Modalities for Foreign Bank Entry into Ethiopia A Need for Caution in Policymaking

The Council of Ministers in its 13th regular session held on August 4, 2022, resolved to open the banking sector to foreign investors by endorsing a policy document. Following this decision, the National Bank of Ethiopia (NBE) circulated the policy along with a draft amendment to the banking business proclamation. The policy document as well as the draft legislation allow four models for the entry of foreign banks into Ethiopia, viz., acquisition of stakes in existing banks, subsidiary formation, the opening of branches, and opening of representative offices. While opening a representative office cannot amount to market entry, it has long been permitted for some foreign banks. Representative offices can only do promotional activities and, most importantly, cannot offer services to customers. There is no mention of the joint venture as an entry model, contrary to earlier reports in some media. This is not to suggest that the proposed models are not good enough. On the contrary, one may be tempted to judge that the policy gives too much in terms of entry options. With Ethiopia being the second most populous country in the continent with one of the lowest rates of financial inclusion, there was no doubt that Ethiopia’s banking market would attract interest even if the country restricts the modes of entry.

In this brief piece, I will analyze the pros and cons of each model, both from the regulatory and competitive points of view. I stress that permitting foreign bank presence through branch opening doesn’t seem to be a wise policy from these two points of view.

Branching—establishing a presence through branching—will be the easiest for foreign banks. However, it will also be the most difficult to regulate for the National Bank of Ethiopia (NBE). Key prudential requirements such as solvency cannot be supervised at the branch level. Other requirements, such as capital adequacy, can also be problematic to monitor at the branch level. Thus, generally, home authorities are the ones that can exercise regulatory authority over foreign branches of their domestic banking institutions. In contrast, host country central banks have the lead regulatory responsibility for foreign subsidiaries they host.

From the prudential point of view, branches can expose the Ethiopian financial sector to the risk that shocks in other countries can easily spill over into our domestic financial systems—risks that NBE cannot prevent because it can’t sufficiently regulate the branch concerned. If the home country authorities are either unable or unwilling to intervene, branches can cause risk to domestic consumers and the industry. Most industry insiders remember the failure of the Icelandic bank, Landsbanki, that left the Icelandic authorities with the obligation, but not the fiscal capacity, to protect depositors of overseas branches, mainly in the UK and the Netherlands. It is also difficult to supervise corporate governance at the branch level, as opposed to the case with subsidiaries.

The business case against branching is equally compelling. It is true that foreign branches can facilitate a more efficient allocation of savings mobilized continentally or globally, lower intermediation costs, and improve access to credit for households and businesses. Likewise, the establishment of branches of foreign banks in Ethiopia means, at least theoretically, the free flow of deposits mobilized in Ethiopia to other countries where the bank operates. However, the draft law prohibits cross-border lending. So, what value proposition is the country expecting from foreign branches?

The ease of establishing branches compared to the acquisition of stakes in existing banks or setting up subsidiaries means it can be the preferred strategy for foreign banks. Unless hefty upfront investment is required, branches of foreign firms can be set with a fraction of the capital and investment of local banks but can compete for bigger customers thereby creating unhealthy competition. As branches can minimize the supervisory intervention of Ethiopian regulators, it may also give an added advantage.  What is more, branching can be a less audacious strategy because foreign banks can simply follow the main clients working in Ethiopia, and prize them away from local banks instead of enhancing financial inclusion. To this extent, branches of foreign banks can be threats to domestic banks. This might be the reason why most African countries do not allow branches of foreign banks. According to data from the World Bank Banking Regulation and Supervision Database (2012) and the Regulatory Framework Database (AfDB 2010), only 10 out of 48 countries practically allow foreign bank presence through branching. What is more, entry through branching is most common in the countries with some of the most developed financial sectors, such as South Africa, Mauritius, and Seychelles.

Subsidiary formations

Subsidiary formations look like the most appropriate foreign bank entry model. Both the policy and the draft legislation provide a subsidiary as one of the options. Such a subsidiary can be a wholly owned subsidiary (WOS) or a majority-owned subsidiary (MOS) of a foreign bank. While in WOS, almost 100Pct of the shares are owned by the parent, a few nominal shareholders can be accommodated in order to meet minimum membership levels. In MOS, more than 50Pct of the shares are held by the party, but more often the parent’s holding goes above two-thirds of the voting shares for the control to create a clear parent-subsidiary relationship.

Here, there seems to be an inconsistency with existing regulations. On the one hand, foreign ownership in existing banks is restricted to a maximum of 30Pct, but then wholly- or majority-owned subsidiary banks are allowed. The rationale behind the policy is not clear. Whether it is giving a head-start to indigenous banks, preserving local control in existing banks, or protecting investors of the existing banks. One thing clear from the regulatory perspective is that there will be regulatory unevenness in the market. What is more, Ethiopian shareholders are to be limited to hold a 5Pct maximum shareholding. It is strange to allow foreigners 100Pct control of banks (even if it is a subsidiary), and then maintain the ownership limit of local investors to 5Pct in indigenous banks. If the rationale for the restriction is reducing the risk from the excessive influence of block-holders, it is not clear why the risk is treated differently when it is coming from foreign bank ownership.

On the other hand, the policy and the draft clearly recognize a one-member company as a form of entity, presumably for wholly-owned subsidiaries. While it is clearly stated in the documents that a dual board of directors (executive and supervisory) is mandatory regardless of the form of a legal entity, breaking the long-established tradition of requiring a share company form seems unwise. Having a board of directors as the highest governance organ is good, but good corporate governance is more than having a board of directors. The wiser solution would be to require a share company to be in the form of a legal entity, which in and of itself entails the strictest corporate governance regime conforming to the high standards of the financial sector regulatory framework.

For NBE, regulating WOS and MOS will be a completely new challenge. Up till now, the central bank has had to deal with the board and management of the most widely held companies in the financial sector. Ownership was kept below 5Pct so as to discourage the owners’ vigor for interference in management. What is more, NBE’s directives allowed it to closely monitor the behavior of shareholders owning more than 2Pct by designating them as “influential shareholders.” This created a reality where the management and boards served NBE as their true master. Apparently, the draft proclamation prescribes a board of directors as a solution to corporate governance challenges in WOS and MOS. In fact, a two-tier board of directors tiered into an executive board and a supervisory board is prescribed. However, no board of directors, however independent or qualified, can control an unscrupulous 100Pct owner. In contrast, requiring a share company as the form of a legal entity can provide the necessary corporate governance sub-structure for a healthier operation.

Mergers and acquisitions (M&As) with existing banks

Of all the entry options presented, M&A with existing banks is the one made clear so far. It is clearly stated that foreign banks will be allowed to acquire stakes in local banks up to a maximum of 30Pct, and individuals and non-banks to be limited to the existing 5Pct cap for single shareholding. The maximum foreign shareholding combining foreign banks and non-bank foreigners (entities and individuals) will be 40Pct in one bank.

Will a 30Pct stake be attractive enough? In other industries, foreign ownership stakes need to be relatively larger (over 50Pct) if a target company is to be successfully restructured and achieve improvements in cost efficiency. Nevertheless, as far as the 5Pct ownership cap remains in place for other shareholders, 30Pct shares are sizable enough to exercise control for foreign banks. And, at any rate, the practice of restructuring the operations and management in the aftermath of takeovers will be unlikely to happen in the banking sector due to close supervision and oversight of NBE, whose tight grip will not allow drastic structural changes without its approval. And, any clue that such changes are initiated by a block-holder can be reason enough in itself for rejection of the proposed change. The NBE’s regulatory culture is tuned in this way.

Apart from the consequence of the M&A between foreign banks and their local counterparts, there should also be questions about the process of such M&As. First, there is a need for regulatory guidance on whether foreign banks will be required to be issued new shares or will bid for existing shares from the shareholders. Maybe this is to be left to each bank participating in the M&A transaction. The draft amendment proclamation is replete with references to future directives to be issued by NBE. Probably, such directives will clarify this. In the long-term interest of the financial sector, it would be wise if the law mandated foreign banks be issued new shares through a capital increase.

However, where existing shares are to be acquired, one may inquire whether such share acquisitions shouldn’t be done through a transparent auction so that all shareholders interested are given the chance to sell their shares pro-rata or on a first come, first served basis. The sale of 30Pct stakes comes with a de-facto control right because of the dispersion of ownership in banks. Therefore, there is always a control premium on the price of such a block of shares. Such a premium should be fairly distributed amongst all the members. Otherwise, it will be cashed in by influential shareholders to the detriment of dispersed members. Even though the Ethiopian commercial code doesn’t require a public bid for the acquisition of shares of less than 50Pct, the situation in financial sector companies is different, and it will require different rules. The NBE’s power to issue directives on corporate governance can give it authority to issue such directives.

Last, in relation to M&A, the role of the Trade Competition & Consumer Protection (TCCP) body, currently within the Ministry of Trade and Regional Integration (MoTRI), is important as in other industries. There is, however, a marked lack of experience in evaluating M&A in the financial sector. NBE needs to create the necessary working relationships with this entity to smoothen future M&A in the banking sector.

Joint venture

There is no mention of joint ventures (JV) both in the policy and in the amendment proclamation. A JV in the banking industry is a company formed by different banks, often as an entity strategy in new markets. It is unclear whether a handful of foreign banks can form joint ventures without surpassing the 30Pct cap. In fact, this is how the Basel Concordat (BIS 1983) defines JV in transnational banking. While there is feasibility for a group of foreign banks to set up JVs in Ethiopia, policy-wise, such a move will be more beneficial if the JV also includes Ethiopian institutions. Otherwise, foreign banks can join hands, making the competition even harder for local players.

JVs in international banks can be set up not only between banks but can also include other non-banking companies. This seems to be ruled out, seemingly by design rather than by default.

Consistency and innovation

Among the entry options prescribed, efficiency may favor branches, but financial stability and regulatory simplicity imply that subsidiary formation and M&A with local banks are the better entry options. Foreign subsidiaries can be strong competitors to local players. But given the considerable investment they make, and the technology and knowledge transfer as well their contribution to financial inclusion due to the bigger scope of operation, it will be worth the trouble. Thus, NBE is under huge pressure to adapt its regulatory framework without compromising key prudential and corporate governance requirements. It has to be innovative enough to create solutions to newer challenges resulting from the entry of foreign players into the market. At the same time, the adaptations and new solutions should be consistent and predictable.

11th Year • Oct 2022 • No. 111