Financial Sector on the Brink

Foreign Banks Entry, Domestic Mergers

The Ethiopian financial sector has undergone significant transformations in re-cent years, including the proliferation of interest-free banks, new conventional banks, and digital financial services. The government’s decision to allow foreign banks to operate in the country for the first time in five decades while also seeking to strengthen domestic banks presents a potential for increased competition and enhanced efficiency. EBR’s Munir Shemesu investigates if these changes could bring about a more robust and dynamic financial sector, as seen in other African countries that have managed similar transformations.

For the past few years, Ethiopia has been making slight hesitant steps towards an ‘open’ economy. Sa-faricom Ethiopia’s entry into the telecommunications sector, ending 125 years of state monopoly, the removal of restrictions on foreign capital, and the impending entry of foreign banks all signify a grander economic trend. Yet, the most consequential industry for a 21st-century economy, finance, has been shielded for nearly 50 years from direct foreign participation. The necessity of these reforms is becom-ing increasingly urgent.

Prime Minister Abiy Ahmed (PhD) has promised to allow foreign banks to enter the Ethiopian financial ecosystem ever since his ascendance to power in 2018. While the revelation of a policy draft three years back signalled an imminent entry, a series of economic and policy reforms had to precede the final green light. As we will see, these reforms hold the potential to transform the Ethiopian financial sector and pave the way for its growth and development.

An amended banking law draft proclamation for reestablishing the National Bank of Ethiopia (NBE), set to receive parliamentary nods in the coming few months, entail a foundational legal backdrop. The draft banking law sets up four modalities for entry of foreign banks:  a subsidiary, opening a branch, establishing a limited-function representative office, or buying shares in Ethiopian banks. Even with foreign ownership of a bank capped at 40% in the draft document, the concerted push by Abiy’s admin-istrations towards mergers of local banks have stirred wild speculations on its potential outcomes.

Addressing an assembly of bankers and senior government officials three days after Ethiopia shifted towards a market-based exchange regime policy, the PM intimated the inevitability of mergers for the 30 private commercial banks.

“Five or six strong banks will do well,” Abiy underscored.

The PM hinted at protecting the banks if they can integrate to form ‘what could be called ‘banks’ extri-cated from ethnocentrism, favouritism, and exclusivity. Abiy scolded the banks for practising nepotism and, at times, engaging in parallel market dealings in their recent history.

“What we have now are not banks but kiosks,” the commander-in-chief noted.

Abiy emphasized the need to shift from localized small financial institutions offering ‘ownership to rel-atives’ toward strong banks locked in on grander economic targets.

He alluded to the recent increase in mobile subscribers and internet users following the opening of the telecom sector to illustrate the benefits of competition.

The PM recalled economic opening up being the first agenda item at his inaugural chairmanship of the now-dissolved Ethiopian People’s Revolutionary Democratic Front (EPRDF) party meeting.

Abiy called on the banks to prepare for competition, share their expertise and innovate as the sector opens to foreign capital.

However, the wild speculations are rooted in much more than the Prime Minister’s words. The draft banking law clearly states “Statutory mergers” as an option for the NBE to move to create “strong, via-ble banks.”

Dawit Keno, President of Hijra Bank, recalls that mandatory mergers are one of the issues discussed with authorities as the draft law was making its rounds. He expects the potential economic benefits of merging to entice many of the smaller banks rather than regulatory pressure.

“We would welcome a strategic partnership,” Dawit told EBR.

The president notes the likelihood of increased pressure through indirect instruments, including pruden-tial regulatory requirements, to bring about mergers. He referred to voluntary mergers as an option for struggling banks even under current legislative conditions.

Dawit considers economic incentives under free market operations more alluring for banks, which might face competition from those that partner with foreigners.

“Mandatory measures are likely only for problematic banks,” he says. “If applied at all.”

Dawit anticipates the most profitable partnerships to emerge from economic viability and alignment of corporate values between institutions. He recognizes targeted acquisitions by full-fledged Sharia-compliant international banks as an avenue worthy of exploration for Hijra.

Full-fledged interest-free banking is one of the most notable reforms to Ethiopia’s banking system over the past few years. In 2019, a segment restricted to window services at most conventional banks re-ceived a regulatory springboard to a full-fledged institution. Amid the flurry of reformist policies that ensued, a decision to increase banks’ minimum paid-up capital requirement to five billion birrs by 2026 has attracted significant attention.

The Ethiopian government may be nudging the banks to a certainty that they will have to contend as early as 2025 with the entrance of foreign capital.

Zemedeneh Negatu, Global Chairman of Fairfax Africa Fund, has long advocated for a liberalized banking sector and has publicly advocated consolidating the bloated banking industry into a few strong institutions.

“My views on the matter are quite public and consistent,” Zemedeneh told EBR.

He recently posted a series of threads on his X, formerly Twitter and Linked In accounts, in which he echoed sentiments previously expressed by senior government officials. Zemedeneh relayed experiences with bankers, who disclosed that being formed along tribal or regional lines was one of the hurdles to mergers.

“The Dollar and the birr don’t care about ancestry,” the chairman noted on his feed.

Zemedeneh pointed out the emergence of a request of sorts as the government allows the entry of for-eign banks. He cited the annual ranking of Africa’s banks, in which only three Ethiopian banks made it to the top 100 list.

“Most of the banks make the top 200 following the currency change,” the chairman underscored.

This year’s list of the biggest banks in Africa by the African Business Magazine includes three Ethiopi-an private banks: Awash Bank, at 68; Dashen, at 87; and the Bank of Abyssinia, at 89. The state-owned Commercial Bank of Ethiopia (CBE), at 28, and the Development Bank of Ethiopia (DBE), a policy bank, at 44th rank, also made the list.

Zemedeneh’s insistence on five or six consolidated banks besides CBE centres on the economy’s rapid growth, contrasting with the banks’ smallness.

This notion finds some solid footing when viewed in the context of the central bank’s latest stability report. It revealed that the banking industry, which has assets equivalent to nearly 33% of Ethiopia’s GDP, was immensely limited in its service provisions. The top 10 borrowers in the banking industry held almost 23.5% of the total 1.9 trillion Br in loans and advances.

Perhaps most striking about the report was that the banks failed to serve most of the population while tightening a tight noose around themselves and the financial industry. If the ten largest depositors at each bank withdrew all their funds simultaneously, 18 of the 29 commercial banks would fall below NBE’s minimum regulatory liquidity requirements.

An alarming picture of concentration and risk starts to form upon a thorough report analysis.

While NBE’s 10th governor, Mamo Mihretu, has never publicly advocated for statutory mergers of the banks, he has often cited the need to modernize them to achieve greater financial inclusion.

A senior banker at one of Ethiopia’s biggest banks expressed the high likelihood of involuntary mergers due to the mere inability of the banks to meet the wave of prudential requirements recently introduced by the regulator. He foreshadowed significant challenges for the banks in subscribing to five directives issued in June, including related party transactions, corporate governance, asset classification and single borrowing limits within a three-year deadline.

“A revaluation of banking norms could be in the cards for some,” he told EBR.

The banker expects increased prudential oversight and foreign competition to expose potentially sys-temic inefficiencies that could be resolved through mergers. He says liquidity issues exacerbated by the rapid rise of telebirr and a flurry of new banks are emblematic of historical problems in Ethiopia’s banks.

While most banks have liquidity levels above the regulatory minimum of 15%, increased provisioning for non-performing loans and the largely uncalculated degree of exposure from related parties present potential black swans. Banks’ liquid assets only incorporate a small share of high-quality liquid assets, resulting in severe real-time transaction shortages, with some capping withdrawals at 2,000 birr some-time last year.

If approved under its current format, the draft banking proclamation will grant NBE powers to issue statutory mergers for banks exhibiting managerial, operational, and financial weaknesses. A problem bank is defined as one that requires stringent actions and significant improvements to its business mod-el, risk management system, or governance promptly.

While NBE officials remain closely guarded about how statutory mergers will be implemented, industry veterans recognize them as helpful tools in most central banks’ regulatory toolboxes.

Eshetu Fanataye, a banking expert with extensive experience in Ethiopia’s financial ecosystem, recalls the mergers in Nigeria, which resulted in the number of banks dropping from around 89 to 21 due to revised capital requirements by the Central Bank of Nigeria in 2004. He attributes having a provision allowing statutory mergers as a sensible card to be wielded by any central bank.

“It is not as uncommon as some may think,” Eshetu told EBR.

In recent years, statutory banking mergers and acquisitions have occurred in countries like India and Malaysia and in sub-Saharan countries like Nigeria.

Eshetu recognizes a string of pull and push factors toward mergers and acquisitions that could drive the banks and prove beneficial in the long run. The founding president of Ahadu Bank partly echoes Prime Minister Abiy’s reflections on ethnic, tribal, or topological proximity underlying the formation of some of Ethiopia’s banks.

He laid out how an ‘elite’ class might attach itself to some form of group identity by forming a financial institution while only harbouring wealth preservation or accumulation objectives.

“It could have become a headache for the central bank,” Eshetu explains.

He also has noticed a limited perimeter of service provision by the banks stemming from several factors.

The keen observer recalled early reservations by CBE’s former management about expanding into neighbouring countries like Djibouti or Sudan despite having some form of operation in those countries.

“Growth has been restricted by an unwillingness to expand,” Eshetu pointed out.

The banking expert underscores the importance of the banking industry creating a regional or even con-tinental presence to realize Ethiopia’s trade and export potential. He emphasized the need to consolidate capacities since Ethiopia is a signatory to the African Continental Free Trade Area (AfCFTA).

“Otherwise, competition with international players is not feasible,” he notes.

Nonetheless, Eshetu stresses the need to separate the economic viability of mergers and acquisitions while factoring in whether they are voluntary. He says some mergers serve the interests of shareholders by guaranteeing the prospects of long-term stability, while others might not.

According to the expert, for successful mergers, efficiency measures need to be supplemented by a thorough analysis of typical performance measures like Return on Equity (ROE), Return on Assets (ROA), and capital.

Ethiopia’s adoption of a market-based foreign exchange regime could also lead to the reevaluation of the NBE’s capital requirements. However, sources from the central bank have confirmed to EBR that no such process is being planned now, with any subsequent directives contingent on the ratified banking proclamation.

Eshetu indicates that the reputation of the banks could also be gleaned by considering the willingness of correspondent banks to engage in business dealings with their Ethiopian counterparts.

“Multiple factors justify mergers for Ethiopia’s banks,” he surmised.

While intense public debate accompanies the decision to allow foreign banks to enter Ethiopia, the in-troduction of banking itself is intimately tied to foreign intervention. The British-owned National Bank of Egypt established Ethiopia’s first bank, the Bank of Abyssinia, in 1905, with three other banks com-ing later in the decades.

Following the split of the State Bank of Ethiopia into two separate institutions, the National Bank of Ethiopia, the country’s central bank, responsible for monetary policy, regulating the banking system, and issuing currency; and the Commercial Bank of Ethiopia, a commercial bank, offering retail and corporate banking services to the public, under a new banking law, foreign banks which retained a maximum of 49% ownership flourished until the dawn of the socialist era. One of the last batch of for-eign banks, including the Addis Ababa Bank, which had 26 branches at the time, was 40% owned by the British Grindlays. The bank shut down operations in 1975. It was established in 1963 as part of the restructuring of the Ethiopian banking system following the split of the State Bank of Ethiopia.

Banking mergers, including establishing the Agricultural and Industrial Development Bank from the fusion of the then Development Bank of Ethiopia (DBE) and Investment Bank, were also reported until the final years of the imperial regime. An open door to foreign financial flows was also quite common, with the establishment of the Housing and Savings Bank being facilitated through a grant from the United States government.

Nevertheless, sweeping nationalization over 17 years under socialist principles would radically change banking in Ethiopia. Public enterprises became the primary borrowers and recipients of foreign curren-cy, CBE became the primary facilitators of development in Ethiopia, and foreign bankers became obso-lete. In contrast to several other African countries flirting with government banking, CBE staved off a significant accumulation of bad debts as most state-owned enterprises remained at a loss. This would be short-lived as the Socialists fell, and a slightly new era of economic liberalization followed.

With the downfall of the Dergue in 1991, the new EPRDF regime allowed the creation of private banks if they were 100% locally owned.  For thirty years, a solid aversion to foreign-owned banks would be the modus operandi, and the state would continue to play a significant part in the financial sector.

The late Prime Minister Meles Zenawi famously said, “How can we allow instruments we barely un-derstand to operate in our country?” He referred to the difficulty of regulating foreign financial instru-ments to Ethiopian authorities until adequate capacity is built at the regulatory level.

Meles was referring to the solid institutional capacity that the NBE needs to properly develop to be able to monitor and regulate the presence and operations of giant foreign banks with all the instruments these giant multinational corporations are known to deploy to avoid taxes and keep the economy on its feet. Indeed, Meles’s concerns about the presence of foreign banks in Ethiopia were well-founded. His statement highlighted potential challenges when a country’s regulatory framework cannot effectively oversee complex financial instruments and institutions.

With all their sophisticated financial instruments, foreign banks could potentially engage in tax avoid-ance strategies, leading to a loss of revenue for the Ethiopian government. They would also serve the affluent economic class, leaving the bulk of the underserved society at a disadvantage.

The presence of large foreign banks could raise concerns about foreign economic influence and the po-tential for these banks to exert undue control over the Ethiopian economy, which was also a big concern at the time.

However, as Ethiopia embraces a new era of banking championed by the reformist Prime Minister Abiy Ahmed, the complexity of banking instruments needs to be addressed. The NBE is poised for a forty-fold capital boost to 20 billion birr and enhanced technical proficiency to regulate in new financial waters. A banking industry that has survived on laurels questionably earned will sink or swim as a rapturous typhoon bellows at its bow..EBR

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13th Year • October 2024 • No. 134