – implying a lack of access to finance for SMEs that exists between large firms and micro-businesses. High perceived risks, limited SMEs financing strategies, and high collateral demands are some of the major constraints. Hence, those businesses that contribute hugely to ensure economic growth, job creation, and poverty reductions are the very ones that are constrained by lack of access to finance. In these cases, development banks could mobilize financial resources to support SMEs and productive investments that have high social return.

Technological advancement has dramatically changed the face of production, led countries to look for innovative and sustainable sources of economic growth. We are currently witnessing how the successful public development banks are undertaking a broad transition from large-scale financing of infrastructure projects to financing of innovative businesses. At this time, successful development banks (e.g., in Korea, Germany, China) are emphasizing entrepreneurship and innovativeness. When we say “success”, it refers to the contribution of the banks to economic growth by acquiring and disseminating financial expertise in long-term industrial finance. The most recent focus of these development banks has been on financing innovations and sustainable development. To remain true to its development mandate that takes precedence over pure commercial motives, DBE is also taking the initiative to play the leading role in financing innovative startups and business ideas to support entrepreneurial ventures. Accordingly, the bank has the appetite to provide finance for small businesses are believed to have a long-term growth potential, but face significant financing gaps and a lack of access to financial resources in the conventional commercial sector.

Fundamentally, the mandate of development banks is guided by industrial policy and social views. Industrial policy can be defined as “any government measure or set of measures, to promote structural change in ways that the government views as desirable.” In the industrialization process, the need for a long-term access to capital is unquestionable. This indicates that there are significant gaps in the operations of development banks with the conventional banking system. The importance of development banking stems from these gaps that are not well-served by the commercial sector. The commercial sector is by no means in a position to perform what a development bank is expected to do. The key function of development banks is providing long-term capital at subsidized rates which commercial banks couldn’t perform. In developing countries, like Ethiopia, problems stemming from the scarcity of capital and technical know-how are among the serious impediments to the development of potentially available natural resources, entrepreneurship and industrialization. The main limitation is the lack of finance for large-scale industrial projects to bear the costs of the discovery of new technologies and production processes. Government funding will help to provide long-term loans at lower-than-market rates. This has a benefit for the industrial sector to generate hidden potential, increase productivity and competitiveness. Indirectly, more jobs will be created, infrastructure with positive externalities expanded, and capital markets extended. Another area where these banks should lead the way, and others could follow, is in the protection of environmental and social standards for projects that they finance. In both debt and equity financing, development banks also support projects that have strategically important national projects, even if these are not attractive for profit-making. In this regard, DBE’s resource mobilization by issuing bonds for the construction of the Grand Ethiopian Renaissance Dam can be mentioned. Although the main purpose is to foster development, profitability is also vital for ensuring financial sustainability and to exercise its mission in the long-term. In this regard, DBE recorded higher profits even compared to the better-performing commercial banks in the just-ended fiscal year.

Since 1909, the DBE…

The fundamental role played by financial institutions in economic development has been extensively explored in the literature. At the beginning of the 20th century, Ethiopian leaders recognized the role of finance in development. Hence, the beginning of banking business in Ethiopia takes us back to the reign of Emperor Menelik II. After the Adwa victory, the emperor opted to establish an independent bank as a sign of national pride, instead of opening up a foreign bank branch for easier and more efficient operations. According to research studies, the emperor consulted several European delegates. Talks were held with France, Italy, and others, but Britain’s response arrived promptly. In 1905, agreement was reached in Addis Ababa to open a new bank called Bank of Abyssinia, which was part of the British-controlled Egyptian Bank. The agreement gave the Bank of Abyssinia a 50-year banking monopoly in the country. Although the agreement was officially signed between the emperor and officials of the Bank of Egypt, the emperor was disappointed starting from the early period given that the most important administrative decisions regarding the bank were made at meetings held in Cairo.

From the very beginning, problems began to appear in the operation of the Bank of Abyssinia. Its activities were purely commercial instead of supporting development efforts. Its “sound” banking operations were towards financing foreign enterprises, wealthy clients, and international trade, with limited attention given to supporting local development and the indigenous small borrowers. Later on, the emperor realized that the agreement granted Britain the full administrative control of the bank. Then, the validity of the 50-year monopoly granted to the Bank began to be questioned. Authorities consider establishing another financial institution that supports local economic development initiatives. In 1909, accordingly, the foundation for the Development Bank of Ethiopia was laid down. The realization of this development bank was based on agreement made by seven top leaders of the country became shareholders (including Emperor Menelik himself, Empress Tayitu, Bajrond Mulugeta Yeggazu, Ras Bitweded Tessema, Fitawrari Habte-Giorgis) and the decree said “Hereunder, we have signed a declaration to establish “National Society of Ethiopia”. According to the Emperor’s request, the first task was to re-organize the “Society for the Development of Agriculture and Commerce” processing banking services under the official name “Societe Nationale d’ Ethiopie Pour le Development de l’ agriculture et de Commerce’’. Therefore, historical facts indicate that there has been 115 years of development banking experience in Ethiopia. This bank was founded with the support from international groups, especially France, and its headquarters are in Addis Ababa.

Literature sources indicate that the role of the French government was instrumental to establish the “National Society of Ethiopia”. The two major rival colonial powers in Africa, Britain and France, were also competing in Ethiopia. French, the winner in the Railway affair (Ethio-Djibouti Railway Line) was a loser in the banking sector. But this didn’t stop France’s efforts to penetrate into the Ethiopian financial market. France was convincing authorities in Addis to revoke the 50-years privilege granted to the Bank of Abyssinia, to pave the way for the entry of French banks. However, the entry of French banks (that reinforced the French position in Ethiopia) would have been dangerous to Britain from both an economic and political point of view. Accordingly, the Ethiopian authorities have announced the establishment of a bank that will provides financing for indigenous development projects. Unlike its predecessor, at the beginning, the new bank was an Ethiopian institution where all its employees and shareholders were Ethiopians. It was established primarily to fill the credit gaps left by the former bank; hence it did not pose a real danger to the interests of the former bank as well as the British prominent position in the country. This bank was established with a capital of 1 million thalers. Later on, its capital was increased to 3 million thalers and subscribed in the proportion of 60 percent to the French and the remaining to Ethiopian groups.

DBE in new business-model

The DBE has a long development banking experience but passed through a difficult history with ups and downs. Since its inception, the bank has undergone several restructuring processes and changes in names. However, the Bank did not undergo significant progress in its operational strategies except for occasional adjustments following the socio-political transformations in the country. Hence, the bank has been renamed eight times in its entire history. During the EPRDF era, the bank has received special attention to fulfill its mission and strengthen its internal capacity. Following the Monterrey conference, which emphasized the need for strong development banks to ensure sustainable development, the EPRDF government has re-organized the Bank with a clear role and responsibility in 2003 to play its leading role in supporting national development efforts. It is also worth mentioning that the bank was prone to serious administrative challenges and embezzlement during the EPRDF era. During the reign of Haile Selassie and Mengistu, the bank did not make significant progress and also did not suffer a major setback in its existence. This does not mean that the bank’s contribution to the economy was zero during the imperial and Derg eras. During the Derg regime, for example, the major source of the capital to establish a state-of-the-art gold mining company in what was then known as Kibre-Mengist (currently Adola Weyu) came from the Development Bank of Ethiopia. Hence, it is worth mentioning that the Bank has played a key role for the establishment of a mining company that has enabled the country to earn foreign exchange from gold supply to date.

While the current management is making great strides in bringing the bank back on the right track, it is an open secret that a few years ago the bank was in dire financial setbacks that threatened its existence. This was mainly because of weak internal leadership and “systemic” corrupted practices targeting to reward politically connected but inefficient industrialists or firms. At this time, the investment criteria were shifted from resolving credit market gaps based on industrial policy and social views towards directing finance for the politically connected individuals without a proper assessment of project viability. Such a misallocation of public funds to “bailout” inefficient market players diverted precious resources away from those productive firms. Accordingly, the bank was carrying more than 40 percent of non-performing loans, which is much higher than the minimum requirement for development banks in Africa (the recommended ratio is no more than 15 percent). Hence, the bank was struggling to finance fresh loans for productive and entrepreneurial projects. With strong leadership and direction, the credit and financial aspects of the bank have improved significantly and the NPLs ratio and profitability indicators have improved. The bank had a target to bring down the NPLs ratio below 20 percent by the just ended budget year, but the actual NPLs ratio is found to be at 30.4 percent. It was noted that the main reason for the limited success was the war that erupted in the northern part of the country. If the country had not been in such dire situation, the bank could have been reducing its NPLs ratio as per the plan. This is because loans that were healthy in the Tigray Region are now included under the NPLs category.

The literature primarily recommends development banks to set clear targets for policy objectives, monitor investments performance, systematically review their policies and investment decisions, and discontinue loans if firms fail to achieve the objectives. In the absence of these controls, development banks may end up providing capital to low-productive firms that do not qualify for subsidized credits in the first place. If proper control mechanisms were in place, development banks that are supposed to resolve credit market failure would not have been a sign of “governance failure” that would reduce societal welfare and efficiency as evidenced in DBE’s credit operation some years ago. Recognizing the role of DBE for the success of national development, the government’s recent decision of a four-fold increase in the bank’s capital (injected Birr 21.5 billion) hugely saved the Bank’s survival.

It has also been suggested that if development banks failed to meet their mandated mission, reform is essential to strengthen internal capacity and to provide cutting-edge banking services. Institutional and administrative reforms are necessary to urge governments to pay more attention and to learn from the past mistakes. The reform should be a complete package; and hence reforming one area in isolation is unlikely to deliver results. Likewise, the DBE is in mid-term implementation of its five-year strategic reform plan that covers the period from 2019/20 to 2024/25. The reform plan has been prepared after a detailed analysis on the bank’s previous prudential and financial setbacks to learn lessons from its past mistakes and international best development banking practices to formulate strategies to ensure financial sustainability and strong internal organizational capacity. The strategic reform plan has seven pillars and twenty-seven objectives; each has key performance indicators and targets. As part of the reform plan, the bank’s Board of Management has approved a new business model that will enable the Bank to achieve its vision, mission and long-term strategic objectives.

As part of the reform plan, a cluster-based organizational structure is implemented with different clusters specialized in key economic sectors such as core corporate agriculture, industry, and SME financing that are aligned with the national development strategy. Moreover, there is also growing interest on development research for knowledge-driven operations to support evidence-based policy making in the Bank. To this end, the bank established a Research and Development (R & D) Cluster to lead the bank’s priority in the generation, analysis, and dissemination of knowledge solutions in cross-cutting themes of development. Finally, the provision of technical assistance and advisory services has also attracted significant attention in the new business model of the bank. Very recently, for instance, in collaboration with the World Bank, DBE has managed to deliver business development as well as financial management instruments training in government priority economic sectors for participants close to thirty thousand SMEs in various training centers across the country to support potential private sector and SMEs businesses through lease financing. This implies that the bank is aspiring also to offer non-financial services in conjunction with the provision of development finance to its potential customers. In conclusion, by any standard, the current Development Bank of Ethiopia is a unique and modern institution compared to its predecessors in terms of internal service delivery for customer satisfaction, development banking operations, and internal organizational capacity.

11th Year • Dec 2022 • No. 113