From Shareholder Power to Depositor Protection

The Evolution of Corporate Governance in Ethiopian Banks

Recently, the National Bank of Ethiopia (NBE) has issued a series of directives about the banking industry. These include directives such as “Requirements for Persons with Significant Influence in a Bank” and “Bank Corporate Governance.” One area that gained attention for reform is bank corporate governance. Deficient corporate governance practices in the banking industry have required repeated NBE interventions. In the past year alone, the controversies around Nib Bank and Amhara Bank and the subsequent NBE interventions indicate the situation.

Corporate governance began with listed companies but quickly spread to include other businesses, government agencies, and non-profit organizations. At its core, corporate governance is about how companies are managed and controlled. The principal-agent theory explains that a private corporation is a network of contracts between different parties, such as owners and managers (a bank). These relationships can often lead to conflicts of interest, especially when there is a lack of information or clarity on the behaviour and actions of agents (CEOs and or board of directors). Corporate governance aims to resolve these conflicts by ensuring that companies are run transparently and accountable, protecting the interests of all stakeholders involved-depositors, creditors and stock owners in the case of banks.

A corporate governance framework such as the one recently introduced by NBE addresses three primary agency problems. First, it focuses on the relationship between the board of directors and shareholders, mainly when directors prioritize personal gain over shareholders’ profit, creating conflicts of interest. This challenge is amplified when share ownership is widely dispersed, complicating shareholder oversight. Robust internal controls such as clear accountability structures and vigilant board oversight are crucial to counteract these issues. Externally, regulatory frameworks and shareholder activism are pivotal in ensuring directors act in shareholders’ best interests and uphold the bank’s integrity and performance. This dual approach is essential for effective corporate governance, fostering transparency and accountability while safeguarding shareholder value.

Second, when a small group of shareholders owns a significant portion of a bank’s shares, it creates a situation where these controlling shareholders can easily influence management. However, this concentration of ownership often leads to another critical issue:- majority shareholders may prioritize their interests, potentially neglecting the needs and rights of minority shareholders. This situation is notably problematic in the Ethiopian banking industry, highlighting the urgent need for corporate governance rules that specifically protect the rights and interests of minority shareholders. By establishing robust frameworks and oversight mechanisms, such as ensuring transparency in decision-making and equitable treatment of all shareholders, these rules can help mitigate the risks associated with concentrated ownership and promote a fair and accountable banking environment for all stakeholders involved.

Third, the relationship between the controllers of a bank—whether they are directors or majority shareholders—and non-shareholder stakeholders, particularly creditors/depositors, is of paramount importance. This issue is critical in banking regulation as it directly impacts the protection of depositors, which is fundamental to ensuring the stability and integrity of financial institutions. Therefore, effective corporate governance practices must encompass shareholder interests and the obligations owed to creditors and other stakeholders. By adhering rigorously to regulatory standards and ethical principles, banks can uphold depositor confidence and foster a resilient financial environment that serves the interests of all stakeholders.

In Ethiopia, the evolution of corporate governance rules began to take shape in the early 2010s, initially addressing fundamental issues such as conflict of interest. While some regulations concerning CEO qualifications, experience requirements, and limits on shareholding existed, they marked the nascent stages of formal corporate governance practices. Recent developments have emphasized two primary objectives. First, they aim to ensure that individuals wielding substantial decision-making power within banks act in the best interests of shareholders and broader stakeholders. Second, there is a concerted effort to enhance the competence and accountability of crucial bank personnel, including CEOs, senior staff, and board members. These initiatives reflect a growing commitment to bolstering governance frameworks that promote transparency, ethical conduct, and the long-term sustainability of Ethiopia’s banking sector.

The rules concerning these matters have progressed to encompass critical areas such as risk management, establishing an independent internal audit function, forming audit committees, and determining the size and composition of boards. A significant focus has been placed on enhancing governance by addressing the representation of minority shareholders on boards of directors. This measure is pivotal in safeguarding their interests and ensuring their voices are heard in decision-making, fostering greater transparency and accountability within corporate governance frameworks. These developments underscore a commitment to strengthening regulatory standards that promote fairness, integrity, and sustainable growth in Ethiopia’s corporate sector, particularly within its banking industry.

Despite the issuance of comprehensive corporate governance rules by the NBE that banks must adhere to, the banking industry continues to face significant challenges. These issues primarily revolve around influential shareholders and senior management, frequently criticized for prioritizing their interests over the well-being of other stakeholders, such as minority shareholders and depositors. This dynamic raises concerns about fairness, transparency, and the equitable treatment of all parties involved in the banking sector. Addressing these challenges demands a renewed commitment to enforcing and strengthening governance standards, ensuring that regulatory frameworks effectively promote accountability, integrity, and sustainable practices across Ethiopia’s banking landscape.

The new directive introduces several additional elements to tackle the governance challenges prevalent in the banking sector. It mandates that banks establish a corporate culture and values that promote responsible and ethical conduct among all stakeholders. Moreover, the directive mandates that banks integrate sustainability factors into their decision-making processes, emphasizing a commitment to long-term economic development. While ensuring compliance with these provisions poses significant challenges, their implementation can enhance corporate governance practices within the banking industry. By fostering a culture of integrity, ethical behaviour, and sustainability, banks can strengthen their governance frameworks and contribute positively to the broader financial stability and trust in Ethiopia’s banking sector.

The directive outlines specific duties for directors, marking a significant shift in board composition rules within the banking sector. While the board size remains unchanged, the new directive substantially changes how directors are nominated and elected. Crucially, it mandates the inclusion of independent directors on boards. According to the directive, an independent director is a non-executive board member lacking familial, business, professional, or commercial ties with the bank. Importantly, they are not part of senior management nor involved in the bank’s daily operations. These requirements aim to bolster board independence and governance oversight, ensuring that boards operate impartially and prioritize the broader interests of shareholders and stakeholders. This evolution in board composition underscores a proactive approach to enhancing transparency, accountability, and effective governance practices across Ethiopia’s banking industry.

The previous directive stipulated that 1/3 of Board members must be nominated and elected by shareholders holding at least 30% of shares, 1/4 by those with less than 30%, and the remainder by all shareholders collectively. In contrast, the current directive has revised this framework: now, 1/3 of Board seats are designated explicitly for nominees of non-influential shareholders to be elected exclusively by them; another 1/3 are open for election by all shareholders collectively; and the final 1/3 are allocated to independent directors, who are also to be elected by all shareholders. This adjustment mitigates the dominance of influential shareholders implicated in the second principal-agency problem previously discussed. The heightened role of independent directors is anticipated to catalyze significant improvements in governance practices within banks, promoting heightened transparency, accountability, and equitable decision-making processes throughout Ethiopia’s banking sector.

The initiative to curb the influence of influential shareholders and mitigate their improper practices must also confront persistent challenges related to abuses of power within senior management of banks. Addressing these issues requires a multifaceted approach. First and foremost, enhancing onsite supervision is crucial to monitor and regulate the conduct of senior executives proactively.

Strengthening public disclosure requirements will promote transparency, enabling stakeholders to hold banks accountable for their actions. Additionally, imposing criminal sanctions on individuals who breach corporate governance standards and cause harm to banks can serve as a deterrent against misconduct. Equally important is addressing market distortions and unhealthy competition, which create fertile ground for corrupt practices. For instance, distortions in forex markets and opaque loan pricing mechanisms have significantly contributed to unethical behaviours within the banking industry. Regulatory bodies can mitigate the risks associated with corrupt practices by rectifying these distortions and promoting fair competition. Combining enhanced supervision, stricter regulatory enforcement, and market reform, this holistic approach aims to foster a banking environment characterized by integrity, transparency, and responsible governance practices.

To sum up, the evolution of corporate governance in Ethiopia’s banking sector reflects a proactive response to longstanding challenges and recent controversies. The National Bank of Ethiopia’s directives have aimed to enhance transparency, accountability, and stakeholder protection within financial institutions. Despite these efforts, issues persist, particularly concerning the influence of influential shareholders and ethical lapses in senior management. Moving forward, sustained regulatory vigilance, strengthened enforcement of governance standards, and reforms addressing market distortions are essential. These measures are crucial for fostering a banking environment that prioritizes integrity, fairness, and sustainable growth, ultimately bolstering trust and stability in Ethiopia’s financial sector.

12th Year • July 2024 • No. 130