Reinventing Ethiopian Banks

Seizing the Inflation Battle Opportunity

Ethiopia’s central bank recently implemented a policy to cap credit lending rates at 14Pct to combat inflation. While this move may appear challenging, it presents an opportunity for Ethiopian banks to strengthen their financial institutions, contribute to economic stability, and enhance long-term competitiveness. Key to this transformation is the adoption of robust credit risk management frameworks, a disciplined focus on enterprise risk management, adherence to international standards, and active cost management across the entire organization, argues Michael Okwusogu, Managing Partner and Head of Financial Services at Value X Partners

Credit Quality Preservation

The 14Pct cap places immense pressure on banks to maintain the quality of their loan portfolios. With lower interest rates, banks may face challenges in generating sufficient interest income to cover the cost of funds and maintain profitability. This elevates credit risk exposure because, with lower interest margins, banks may be tempted to take on riskier loans to sustain profitability. This increases their vulnerabilities; necessitating robust risk management practices and making banks assess and manage credit risk rigorously.

Strategic Shifts

Banks must rethink their lending strategies. They will need to focus on more efficient lending practices. This includes better due diligence, stricter underwriting standards, and diversifying their loan portfolios to reduce risk concentrations.

Asset-Liability Management

The cap necessitates banks to sharpen their asset-liability management practices. They must ensure their sources of funds align with the lower lending rates to avoid liquidity mismatches and interest rate risk.

Proactive Credit Risk Management

Robust credit risk management is the cornerstone of any successful banking institution. Ethiopian banks can leverage this policy to build a strong foundation for their operations. To seize the opportunity presented by the central bank’s policy, Ethiopian banks must prioritize robust credit risk management. This involves a comprehensive assessment of borrowers’ creditworthiness, prudent risk assessment, and proactive risk mitigation.

These are some key benefits:

Reduced Non-Performing Loans (NPLs)

Implementing stringent credit risk management practices helps banks identify potential problem loans early on. By minimizing NPLs, banks can protect their capital and maintain financial stability.

Enterprise Risk Management (ERM)

The central bank’s policy also highlights the need for a disciplined focus on enterprise risk management. ERM is a holistic approach that considers all aspects of risk within an organization. By embracing ERM, Ethiopian banks can identify and manage risks in their lending activities and their entire operations.

This comprehensive risk assessment prepares banks for unexpected challenges, such as economic downturns or external shocks. It enhances their ability to make informed decisions, allocate resources efficiently, and safeguard financial stability.

Improved Asset Quality

Banks with substantial credit risk management frameworks tend to have healthier asset portfolios. This safeguards the institution and fosters trust among depositors and investors.

Mitigating Default Risk

With potentially riskier lending practices, banks must enhance their credit assessment and underwriting processes to effectively identify and mitigate default risk.

Portfolio Diversification

Diversifying their loan portfolios by industry, borrower type, and loan products can help banks spread risk and minimize the impact of loan defaults. This diversification can lead to more stable and sustainable lending practices, benefiting the banks in the long run.

Stress Testing

Regular stress tests can prepare banks for adverse economic scenarios, ensuring they have adequate capital reserves to absorb losses.

Credit Scoring Models

Implementing advanced credit scoring models and data analytics can give banks more accurate risk assessments, aiding in responsible lending.

Continuous Monitoring

Regularly monitoring borrowers’ creditworthiness throughout the loan term can help banks identify early warning signs of potential defaults.

Adoption of International Standards

Ethiopian banks must align with international banking standards and best practices to thrive in today’s global economy. The adoption of robust international standards ensures that these banks can compete on a global scale and provide services to international clients. Meeting international standards also enhances transparency and accountability, which is essential for building trust with customers and investors.

Access to International Capital

Compliance with global banking standards makes Ethiopian banks more attractive to foreign investors and lenders. This can lead to increased capital inflow, vital for growth and expansion.

Enhanced Reputation

Adhering to international standards boosts a bank’s local and international reputation. This can attract a broader customer base and foster trust among stakeholders.

Opportunity for Operational Restructuring: Operational Efficiency

The lending rate cap also offers an opportunity for operational restructuring. Banks can right-size their operations, focus on technological and data enablers and attract and retain talent to thrive in the evolving financial landscape.

Product portfolio diversification

Banks can and should diversify their revenue streams by expanding or pivoting to non-interest income (NII) business lines. Offering fee-based services, such as wealth management and advisory services, will help them reduce reliance on NII, mitigate earnings volatility and stabilise revenue across the business cycles.

Governance, Risk and Compliance (GRC)

Regulatory reforms are making GRC more complex and crucial to operational viability. Banks must adopt advanced risk management, governance and compliance tools and methodologies to adhere to regulatory requirements and maintain a strong risk culture.

Risk Mitigation & opportunities discovered

Restructuring can help banks mitigate risks associated with the 14Pct lending rate cap. A well-thought-out restructuring plan can align their operations with the new economic realities, reducing exposure to credit and interest rate risk.

Strategic Positioning

A restructuring exercise provides an opportunity for banks to redefine their strategic priorities. They can explore new markets, products, and partnerships that align with the changing dynamics of the Ethiopian financial sector.

Active Cost Management

Efficient cost management ensures the sustainability of individual banks and contributes to overall economic stability by preventing excessive inflation caused by high-interest rates.

To maintain profitability within the confines of the lending rate cap, banks must focus on active cost management across their organizations. This entails identifying and minimizing inefficiencies, streamlining operations, and optimizing resource allocation.

Benefits include:

Sustainable Profitability

Efficient cost management allows banks to maintain profitability even in a low-margin environment. This ensures their long-term viability and ability to weather economic downturns.

Competitive Advantage

Banks that can provide services at a lower cost can gain a competitive edge in the market. This can lead to increased market share and long-term success.

The Economy and Competition

This new approach benefits the Ethiopian economy in several ways. Firstly, it helps combat inflation by curbing excessive borrowing and lending practices that can fuel rising prices. Secondly, it encourages banks to focus on responsible lending, which promotes financial stability and reduces the risk of banking crises.

Furthermore, this policy enhances competition within the banking sector. Banks must differentiate themselves by offering innovative products, improving customer service, and optimizing their operations. Increased competition benefits consumers, leading to better services and more competitive interest rates.

Conclusion

Ethiopian banks find themselves at a pivotal moment. A robust credit risk management framework and structural adjustments are imperative to navigate the challenges the central bank’s policy poses to cap lending rates and the on-going professionalization of the financial services industry. While these changes may present immediate challenges, they offer opportunities for banks to emerge more robust, efficient, and strategically positioned for long-term success. The ability to adapt and thrive in this evolving landscape will depend on taking proactive measures to address credit risk. Adopting and constantly iterating the enterprise risk management framework and ensuring that governance, risk, and compliance (GRC) are at the forefront of the operational management whilst restructuring operations effectively is essential.

To learn more about how VXP supports Financial Service firms, please contact Michael Okwusogu, Managing Partner, and Head of Financial Services. michael.okwusogu@valuexadvisory.com

---

12th Year • Nov 16 – December 15 2023 • No. 123