GAMBY Medical and Business College

Master of Business Administration (MBA) Program

Financial Markets and Institutions (MBAd 731)
Group Assignment (30%)
Group members
N Name ID No
o
1. Kidist Baye GMBA/GE/013/14
2. Haimanot bogale GMBA/GE/003/13
3. Hilina Gezahegn GMBA/GE/009/14
4. Inyesu Christopher GMBA/GE/004/13
5. Medhin Getaneh GMBA/GE/015/14
6. Saron Melku GMBA/GE/020/14
7. Werkinesh Tadesse GMBA/GE/030/14

Topic
1. Ethiopian financial markets & institutions
1.1. The formal, semi-formal, and, informal financial sectors
1.2. Financial market regulation in Ethiopia

Submitted on – November 16, 2022

Submitted to - Biruk, Ph.D.
 1. Ethiopian financial markets & institutions
1.1. The formal, semi-formal, and, informal financial sectors
1.2. The formal sector
1.2.1. Definition and origin of formal sectors

The formal financial sector is currently one of the principal areas of intervention intended to
provide social protection and poverty alleviation for the poor. The intervention has taken the
form of formal transfers and improved access to credit and/or subsidization of credit. Credit
during the pre-revolution period in Ethiopia was characterized by the concentration of bank
operations in a few urban centers.

Formal credit and transfers may not only alter the allocation of resources within the
household, but they may also alter the allocation of resources between altruistically linked
households.

Households that are recipients of formal transfers and credit may transfer some of the benefits
by increasing (decreasing) gifts and loans to (from) altruistically linked households,
generating possible third-party effects. In the most extreme case, formal sector programs
could have no income effect on their targeted population if the formal sector fully replaces
the informal sector.

Formal Sector/Formal Credit Received: Loans from microcredit organizations, government

institutions, commercial banks, cooperatives, and other NGOs are defined to be from the
formal sector. Our formal sector variables capture the cumulative amount of all loans (greater
than or equal to 1,000 Taka) received in the past year.

The great bulk of the Ethiopian population makes little or no use of formal savings and
lending institutions. In a country where more than 80% of the population lives in rural areas,
the few banks and credit associations that are presently operational are limited to urban areas.
Moreover, these banks are little used even by the urban population.

1.2.2. The formal financial sector in Ethiopia

During the pre-revolution period in Ethiopia, credit was characterized by the concentration of
bank operations in a few urban centers (e.g. Addis Ababa alone accounted for 64% of the
bank branches), high collateral and minimum loan requirements favored big businessmen,
and the virtual neglect of the agricultural sector. By 1974 agriculture had received no more
than 10% of the total bank credit even though the sector had accounted for more than 50% of
the GDP (National Bank of Ethiopia, 1975, pp. 29-41; Haimanot Asmerew, 1990).

The post-1974 period saw the nationalization and consolidation of various types of banks into
specialized banks: National Bank of Ethiopia (NBE), Commercial Bank of Ethiopia (CBE),
Agricultural and Industrial Development Bank (AIDB), and Housing and Saving Bank
(HSB). The NBE, being the Country’s central bank, is responsible for issuing currency,
planning and coordinating all banking activities, formulating monetary policies, and acting as
a financial arm of the government. The CBE, the biggest bank in the country, is primarily
responsible for the mobilization of domestic savings and for extending loans to all
commercial activities.

The financial intermediaries in Ethiopia are highly biased in favor of the socialist sector of
the economy. For example, the loan interest rate is 7% for individual farmers and private
enterprises and 6% for state and collective farms (NBE Credit Regulation NBC/CR 1). Most
of the agricultural loans of the AIDB (89%) go to state farms which account for not more
than 5% of the total agricultural output, while the private peasant sector receives an
insignificant amount of loans (less than 1%) (Haimanot Asmerew, 1990, p. 54). Existing
credit policies of the government have contributed to limitations in the farm household's
access to formal sources of credit.

In recent years, the CBE has attempted to reach the rural population by increasing the number
of bank branches from 86 in 1974 to 147 in 1986 (NBE, 1975, p. 31; Yeshitla Yehualawork,
1989, p. 399; Mahtsentu Felleke, 1989). However, in a country where three-quarters of the
rural population live a day's walk from the nearest all-weather road, it can be said that the
'savings in Ethiopia are only mobilized from urban population and organizations' (Yeshitla
Yehualawork, 1989, p. 399).

The total banking system deposits (NBE, CBE, AIDB, and HSB) in 1986/87 amounted to bin
4.3 billion, of which demand deposits were 60% (NBE, 1986-87, P. 27).

1.2.3. The Relationship between the Formal and Informal Sectors

The relationship between the formal and informal sectors, though the relationship also is
relevant for program impacts. Knowledge of the relationship between the formal and
informal sectors is relevant for researchers and policymakers interested in targeting program
beneficiaries and measuring program impacts. Crowding out occurs when increases in access
to formal transfers and credit results in reductions in informal transfers and credit, or vice
versa.

The informal sector and the relationship between the formal and informal sectors are also
relevant to evaluating program impacts. As a result of crowding out, Cox and Jimenez (1990)
suggest that examining only participating households may not adequately measure the full
effects of public programs.

1.3. Semi-formal financial sectors

Semi-formal providers are microfinance institutions registered as banks with a special charter
or NGOs that serve those who have been excluded from the formal banking system.

1.3.1. Semiformal – Saving and Credit Cooperatives

Savings and credit co-operatives (SACCs) can be designated as semi-fonnal financial

institutions. They are outside the control of the central authorities with respect to ownership
of assets and management. As a semi-formal financial sector, the SACC can establish a link
between the informal (the iqqub and iddir) and formal sector

In other words, the semi-formal sector includes those institutions which are regulated
otherwise but do not fail under the jurisdiction of the central bank, insurance authority,
securities and exchange commission, or any other enacted financial regulator.

The SACCs in Ethiopia have recent origins. The oldest ones were established in the late
1960s, and they grew very slowly until 1978. One reason behind such slow growth was the
political and social instability which followed the 1974 uprising. SACCs have been growing
fast since 1978. In Ethiopia, there are three types of saving and credit cooperatives:
Institution based SACCOs; Community based SACCOS; and SACCOs sponsored by NGOs.

The basic goal of a savings and credit association is to encourage thrift among its members
not to make profit, and not to supply charity, but to provide services. Members are paid
dividends on shares and interest on savings/deposits. SACCs grant loans to members who
might not qualify for credit elsewhere and who cannot afford the high loan rates offered in
either the informal sector or by other types of financial institutions.

Savings and credit cooperatives are the type of organizations providing financial services to
the poor in rural areas of Ethiopia. These include multi-purpose and credit and saving
cooperatives. Unlike other formal financial institutions (banks and microfinance institutions),
their members own, control, and capitalize savings and credit cooperatives. This implies that
the savings and credit cooperatives are not subjected to the supervision and regulation of the
National Bank of Ethiopia.

The ministry of cooperatives is responsible for the coordination of their activities. One of the
principles of SACCOs is that lending is limited to only members of the cooperatives and the
amount of the loan depends on the level of individual saving deposits. One of the weaknesses
reflected in the cooperative sector is poor administrative and financial management. On the
other hand, the government through the relevant ministry is not adequately equipped to
monitor and control the cooperative movement.

Savings and credit cooperatives in Ethiopia are not permitted to take deposits from non-
members. Many rural saving and credit cooperatives provide loan services for agricultural
inputs, animal fattening, and in some cases off-farm activities. Loan disbursement policies
are prudent, only those with sufficient savings and collateral can lend. The majority of loans
are provided for a period of one year or less.

Today SACCs are organized and supervised by the Savings and Credit Co-operative
Development Office (SACCDO) of the National Bank of Ethiopia in accordance with the
provisions of Proclamation No. 138 of 1978. SACCDO, among other things, sees to it that
SACCs implement the following rules and procedures:

• Registering SACCs, issuing certificates of establishment and dissolving them

when necessary;
• Formulating by-laws for the administration of SACCs;
• Auditing the accounts of SACCs;
• Paying members an interest rate of 6% per annum on their deposit with SACC;
• Making sure that credit released to members is in line with the National Bank's
policy of controlling inflation;
• Keeping 25% of the gross profit of an SACC in the bank in the form of reserves in
line with the practice prior to the 1978 proclamation;
• Making accounts available for auditing by the National Bank.

The key issues impeding SACC expansion in Ethiopia can be characterised as policy,
structural, social, and technical obstacles. Some of the issues are that regulatory limits and
bureaucratic tangles limit chances for profitable investment. Thus, savings and credit
cooperatives have enormous potential for mobilising savings in Ethiopia. Although the
growth rate of these co-operatives has been quite strong since 1978, considerable work
remains to be done to fully achieve their potential.

1.4. Informal financial sectors

1.4.1. Definition and origin of informal finance

Informal finance refers to the unrecorded actions that occur outside of official financial
institutions. It is critical to understand that informal sector activities are legal; they are simply
uncontrolled. Informal activities have a diverse operational scope and features: some are
community- or group-based, while others revolve around individuals. Some mobilize only
savings; others mobilize both savings and loans; while still others mobilize only lending.
Although there is no barrier to entry, lending is done mainly on personal recommendation.
The geographical coverage of the units is limited in scope, as deposit-taking and lending
often take place among people of the same locality.

There are two schools of thought about the origin of informal finance: the financial repression
and the structuralist schools. The financial repression school, which originated from the
seminal work of McKinnon (1973) and Shaw (1973), argues that informal financial agents
start operations as a result of excessive regulation of the formal financial sector, represented
by the use of policies of directed credit, interest-rate ceilings, and preferential credit
allocation to government. As a result, lead to the development of the informal financial
sector.

The structuralist school ascribes the existence of informal finance to other factors. This
school of thinking holds that informal financial systems are subordinate to the official
(formal) system. Market segmentation occurs, not because of regulation, but because
informal financial institutions serve other social goals. They redistribute income among
community members and provide a form of social security by meeting their fluctuating
liquidity needs.

1.4.2. Operation of informal financial markets

There are three types of models for the operation of informal financial markets:

 The traditional or monopoly model

 The intervention-free or perfect competition model; and

 The imperfect information model.

The traditional view of rural credit is that it is dominated by monopolies, resulting in
inordinately high-interest rates. The policy prescription to ameliorate the adverse effects of
such high-interest rates is the introduction of formal subsidized credit for rural dwellers and
SMEs. In many developing countries the result of such intervention has been very
disappointing.

The intervention-free model is pioneered by Von Pischke, Adams, and Donald in 1983,
however, idealizes the informal credit market that would exist in the absence of major
intervention. It asserts that if the government did not intervene, its operation would be similar
to the perfect competition model.

Hoff and Stiglitz (1990) use the imperfect information model to explain that rural credit
markets are incomplete and operate in an environment of imperfect information and
imperfect enforcement. This is because, in the rural credit market, lenders have to choose
between competing potential borrowers. This is the screening function. After lending, they
have to take appropriate actions to ensure that the promise to pay is fulfilled. This is the
contract enforcement function. In carrying out these functions, lenders are confronted with
problems of information asymmetry, moral hazard, adverse selection, and adverse incentives.

The information asymmetry problem arises because lenders do not know which potential
borrowers are likely to fail. Furthermore, once the loan is given but before repayment begins,
the assumed conditions, such as borrowers' willingness to use the money as promised or the
proper climatic or investment environment, may change rapidly. This is the issue of moral
hazard. Adverse selection is frequently caused by the problem of high lending rates. In such
cases, lenders frequently favor risky projects with high potential returns. Borrowers, when
faced with similar circumstances, tend to favor risky investments with appealing potential
returns. This is referred to as the adverse incentive problem.

To address the issues raised by imperfect information in the credit market, two types of
mechanisms. These are direct and indirect. Indirect mechanisms rely on the design of
contracts by lenders such that, when borrowers respond to these contracts in their interest, the
lender obtains information about the riskiness of the borrowers and this induces him to take
action to reduce the likelihood of default.

Direct mechanisms are commonly adopted by informal sector lenders and have proved more
effective. Since they rely on lenders expending resources to screen applicants and enforce
loan contracts. It follows that high-interest rates may reflect the high cost of these activities.
Examples of direct mechanisms include the use of personal relationships like ethnicity,
kinship, and locational and religious affiliation.

Ultimately, saving in the informal sector faces the same information and enforcement
challenges as lending. As a result, informal saving is restricted to close social groups to avoid
the moral hazard and adverse selection issues associated with entrusting assets to strangers.

1.4.3. Informal Finance in Ethiopia

The great bulk of the Ethiopian population makes little or no use of formal savings and
lending institutions. In a country where more than 80% of the population lives in rural areas,
the few banks and credit associations that are presently operational are limited to urban areas.

The question now is 'why does the population not effectively use the formal sector?’ In the
first place, it should be noted that households have a low capacity to save mainly because of
the low level of per capita income in the country. In addition, the political and social climate
in the country is not sufficiently conducive to savings mobilization. In the second place,
limited savings mobilization through the informal sector may be traced to two related factors:
the inability of formal financial institutions to attract households and household reluctance to
use these institutions.

The formal institutions, which are transplanted from industrial countries, seem largely
inappropriate to Ethiopian realities. High costs per transaction, complex bureaucratic lending
procedures, elaborate paperwork, high collateral requirements, and delays are some of the
factors which militate against the effective utilization of existing banking facilities.
Moreover, the low-interest rate offered to savers does not provide an incentive to the public.
On the other hand, households may be reluctant to use the formal sector due to a lack of
confidence in the banking system, lack of information, and age-old social norms.

On the other hand, the informal financial sector, as shown by studies undertaken in
developing counties such as Ethiopia, has certain advantages over the formal sector. The
average scale of operation and the cost of lending and recovering is small; there is freedom of
entry and exit and freedom from de jure and de facto central banking control; information-
gathering is kept to the minimum while trust and first-hand knowledge of a participant are
important; the purpose of credit is for both consumption and investment. The nature and
procedure of the informal financial sector in Ethiopia are also been extensively described and
well-known.
In both rural and urban areas in Ethiopia, it is common that neighboring family households to
organize themselves and develop their institutions, popularly known as Community-Based
Organizations (CBOs). The nature of the CBOs highly varies from social, religious, and
financial concerns, but are all aimed to address the needs of the people. In most communities,
membership in traditional community associations such as iddirs, iqqubs and mehabers are
very common. More importantly, these traditional institutions also play a crucial role in
savings and beneficiary mobilization in the informal financial sector.

According to Micro Ned (2007), the outreach of the informal financial sector is high; more
than two-thirds of the population have access to an informal finance provider, whether it is
from money lenders, friends/relatives, or from one of the three popular systems (iddirs,
iquips and mehabers)  of informal finance.

Informal finance is very popular in Ethiopia due to three main reasons:

 First, it has more often than not been the only form of service delivery available.

 Second, loan processing is quick and, not too many questions are being asked about
the application of the borrowed sum.

 Third, in the case of Iddir and Iqqub, loans are provided in the context of social

intermediation and self-organization.

The informal financial sector in the country consists of unregistered traditional institutions
such as Iqub (Rotating Savings and Credit Associations) Idir (Death Benefit Association) and
money lenders.

1.4.3.1. Iddirs

An Iddir is the most common informal institution in Ethiopia, common in both rural and
urban areas. It is an association made by a group of persons united by ties of family and
friendship, by living in the same district, by jobs, or by belonging to the same ethnic group. It
acts in providing mutual aid and financial assistance in certain circumstances.

It is primarily used in burials whereby savings are made to cover the cost of funerals, but it
can also be used for weddings. Whenever a death occurs among its members, the
organization raises an amount of money to handle the burial and other related ceremonies. It
further aims to address different community concerns and provides various services to its
members. Membership is usually by residence, whereby members pay a small monthly fee.
In practice, Iddir is a sort of insurance program run by a community.  It is very popular
among people because it is culturally appropriate, flexible, easily accessible, and cost-
effective. It is basically a non-profit making institution based upon solidarity, friendship, and
mutual assistance among members. In general, individuals tend to join iddirs when starting to
have a family. Membership of iddirs is also increasingly widespread particularly, among the
poorest members of society, who are in most need of their support. Iddirs can establish bank
accounts in their names only upon presentation of a document certifying that they are
registered with the Ministry of Internal Affairs but most of the associations are not officially
registered due to the high cost of registration and bureaucratic tangles involved.

It is possible to distinguish between four types of iddirs:

 Community or territorial, referring to people living in the same vicinity;

 Work-place or occupational, referring to people working in the same institution;

 Friends' iddir, referring to former schoolmates or people having close friendships;

 Family iddir, involving blood relatives or very close friends.

In terms of organizational structure, nearly all iddirs have a secretary and a treasurer, in
addition to a chairman and a judge. It is frequently referred to as Ethiopia's most democratic
and egalitarian social organization due to its unbiased membership structure, with
membership open to anyone regardless of religion, socioeconomic status, gender, or ethnic
affiliation. Hence, it has been acknowledged by both the government as well as by non-
governmental institutions (NGOs).

1.4.3.2. Iqqubs

Iqqubs have played a significant role, especially in the informal sector in Ethiopia.

An iqqub  is a traditional saving and credit association (Rotating Saving and Credit
association), whose purpose is basically to pool the savings of their members by the rules
established by the group. Members usually deposit contributions on a weekly or monthly
basis, and lots are drawn by turns so that the one who wins the chance gets the total sum. This
process continues regularly until the last member receives his/her share of what she/he has
been saving through the months and the whole process starts again.

1.4.3.3. Mehabers
Another common CBO is the Mehaber, which is a religious, informal institution that aims to
raise funds for medical and burial expenses. It is widespread among the Orthodox Christians
of Ethiopia, as it typically draws its members from the church. Members usually meet every
month for food and drinks, and commonly support each other in times of difficulty.

In summary, several characteristics can be identified for the informal finances sector: -

 Heterogeneity – It includes a wide variety of institutional forms and, within any one
type, a variety of financial contracts between savers and borrowers can be found. The
frequency with which these financial arrangements are found varies widely: Africa
and Asia seem to have a greater variety of informal finance arrangements than Latin
America, for example.

 Services – It offers both loan and savings services, unlike supply-leading finance
which often ignores savings. Many types of informal finance also offer marketing and
other services.

 Specialization – Some informal financial arrangements serve a broad clientele but

informational problems often encourage specialization. For example, money keepers,
moneylenders, and trader lenders often provide only one type of financial service and
it is limited to those clients for which the supplier has good information.

 Access – Informal finance is used by the rich and the poor, but often it is the only
source for the poor while it is an alternative source for the rich.

 Collateral – Like formal finance, some informal financial arrangements may require
collateral for loans (e.g., credit unions, pawnshops), but frequently informal finance
has developed effective collateral substitutes through interlinked contracts, peer
monitoring, and group lending.

 Interest rates and transaction costs – Moneylenders have been criticized for
charging exploitative interest rates on loans, but other types of informal lenders such
as farmers, friends, and relatives often charge no interest at all. What tends to
distinguish informal finance is the relatively low transaction costs for savers and
borrowers because of proximity and a minimum of formal procedures.
  Growth and decline – It are difficult to conclusively determine the trends of informal
finance. The large informal sector observed in many countries implies that informal
finance will also be large.

 Contribution to development informal finance is already contributing to

development because it is often the only source of financial services for the poor, the
landless, and those living in isolated regions.

1.5. Comparing Formal and Informal Financial Sectors

Characteristics Informal Financial Sectors Formal Financial Sectors

Ease of Entry Lower "barriers to entry" Higher "barriers” to entry"
Resource Use Usually local resources Domestic and foreign resources
Scale (Operation) Micro to small Micro, small, medium, and large
Financing Personal or family savings, and maybe Domestic or foreign financial institutions,
micro-credits foreign enterprises, or public sources
Technology Relatively labor intensive Relatively capital intensive
Organization Self-employment, family-oriented Corporate, "modern," bureaucratic
Skill Acquisition Informal apprenticeships, outside of the Formal educational system
formal school system
Labor Market Competitive, on-unionized, and unregulated Less competitive, perhaps unionized,
regulated, minimum wage laws
Taxation Usually not taxed, except for licensing Taxed
Regulation Mainly unregulated Regulated: labor legislation
environmental regulations
Public Policy Unprotected, less assisted via credit, tariffs, Often protected and assisted via credit,
tax incentives, infrastructure infrastructure provision, tax incentives

2. Financial market regulation in Ethiopia

The structure of financial development of a country especially developing countries has been
widely discussed and highly debated. On the one hand the financial repression school noted
that government intervention in the financial sector, especially through subsidizing interest
rates and favored allocation of credit is important for economic growth of developing
countries. On the other hand following McKinnon (1973), Shaw (1973) and the World Bank
and the International Monetary Fund, financial liberalization has been given great emphasis
for developing countries. While liberalizing its financial sector may bring economic and
social benefits it also involves certain risks. Therefore weighing its benefits and risks
carefully is important in deciding whether or not to liberalize.

In Ethiopia, because of its importance for economic development, the Government has taken
a cautious approach towards financial sector reform. In introducing financial liberalization
the Ethiopian government adopts a strategy of (a) gradualism: gradual opening up of private
banks and insurance companies, and step by step liberalization of the foreign exchange
market. (b) Intensification of domestic competitive capacity before full liberalization,
strengthening the regulatory and supervisory capacity of the NBE, giving the banks
autonomy, and strengthening the interbank money market (Geda and Dendir 2001). However
the government position in case of privatization is very strong and did not have any sign
either to privatize or to decrease its influence and dominance.

2.1. Types of regulation

2.1.1. Corporate governance

Initially Corporate governance is closely related with the founding of “corporate suffrage”,
where each shareholder had one vote (Dunleavy, 1998). Its aim was to create “democracy” by
reducing special privilege by restraining shareholder’s number of votes irrespective of the
number of shares own, but now days it was already changed into “plutocracy” by moving
towards “one-share–one-vote” and thus permitted for concentrated ownership and control
[Dunlavy (1998)].

Based on this, researcher has identified five alternative mechanisms to mitigate corporate
governance problem:

 Creating partial concentration of ownership and control.

 The regulatory body make hostile takeovers and proxy voting contests, temporarily in
time of concentration of ownership or voting power

 Delegation of concentration of control in the board of directors

 By making the compensation plan of executives clear align managerial interests with
investors
  By making CEOs to have defined fiduciary duties

Regarding concentrations of ownership the National Bank of Ethiopia issued a directive

whose aim is to limit for reduction and/or relinquishing shareholdings in directive no. SBB
/47/ 2010. In this directive any person was not allowed, to hold more than 2 percent of a
bank’s total shares either on his own or jointly with his relatives( his spouse or with a person
who is below the age of 18 related to him). Similarly the Bank has given the power to limit:
proxy votes in any meeting of shareholder, shareholders voting rights (who borrowed money
from the bank) and may suspend the voting rights of an influential shareholder of a bank fails
to fulfill the given ethical and propriety requirements.

Consequently, in order to have a clear compensation plan and to limit the remuneration of
board members and number of employees’ that can be members of the board, the Bank issued
Directive No. SBB/49/2011. In this directive the annual compensation to a director is limited
to 50,000 Ethiopian birr, the monthly allowance paid to a director not to exceed birr 2,000
(two thousand birr). And it did not allow an employee of the bank to be aboard member.
Consequently in this directive the Bank got the power to issue directives relating to
appointment and suspension of directors.

Even though those regulatory frameworks have been trying to address in the Banks directives
they fails to address the full elements of corporate governance. For example as it is in the
other sector of the economy, the financial sector also lacks clear law on corporate governance
where if the board of directors fails to meet the requirements by the Bank it only penalizes
the bank 10.000 birr not the board members therefore this leads to lack of accountability .
Similarly the Bank fails to address protection of small shareholders through investor’s
activism by representing them in the board members. At the same time there is no mechanism
to set up board standing committee which is out of the influence of board members and
directly responsible to the assembly. At last the directive did not influence the board
members to focus on policy issues since in the Ethiopian experience board members focus on
daily activity of the bank even in directing credit.

2.1.2. Restrictions on Banks, and on Links to Commerce

What is a “bank”? Countries may limit banks to a specific range of activities, or allow them
to engage in a broad activities, because these scope of activities basically defines what the
term “bank,” is, therefore banks may not be the same in every country around the world.
With regard to the meaning of a bank the National Bank of Ethiopia issued proclamation NO.
592/2008 and define bank business as: receiving funds from the public, using the funds for
loans or investment at the risk of the person undertaking banking business, buying and selling
of gold and silver and foreign exchange; the transfer of funds to other local and foreign
persons and the discounting promissory notes, drafts, bills of exchange and other debt
instruments; are some of them.
 2.1.3. Scope of Bank Activities
There are three regulatory variables that significantly affect the activities of banks: (a) Banks
engage in Securities; such as underwriting, brokering, dealing, and all aspects of the mutual
fund industry. (b) Banks engage in insurance underwriting and selling. (c) Banks engage Real
Estate investment, development, and management.
On this issue the NBE issued Directive No. SBB/12/1996 to limit the type of investment of
banks may engage. Though the bank did not prohibit banks from engaging in securities,
insurance and real estate it has put limit their level of investment. For instance the directive
limits banks to invest not exceeding 20% in an insurance company, non-banking business and
real estate and not to exceed 10% of the bank’s equity capital, not to invest more than 10 %
of its net worth in other securities and not to exceed 50% of the bank’s net worth investing at
any one time (excluding investment in government securities). Those limits show that the
banking business in Ethiopia is highly controlled and similar point was shown in the World
Bank African development indicators the central bank’s intervention rate in Ethiopia was
about 425%.

2.1.4. Limitations on Foreign Entry in the banking industry

This regulation variable was captured using; if there is any restrictions placed for foreign
banks to enter the domestic banking through: (1) Acquisition ;( 2) Subsidiary; (3) Branch.
Regarding foreign ownership of domestic banks the government clearly restricts foreign
citizens or companies to; own banks fully or partially, open banks or branch offices or
subsidiaries of foreign banks or purchase the shares of Ethiopian banks.

Ethiopia emerges exceptional compared to its neighbors Kenya, Tanzania, and Uganda and
other developing countries in that it has not so far liberalized its banking sector. The
Ethiopian banking sector still did not affect by the world’s financial distress and is out of the
impact of globalization. Although the ruling party understands the potential benefit of
financial liberalization, believed, that liberalization may result in loss of control over the
economy and may not be economically beneficial. For example the late prime minster which
was the engineer of the current policy regime of Ethiopia argued that;

“When finance was liberalized the entry of foreign banks somewhat increased
competition. The foreign banks have had to focus on the most profitable segments of the
market and these happen to be the largest urban centers and the bigger corporate customers.
They have therefore had a trend of reducing their presence in the smaller towns and rural
areas and reducing their service to customers outside the large corporate sector. The new
entrants have started with such a narrowly focused approach while the older ones have had
to shift towards such a narrow focus. Clearly there has been little improvement in quality of
service or range of service” (Zenawi, n.d)

2.1.5. Interest rate regulation

Financial liberalization is closely related with interest rate deregulation and has been the
agenda of various scholars of private interest view and the World Bank. On the other hand
scholars of the public interest view recommend interest rate control as the main instrument of
financial regulation for the following reasons:

1. Charging high interest rate on lending and low interest rate on saving is considered as
exploitation therefore, according to the scholars of the public interest view, government
should protect borrowers and depositors by setting a ceiling and floor on interest rates.

2. Governments must also implement interest rate controls to obtain cheap funds to finance
their projects that are beneficial for the general public. On the other hand governments
also control interest rates on the assumption interest rate controls can stimulate
investment; this argument is based on the Keynesians notation that investment demand is
decreasing in the interest rate. But this argument does not take into consideration where
lower interest rates, can decrease the availability of funds for investment by decrease
savings.

Regarding this the government of Ethiopia is in favor of the interest regulation. Initially the
current government puts in to action both deposit and lending rate controls but after a time
due to various pressures from the WB and IMF it lifts the lending rate and only limits the
minimum deposit rate at 4% per year. But this interest rate is too low to attract private savers
in time of high inflation experienced in the country. Similarly the NBE in its regulation also
noted that in the scenario of rising interest rate, when liabilities re-price faster than assets,
interest spread would fall and hence profitability of the bank would be adversely affected
therefore to protect banks interest rate regulation is very important.

The main reason to implement this type of financial policy by the government of Ethiopia is
that according to the late prime minster in his monograph the dead end the new beginning
stated that “very high real rates of interest generated by financial liberalization depress
investment. The consequence would naturally be to depress investment, reduce demand for
credit and generate excess liquidity. High interest rates are also known to increase moral
hazard and default risk. Therefore the country must work towards financial repression and it
has succeeded admirably” (Zenawi, n.d).

2.1.6. Prudential regulation

When there is market failure due to information asymmetry and systematic instability in the
financial sector demands prudential regulation. The dominant theories on prudential
regulation focus on restricting banks capital structure and portfolio allocations. The most
important regulation is the Basle accord which focuses on two ratios, namely; maximum
leverage (equity over assets ratio) and risk weighted capital requirement. The Basel accord
specifies that bank capital should not fall below 8 per cent of the weighted sum of risky asset.

2.1.7. Capital Requirements

Capital requirement is one of the areas of government regulation on banks because with
limited liability, owners may have an incentive to engage in riskier ventures, and minimum
capital requirements become important in determining the amount that bank owners must
have at risk (Lamoreaux, 1994). Capital adequacy one of the components of capital
requirement could play a crucial role in aligning the incentives of bank owners with
depositors and other creditors (Berger, Herring, and Szego, 1995); The main reason for banks
to have capital adequacy is if bank owners have more capital at risk, the gains that they would
enjoy from risk business, would be compensated by the potential loss of their capital if their
bank were to experience large losses.

Regarding the capital requirement the NBE issued various directives such as directive No.
SBB/3/95 which focuses on the contribution in kind of the initial capital requirement and
stated capital contribution in kind is not allowed for fulfilling minimum required capital and
even if the bank fulfills its requirement the capital contributed in kind must not exceed 25%
of paid up capital.

Similarly, on directive No. SBB/4/95 the NBE issued various requirements that after banks
fulfill the initial minimum capital they are subject to the following obligations in order have
sound reserves account in their NBE. This obligation is to transfer from its total annual profit
25% to its reserve account until the reserve equals its capital (if their reserve reaches the
capital of the bank only 10% of profit is required to be transferred to their reserve account).
On the other hand this directive also forces banks to have provisions for loans, advances and
bad or doubtful receivables; the value of any assets lodged or pledged to secure liabilities,
including contingent liabilities that are not included in the calculation made to ascertain the
bank's compliance with capital and reserve requirements. This directive also obliges banks to
amortize its capitalized expenditure within a maximum period of five years and to fully cover
its operating and accumulated losses from its annual net profit and not to pay dividend to
shareholders until such losses are fully covered.

There is also another directive which forces banks to maintain 5% of their liabilities( birr and
foreign exchange) and liabilities held in the form of demand deposit( currency, saving and
time deposits) in its reserve account. Therefore, the above directive required to fulfill banks
in case of capital requirements are very hard and can easily substitute for the deposit
insurance in developed countries and can prevent savers from loss and banks from entering
into risky business.

2.1.8. Limit and Directed credits

In order to avoid credit concentration of banks the NBE issued both manual and guideline.
According to the banks manual credit concentration can occur when a bank’s credit portfolio
enclose a high level credits: to counterparties; to specific industry; to specific geography; to
the type of credit (i.e. overdrafts); and to specific collateral.

In its guideline in credit concentration and risk management the NBE identifies ways of
credit management strategies. In this strategy the NBE issued credit limits guideline to
individual counterparties and groups of connected counterparties of banks. According to this
guideline under any circumstance banks are not allowed to set credit limits higher than the
limits set by NBE. This guideline also limits on specific industries, specific geographies,
specific products, and group of borrowers.

Based on this guideline the NBE issued a directive dealing with limitation on Loans to
Related Parties. This directive obliges banks not to extend loans to related parties on
preferential terms (on; conditions, interest rate and repayment periods) than conditions
usually applied to other borrowers. Similarly the regulation has put limits on banks not to
expose to a single and associated borrower. With this regard any bank cannot lend more than
15% of its net worth to a single borrower, and the total sum of loans to all related parties at
any one time shall not exceed 35% of the total capital of the bank.
In directing credit governments usually subsidized selected industries indirectly, the reasons
for subsidization is to narrow the variance between private and social benefits that arise
because of negative externalities, market failure and coordination failures. In this regard the
government of Ethiopia tries to address this issue by selecting certain industries that are
considered crucial for the countries overall economic development such as manufacturing
industries, agriculture and tourism. In line with this the government establishes the
Development Bank of Ethiopia with aim to supply credit at low interest rate which is 7.5% as
compared to the market rate 11.8% and at low collateral rate which is 30:70(30% contributed
by the borrower and the rest was supplied by the bank) as compared to 234% of loan required
for other modes of loan and with long repayment period up to 15 years as compared 1-5 years
in the other modes of loan.

But the government commitment to supply credit at low interest rate, low collateral
requirement and long repayment period did not bring the desired result because of low
demand for credit from the private sector which leads the DBE to have excess liquidity. And
even the Bank lends to selected public institutions it result was undermined due to
inefficiency public firms but continue to receive loans from the DBE. The loans give to these
inefficient firms cannot generate the desire result.