RIFT VALEY UNIVERSITY

GEDA CUMPUS
ACCOUNTING AND FINANCE DEPARTMENT 2011 E.C
ENTRY 3RD YEAR SECTION 6
FINANCIAL MARKETS GROUP ASSIGHMENT

Aderaw Gashayie
1*
Dr Manjit Singh
2

1. PhD Research Fellow, School of

Applied Management Studies, Punjabi
University, Patiala, India
2. Professor of Accounting and
Finance, School of Applied

1
Management Studies, Punjabi
University, Patiala,
India
Abstract
This article presents comprehensive
review of annual reports and articles
on development of financial sector in
Ethiopia and for open discussion.
Keywords: development, financial
sector, Ethiopia
1. Introduction
This article provides an overview
of development of financial sector
in Ethiopia, including Background
and

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Structure of the Financial Sector in
Ethiopia, Rural Financial systems in
Ethiopia, Financial Developments in
Ethiopia, Major Financial Product
Services, Supplies-Demand Gaps in
the Financial Sector, The Legal and
Policy
Environment and The Role of the
Government in the Financial Sector.
The chapter is organized as follows:
Section 2 focuses on Background and
Structure of the Financial
Sector in Ethiopia, section 3 focuses
on Rural Financial systems in Ethiopia
and provides a review of the formal
rural financial system as well as
informal rural financial systems in

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Ethiopia. Section 4 discusses
Financial
Developments in Ethiopia; Section 5
discusses Major Financial Product
Services in Ethiopia; the gap between
credit supply and credit demand in
rural Ethiopia is discussed in Section
6; Section 7 discusses the Legal and
Policy Environment in financial
sector; and Section 8 discusses the
Role of the Government in the
Financial Sector.
Group member’s name ID No.
1. Yohannes Debele…………………………….. 0375/18
2. Sena Ensesu ………………………………… 0365/18
3. Betelehem Girma………………………………0324/18
4. Woynishet Nake………………………………..0373/18
5. Tigist Gonfa…………………………………… 0370/18
6. Fikrte Kefyalew……………………………… 0344/18
7. Meseret Regasa ……………………………………0573/18
8. Betelehem Yerga ………………………………… 0326/18
9. Simegnew Adinew………………………………0126/18/A

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INSTRACTOR.

AHIMED

Table of Contents

Chapter 1 Financial Markets and Institution In Ethiopia ..................................................... 3

1-1. The Development, Policy and Regulation of the Banking, Insurance and Microfinance Markets……... 3
1-2. The Development, Policy and Regulation of Securities Market................................................... ………….6
1-3. Ethiopia does not have comprehensive social security ……………………………………………….8

1-4.The Design of Means of Enforcement of Regulation ...........................................................................9

Chapter 2 Negotiable Instrument in Ethiopia…………………. .............................12

2-1. Definition of Negotiable Instruments................................................................................ 12

2-2. purpose and nature of Negotiable Instrument ............................................................................ 13

2-3. Types of Negotiable Instrument ......................................................... 13

2-3-1. commercial instrument………………………………………………. .................................. 13

2-3-2. transferable security ............................................................................................... … 13

2-3-3. Document title of goods ................................................................................................................14

2-4. Summary ..................................................................................................................... ……..14

Chapter 3 Financial Sector and Institution In Ethiopia ............................................................ 15

3-1. Background and structure of financial sector in Ethiopia ............................................................ 15

3-2. Types of Financial sector .................................................................... 16

3-2.1 Formal Financial Institution in Ethiopia………………………………………………………16

3.2.1.1. Banks…………………………………………………………………………………………..16

3.2.1.2. Insurance …………………………………………………………………………………… 18

3.2.1.3. Micro Finance Institution…………………………………………………………………….21

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3.2.2. Informal Financial Institution………………………………………………………………….23

Chapter 4 Regulation of Financial Sector in Ethiopia.............................................................. 26

4-1. Types of Regulation ............................................................................................................. 26

4-1.1. corporate governance ................................................................................................................ 26

4-1.2. Restriction on bank and on links to commerce.................................................................... 28

4-1.2.1. What is a Bank .......................................................................................................................... 28

4-1.2.2. Scope of Bank Activity........................................................................................................... 28

4.1.3 Limitation on Foreign Entry in the banking Industry ………………………………………29

4.1.4 Interest rate regulation ………………………………………………………………………..29

4.2 Prudential Regulation …………………………………………………………………………….30

4.2.1 Capital Requirements ……………………………………………………………………………31

4.2.2 Limits and Directed Credits ……………………………………………………………………32

References …………………………………………………………………………………………….33

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 Chapter 1
Financial Markets And Institution In Ethiopia

1.1 The Development, Policy and Regulation of the Banking, Insurance and Microfinance Markets

Ethiopia has conducted financial sector reform following the change in government and
economic policy in 1991. It has re-established the National Bank of Ethiopia (NBE) as central
bank and financial market regulator and opened the banking and insurance sectors for domestic
private investment through monetary, banking and insurance supervision laws that are enacted in
1994 and amended in 2008. It has made

 Inter-bank money and foreign exchange markets operational as of 1998.

 It has also introduced a regulatory regime for microfinance, required the formal
establishment of the microfinance institutions within the financial system, and
 Required the NBE to promote development of the traditional savings institutions of the
society along with the microfinance institutions and to encourage participation of the
banks and other financial institutions in the provision of microfinance by a law enacted
in July 1996 and amended in 2009.
 It currently subjects the banks, insurers and microfinance institutions to supervision laws
that are similarly fashioned and complementary to one another.
 It also allows the transformation of the microfinance institutions into formal banks and
the direct engagement of the formal banks and insurers in the provision of microfinance.
 It has licensed 17 private banks, 17 private insurers, thirty microfinance institutions and
more than one thousand insurance auxiliaries under this regime.
 There are also government owned three banks and one insurer. The country has not,
however, achieved desirable level of banking, insurance and microfinance services.

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  All the services are at their beginning stage of development and a substantial size of the
Ethiopian population still lives without them.
 The banks, insurers and microfinance institutions are also weak in their fixed capitals,
service types, governance and competitiveness.
 They have not diversified, modernized, automated and networked their services. The
banks, other than the Development Bank of Ethiopia, also concentrate on short and
medium term trade finance while the insurers concentrate on short term general
insurance making the total long-term insurance less than six percent of the total
insurance business in the country.
 The microfinance institutions also concentrate on short-term deposit taking and lending
with very small section of the society despite their extensive authorization to stimulate
the development of micro and small scale operations.

All these, added to the absence of formal securities market and private pensions in the
country, have also made the

 Country lack dependable domestic long-term finance.

 The payments system of the country has also remained largely to be based on the cash
mode of payment.
 The country needs to improve on all these.
 The banking, insurance and microfinance supervision laws of the country do not also
define and prioritize their specific objectives.
 The NBE does not also link its directives and regulatory measures to specific objectives
consistently in practice.
 The country does not also have comprehensive financial regulatory policy which defines
and prioritizes between the specific objectives of the banking, insurance and
microfinance regulations.

The objectives of regulation are, therefore, only inferred in practice from the powers and
objectives of the NBE as central bank, the monetary policy framework of the NBE, the country's
general economic policy, and the pieces of principles included in the competition and other laws
of the country. The country needs to define and prioritize the specific objectives of its regulations

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in the supervision laws clearly and the NBE needs to link its directives and regulatory measures
to the specific objectives consistently so that there will be no overlooking and abuse of
regulation during enforcement. This will also enable the financial institutions, consumers and
stakeholders to clearly know about the reasons and objectives of financial regulation, appreciate
the importance and legality of the instruments used, and contribute to the enforcement of
regulation. Being a transition economy heading to free market, the country needs to take into
account the experience of both the developed and the transition and emerging market countries
and make the objectives like the ones in the latter. It needs to link the regulations to the
following objectives: - developing the markets; - disseminating, diversifying and modernizing
the financial services; - promoting competition, efficiency and innovativeness in the financial
system; Financial Market Development, Policy and Regulation 357 - maintaining financial
market health, stability and security; - preventing systemic failure; - protecting consumers, the
public and the economy from abuse and financial failure; - increasing information disclosure and
prudential decision making; - meeting monetary policy objectives; and - achieving economic and
social policy objectives contributory to its development and transition to free market. It,
however, also needs to learn from the international experience and enforce the last set of
objectives through the instruments of financial market regulation by formulating them outside
the realm of monetary and financial policy and to the extent that they can be coordinated with the
other objectives of financial regulation. It also needs to enhance the competition regime for the
financial markets and enforce the other objectives of regulation without endangering the
competition objective. The monetary policy of the country also needs to continue to focus on the
objectives of controlling inflation, influencing the cost and availability of financial services,
maintaining price and exchange rate stability, and achieving balance of payments equilibrium
since these are ongoing problems in the country. The current banking, insurance and
microfinance regulatory instruments of the country also have elements from the international
experience. They have also evolved through time. A number of them are, however, incomplete,
restrictive or inappropriate to the domestic situation and needs of the country. Several of them do
not also comply with the latest recommendations of the international organizations (including the
BCBS and IAIS) in terms of both content and enforcement. They fail much in their risk
orientation, use of corporate governance techniques, and enforcement infrastructure. They need
to be improved. The following need to be done among others: 1. The licensing regulation needs

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to be improved to: - promote geographic diversification of branching; - decentralize the
formation of banks, insurers and microfinance institutions to the regions with regulation by the
NBE from the centre and one-stop-shop service of the NBE at the regional state level; - remove
the licensing and prior permission requirements for branching and change of place of business
and focus on regulation of the overall health of the financial institutions; - fix maximum number
of branching or branching ratio in the law to restrain the further expansion of the largest banks,
insurers and microfinance institutions in order to i) make them concentrate more on efficiency
and competitiveness than on size and ii) correct the existing market dominant.

1.2 The Development, Policy and Regulation of Securities Market

Ethiopia had a securities market in the 1960s and 70s.

 The market was closed because of change of policy in 1974.

 The country does not have a securities market currently. It has created only an
agricultural commodity market which is owned fully by the government and operated
outside the financial market.
 The creation of securities market is justified in the country by the following functions:
 providing long term finance which the banks are not doing
 Meeting the growing need for domestic resource to finance investment.
 Providing market place and thereby enhancing the transferability, liquidity and
proprietary value of existing securities.
 curing the excess reserve and liquidity positions of the banks
 Financial Market Development, Policy and Regulation 365 - enabling the NBE to
enforce monetary and financial policy objectives through indirect and open market
instruments.
 Encouraging the creation of institutional savers and investors, diversifying the
financial market and increasing competition
 Motivating companies to go public and widen their ownership bases;
 Enhancing information flow and corporate management, accounting and control
 Assisting individuals, households, business firms and the financial institutions to
diversify their income and investment portfolios; and

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 Facilitating future privatization. It, however, also faces challenges including the
following: - short track record of the share companies in the country to attract
buyers for their securities
 Reluctance of a number of the companies in the country to go public and freely
float their securities
 Lack of separation of ownership and management of most of the share companies
in the country
 Lack of financial and investment experience and conservative attitude towards
money of most members of the business community; - little experience of mangers
of companies in corporate portfolio management and underdevelopment of the
accounting and auditing professions; - more attention of the investment regime and
practice of the country to direct investment than portfolio investment through
company securities; - non-issuance of shares other than ordinary shares by the
share companies, including the banking, insurance and microfinance companies
that could take the lead in the issuance and trading of securities; - low level of the
income and saving of most individuals and households to establish dependable
demand for securities; - fragility of the macro and political situation of the country
to attract investment and enable sufficient supply and demand for securities; - lack
of capacity of the financial regulator (the NBE) to provide strong supervisory
framework for a securities market; and - failure of the tax regime of the country to
encourage creation of securities market. These challenges do not, however, justify
retreat from creation of the securities market since many of them are results of
either the hitherto absence of the securities market or government policy itself.
Most of the other countries of the world have also developed their securities
markets in the presence of these types of challenges (and sometimes market
crashes) and the country needs to learn that the creation of securities market can
happen in the presence of challenges. They, however, indicate the magnitude of
the problem the country has to face in creating and developing the securities
market.

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 1.3 Ethiopia does not have comprehensive social security

. It has only occupational pension for government employees, some provident fund scheme for
private sector employees, and some social assistance for the old, the destitute and the needy. The
occupational pension for the government employees does not serve as universal basic system
since it provides only subsistent income to very small population of the country. It does not also
serve the functions of facilitating saving, employment, investment, corporate finance and capital
market development since its benefit payments are small and its resources are hardly invested.
The private sector provident funds and social assistances do not also serve these functions since
they are informal and voluntary payments. The occupational benefits and severance pays in the
private sector are also piecemeal and negligible. The provision (and consumption) of life
insurance and pension annuity is also very negligible. The country needs to expand its pension
coverage in order to curb these problems and reduce retirement poverty. The country also needs
to focus on two functions which are important for the development of the financial market:

i) Forcing saving and

ii) Mobilizing the saving for investment. The Ethiopian households and individuals are
reported to have very limited saving due to both their expenditure habits and the low
levels of their incomes. The direct mobilization of saved resources from the households
and non-households to investment is also weak due to absence of formal institutional
savers and the market mechanism for direct resource mobilization.

Hence, the development of private pensions is necessary along with the improvement of the
governmental pension system, the encouragement of private insurance, the creation of securities
market, and the taking of other developmental measures. The country needs to enable this by:

i) making the pension reform part of its poverty reduction strategy and the saving and
investment promotion and financial market development policy; Financial Market
Development, Policy and Regulation 372
ii) Compelling the employers and employees in the formal private sector to participate in
the private pension system as this has been done for the governmental pension; and i)
iii) Enacting a retirement law for the private sector. It also needs to consider the issues of
organising the private pensions: - as entities separate or unified with the existing

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 governmental pension system and the financial institutions; - as consolidated or set of
independent funds; - as incorporated or unincorporated institutions; - as funded or
unfunded institutions; - as defined benefit or defined contribution schemes; and - as
competing or public good institutions. It needs to separate them from the existing
governmental pension system since the latter has not been efficient in the tasks of
collecting contribution, generating income and paying benefits. It needs to separate
them from the insurance and microfinance institutions since i) the insurers and
microfinance institutions are not engaging in pension business despite their
authorization to do so and ii) the merger of the pension, insurance and microfinance
sectors will have the disadvantage of eliminating alternative channels and competition
for saving, resource mobilization and investment. It needs to require
institutionalisation of the pensions as incorporated share companies with their own
governance since there is no management experience for unincorporated pension
funds in the country and the share company form is the commonest and preferred
structure for organization of the financial institutions in the country with the
advantages of combining capital, reserve, limited liability, professional management,
shareholder participation (in governance), accounting, external auditing (and control),
and information disclosure. It needs to start with the demutualized profit making
share company form and consider the mutual company form of incorporation when it
becomes necessary since its current company law regime knows the demutualized
profit making company form and there is no public movement for creation of non-
profit making mutual companies. It needs to follow the funded defined contribution
approach and adopt mechanisms (including minimum pay, industry fund guarantee
and similar regulatory requirements) through which it will protect the individual
pension members from the risk shifting effect of the approach since this is the
international trend. It needs to organize the private pensions as competing institutions
with the necessary regulation since the international experience (and the country’s
own experience with the current government pension system) also show that the
protected monopoly approach leads to distortions and weaknesses instead of benefits.
It also needs to adopt a pension regulation that will do the following by way

1.4 The Design of Means of Enforcement of Regulation

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 Ethiopia makes the NBE regulator of all the financial institutions, markets and auxiliaries and
enforces the existing regulations through banking, insurance and microfinance supervision
departments organized in it.

 It confers it with the powers of licensing, inspecting, examining and sanctioning the
financial institutions, markets and auxiliaries.
 It also confers it with some discretion and autonomy from the government.
 It also authorizes it to finance its regulatory functions by its own funds except in cases
where it has been fixed by law that the Financial Market Development, Policy and
Regulation 377 funding has to be borne by the regulated institutions.
 It enforces the competition policy and law through a Secretariat established in the
Ministry of Trade and Industry, a Federal Trade Practice Commission established under
the Ministry, and regional legislative councils and trade bureaus.
 It also recognizes the enforcement of civil, administrative and criminal sanctions against
regulatory violations.
 It also generally subjects the actions of the NBE and the competition enforcement organs
to judicial review under the unique system and allows the financial institutions against
which the NBE passes decision of receivership or takeover of management,
reconstruction, winding up or dissolution to petition to the Federal High Court.
 It also recognizes substantive and procedural principles of good administration in its
constitution and other laws.
 It has also established Ombudsman Office that checks the operation of governmental
authorities as peripheral administrative control mechanism.
 It also works with the IMF and the World Bank. The banking and insurance supervision
departments of the NBE also sometimes attempt at assessing their regulatory and
supervisory practices against the core principles of the Basle Committee on Banking
Supervision (BCBS) and the International Association of Insurance Supervisors (IAIS).

The country does not, however, confer the NBE with regulatory dispute adjudication powers. It
does not also prescribe the measures the NBE may have to take during crisis situation that may
transcend an individual financial institution to affect the financial sector or the economy as a
whole. It also makes the regulatory independence of the NBE fragile by authorizing the Prime

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Minister and the Council of Ministers to administer it directly. It also puts the competition
enforcement organs under direct control of the Ministry of Trade and Industry and makes the
Trade Practice Commission not anything more than dispute investigation office. It does not also
clearly define the work relationship between the NBE as the financial market regulator and the
competition enforcement organs. The NBE does not also fully enforce the tools of off-site
surveillance and on-site examination. It does not also enforce its penalties and corrective
measures strictly although it, in practice, issues directives that subject the financial institutions to
financial and non-financial penalties. The country also lacks administrative procedure law and
the actions of the NBE and the competition enforcement organs are not judicially reviewed
against their legal and public interest grounds in practice. It does not also define the exact roles
of the Ombudsman Office vis-à-vis the NBE and the competition enforcement organs. It does not
also oblige the NBE and the competition enforcement organs to conduct public consultation
during the making of their decisions, rules and actions. The principles of good administration
recognized by the country are also scattered in the different laws making enforcement difficult.
The supervision departments of the NBE and the competition enforcement organs also suffer
from staff and fund constraint. Both are not also members to regional and the international
organizations working in the area of financial market regulation. The regulatory enforcement
regime of the country also complies little with the core principles of the BCBS and IAIS. The
country needs to improve on all these in order to enhance both regulatory and competition
enforcement and legal protection. The following need to be done among others

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 Chapter 2

Negotiable Instrument in Ethiopia

2.1. Definition of Negotiable Instruments

The word negotiable means ‗transferable by delivery ‘and the word instruments ‘means a
written document by which a right is created in favor of a person. Thus, the term negotiable
instruments literally refer to a document containing rights that can be transferred by delivery.
Similarly, Article 715(1) of Ethiopian Commercial Code of 1960 defines the term negotiable
instruments as any document incorporating a right to an entitlement in such a manner that it is
not possible to enforce or transfer the right separately from the instrument. The rights that could
be incorporated in negotiable instruments may be rights for payment of money arising out of
various contracts such as the contract of loan, sale, lease, or any other contract performed by
payment of a certain amount of money. Such rights may also arise from ownership in companies
or loan made to the government or to a share company. The rights that are incorporated in
negotiable instruments may be rights to receive goods under voyage or deposited in a warehouse.
According to this provision, the holder of negotiable instruments can transfer the rights
incorporated in the instrument by transferring the instrument. Similarly, a person who claims the
rights incorporated in negotiable instruments may enforce or exercise them only if he has
possession of the instrument, i.e., he should be a holder to whom the instrument is issued or
transferred following the rules governing its transfer. He must also present the instrument to the
person who is supposed to perform the obligations arising out of the instrument. (See also Art
716/1/). The fact that the rights incorporated in negotiable instruments may be transferred by the

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transfer of the instrument and the fact that a person may not exercise or enforce them unless he is
in possession of the instrument are the two main features which distinguish negotiable
instruments from other documents evidencing rights such as a title de

2.2 Nature and Purpose of Negotiable Instruments

Negotiable instruments represent one form of property rights, i.e., exercised over incorporeal
things ―chose in action.‖ In other words, they are property rights in relation to objects of
property which do not have physical or material existence and hence which cannot be perceived
by the senses. A right of action under contract is a class of property known as ‗chose in
action‘and can be distinguished from a corporeal movable property/ a ‗chose in possession‘
which represent property rights exercised in relation to objects which have material or physical
existence and hence can be perceived by the senses such as a book, a table or a watch. A holder
of this type of property right must have actual possession of the object to exercise rights arising
there from.

2.3 Types of Negotiable Instruments

2.3.1 Commercial Instruments

Commercial instruments are negotiable instruments incorporating rights for payment of a

specified amount of money. They are issued and negotiated on the basis and with the purpose of
performing an obligation that can be performed by payment of a certain amount of money.
Hence, they are used as a substitute for money. These are bills of exchange, promissory notes,
checks, travelers‘checks and warehouse goods deposit certificates as the types of commercial
instruments recognized under the Ethiopian law.

2.3.2 Transferable Securities

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 Securities are negotiable instruments incorporating rights for payment of money. The sources
of such rights may be investments made in companies or loans provided to the government or its
subdivisions through purchase of government bonds and treasury bills or to companies through
the purchase of debentures. A person who invests in a company is entitled to share in the profits
of the company if any, i.e., he has the right to receive dividends and to share in the assets of the
company where the company is dissolved. /Art 345/ On the other hand, the person who has
purchased a government bond or a treasury bill or a company bond, also called a debenture,
acquires the right to receive repayment of the money he has given on loan plus interest. /Art
433/. Refer also to the provisions of Arts 2490-2511 of the Civil Code. However, all securities
are not negotiable instruments. What makes securities negotiable instruments is their
transferability according to rules of negotiation. Therefore, if it cannot be negotiated, it is
difficult to circulate as money. Bonds, stocks and transferable shares are instances of securities
which are negotiable instruments considered.

2.3.3 Documents of Title to Goods

These are negotiable instruments containing rights of ownership over goods that are being
transported or goods which are warehoused and which enable their holders to receive such
goods. Refer Arts 571-576 and 610-619 of the Commercial Code regarding documents of title to
goods under voyage and Arts 2814-2824 of the Civil Code regarding documents of title to goods
warehoused.

2.4 Summary

The word negotiable means transferable by delivery and the word ‗instruments ‘means a
written document by which a right is created in favor of a person. Thus, the term negotiable
instruments literally refer to a document containing rights that can be transferred by delivery.
The rights that could be incorporated in negotiable instruments may be rights for payment of
money arising out of various contracts such as the contract of loan, sale, lease, or any other
contract performed by payment of a certain amount of money. Such rights may also arise from
ownership in companies or loan made to the government or to a share company. The rights that

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are incorporated in negotiable instruments may be rights to receive goods under voyage or
deposited in a warehouse. According to this provision, the holder of negotiable instruments can
transfer the rights incorporated in the instrument by transferring the instrument. Similarly, a
person who claims the rights incorporated in negotiable instruments may enforce or exercise

Chapter 3

Financial Sectors and Institution in Ethiopia

This article provides an overview of development of financial sector in Ethiopia,

including Background and Structure of the Financial Sector in Ethiopia, Rural Financial
systems in Ethiopia, Financial Developments in Ethiopia, Major Financial Product Services,
Supplies-Demand Gaps in the Financial Sector, The Legal and Policy Environment and The Role
of the Government in the Financial Sector. The Paper is organized as follows: Section

1. Focuses on Background and Structure of the Financial Sector in Ethiopia,

2. Focuses on Rural Financial systems in Ethiopia and provides a review of the formal rural
financial system as well as informal rural financial systems in Ethiopia.
3. Discusses Financial Developments in Ethiopia; Section

3.1 BACKGROUND AND STRUCTURE OF THE FINANCIAL SECTOR IN ETHIOPIA

Banking in Ethiopia started in 1905, with the establishment of the Bank of Abyssinia
that was owned by the Ethiopian government in partnership with the National Bank of Egypt
then under British rule. But a well structure banking system started to evolve starting the 1940s-
after the Italian departure. A government owned bank-the State Bank of Ethiopia-was
established in 1942, and a number of foreign bank branches and a private bank were
operating in competition with the government owned commercial bank until they were
nationalized and merged into one government owned mono-bank in 1976. The competitive
banking situation that started to flourish during the 1960s and 1974s was nipped in the bud by
the command system that reign over the 1974-1991 periods. Following the change of
government in 1991, and the subsequent measures taken to liberalize and reorient the
economy towards a system of economy based on commercial considerations, the financial
market was deregulated. A proclamation number 84/94 was issued out to effect the

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deregulation and liberalization of the financial sector, and a number of private banks and
insurance companies were established following the proclamation. Directives issued in
subsequent years further deepen the liberalization mainly including the gradual liberalizations of
the interest rate, foreign exchange determination, money market operation, etc.

In the year 2013/14, there were 16 private banks operating along with three public banks,
namely the Commercial Bank of Ethiopia, the Construction and Business Bank, and the
Development Bank of Ethiopia. Other financial institutions operating in the economy includes
17 insurance companies, one pension fund and about 31 Micro Finance Institutions with a
business focus mainly in the rural areas but in reality concentrated in urban area. The
Development Bank of Ethiopia (DBE) is a specialized bank in project financing and is
not a deposit taking institution (NBE, 2013/14). Generally, public banks dominate the financial
industry in Ethiopia. The Commercial Bank of Ethiopia (CBE), the largest bank in the industry,
accounts 38.8% of the branch networks, over 53.3% of the outstanding loans and mobilizes
about 66.4% of the deposits of the commercial banks (NBE, 2014). However, the progress
observed by the private banks in the last ten years appears commendable. In terms of the fresh
loans annually disbursed, the share of the private bank is at par with the public commercial
banks. In addition, private banks als

3. RURAL FINANCIAL SYSTEMS IN ETHIOPIA

Rural finance in Ethiopia, as in other developing countries, has dualistic features. There exist
both formal and
informal credit institutions in the country.

3.1 Formal financial institutions in Ethiopia: The formal sources are financial institutions that are
set up legally
and engaged in the provision of credit and mobilization of savings. These institutions are
regulated and controlled
by the National Bank of Ethiopia (NBE). In the Ethiopian context formal financial sector
includes National Bank
3.2 Types Of Financial Sector In Ethiopia

In Urban and Rural Area of the Country finance sector in Ethiopia, as in other developing
countries, has dualistic features. There exist both formal and informal credit institutions in the
country.

3.2.1 Formal financial institutions in Ethiopia:

The formal sources are financial institutions that are set up legally and engaged in the
provision of credit and mobilization of savings. These institutions are regulated and controlled by
the National Bank of Ethiopia (NBE). In the Ethiopian context formal financial sector of
Ethiopia

3.2.1.1 Banks

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 commercial banks (owned by private and public), Development Bank of Ethiopia (DBE),
credit and savings cooperative, insurance companies (both public and private) and microfinance
institutions (owned by regional governments, NGOs, associations and individuals)(NBE,
2013/14). According to the proclamation number 84/94, foreign entry in to the financial sector
is not allowed until domestic banks attain a certain degree of desired competitiveness and the
National Bank’s supervisory and regulatory capacity is adequately strengthened. The numbers
of bank branches reached 2208, of which 1003 or about 45 percent belong to the
Commercial Bank of Ethiopia. Despite modest branch expansion, Ethiopia remains as one of the
under-banked countries even at sub-Saharan African countries standard. The bank branch to
population ratio was 1:43 in 2013/14 during 2013/14. Similarly, total capital of the banking
system reached Birr 37.3 billion, of which about 44.7 percent was hold by government owned 3
banks. Commercial Bank of Ethiopia accounted for more than 34 percent of total capital of the
banking system (excluding NBE). Yet geographical distribution of bank branches was highly
skewed to major towns and cities. Nearly 34 percent of bank branches were located in Addis
Ababa (NBE, 2013/2014). Total branches of insurance companies reached 332 at the end of the
fiscal year (2013/14).

 Banking market structure - The banking sector remains relatively concentrated. The largest
commercial bank, owned by the State, represents about 70% of total assets.
 Structure of loans and deposits in the banking sector - Loans and advances to customers are
increasing each year and amounted to ETB 394.56 billion (USD 13.7 billion) in 2017/18. Despite
progress made by private banks, public sector banks have held their dominance in credit with a
53.8% market share. Financing is largely allocated to the industrial sector, which has averaged
40% of the credit granted over the last 3 years, ahead of external trade (19%), domestic
commercial activities (12%) and housing (11%). Thanks to the increase in the number of bank
branches, deposits - mainly savings - rose to ETB 730.26 billion (USD 25.3 billion).
 Deposit and lending rates - The average interest rate on savings stood at 8% and the average
lending rate was 13.5%, after remaining at 11.88% until 2014/15. The weighted average interest
rate on term deposits was 8.09%.
 Financial strength of the banking sector - Ethiopian authorities have chosen not to systematically
adopt the Basel II and III agreements. Instead, the Central Bank has put in place instruments
adapted to the country's context. For the most part, Ethiopian banks have remained well
capitalised and liquid. The sector's capital adequacy ratio has stood at a level above the regulatory
minimum of 8%. The liquidity ratio is also in line with the minimum requirement of 15%. Bank
profitability has continued to remain positive, despite the downward trend. The quality of assets
has been broadly preserved, with the ratio of non-performing loans below the 5% statutory

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 ceiling. However, the quality of DBE's assets has gradually deteriorated. Its bad debt ratio stood
at 39% in 2017/18, well above the maximum threshold of 15% set by the supervisory authorities
for development finance institutions. The reasons for this situation include low productivity in
agricultural projects, political unrest in some parts of the country and low international
competitiveness of textile projects in which the bank is exposed. Although DBE is not a deposit-
taking institution (and therefore excluded from the commercial banking system), the high level of
non-performing loans could pose a threat to the financial sector and a create significant tax
liability for the State. Remediation strategies are being considered by the authorities who have
undertaken a financial assessment of the bank.

3.2.1.2 Insurance
Small market, with very small life insurance market. The majority of insurance business in Ethiopia is
targeted at the corporate market and focused on general insurance business. At less than 5% of total
premiums, the life insurance industry is still very small and a recent addition to their core business of
general insurance for most private insurers. The six corporate focus implies that, to date, insurers have
little experience in intermediating products to individuals and cost margins have not yet been tested
against the more cost-sensitive retail business. Insurance premiums (including both life and general
insurance) totalled US$105m in the 2006/07 financial year (ending June 2007), equating to about 0.2% of
GDP. Life insurance premiums constituted only US$6m or 6% of total premiums in 2007, while general
insurance premiums totalled US$99m or 94% of total premiums. Almost half (43%) of total insurance
premiums derived from motor vehicle insurance. Limited experience to date with retail and life business.
Similar to the banking industry, Young industry at early stages of development with limited skills,
capacity and incentive to push market extension. With fewer than an estimated 0.3m individual formal
insurance clients, the insurance sector is small and underdeveloped with many small insurers displaying
high levels of inefficiency. Few, if any, insurers have implemented electronic management information
systems (MIS) and most still operate using paper-based systems. Although there has been strong growth
in the private sector since liberalisation in the 1990s, the state-owned insurance company, Ethiopian
Insurance Corporation (EIC), still remains the dominant player. The sector is also characterised by low

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and potentially overstated solvency levels due to, amongst other reasons, limited risk assessment and
management capacity, limited and illiquid investment options and the pervasive practice of selling
insurance on credit (with uncollected premiums eventually resulting in bad debt). Furthermore, the sector
displays a heavy dependence on the banking sector for both referral credit insurance business and returns
on investment from shares held in banks. The limited availability of technical skills for product
development and management (e.g. actuaries) also restrict the development of new products. This is
further exacerbated by limited availability of data (e.g. mortality data, weather data), making product
design difficult. Indication of demand for insurance in the low-income market Illness, death and drought
are the biggest risks for Ethiopian households. While focus group discussions allowed for the exploration
of a variety risks to which Ethiopians are subject in their everyday lives, three top risks (depending on the
livelihood of participants) emerged. Crop and livestock failure due to drought emerged as the top
livelihood risk facing most households, while unforeseen expenditure and death related to illness was the
most commonly cited risk by focus group participants. Death in the family also imposes a huge burden on
households. Burial expenses can account for up to 25% of the average low-income household’s yearly
consumption expenses. A wide variety of coping strategies are used, including community-based
mechanisms. Focus group research revealed that households tend to rely on community-based
mechanisms such as iddir (funeral societies that help cover death-related expenses), iquub (rotating
savings schemes) and cooperatives (as a source of credit) to cope with unexpected expenses. The focus
group further found that iddir and iquub are ranked as the most popular risk management strategies for
urban Ethiopians, with iquub being mentioned as the top risk management strategy for coffee farmers.
Familiarity with informal insurance mechanisms means that insurance is not a foreign concept. Due to
households’ familiarity with iddir that tend to operate on insurance-like principles, focus group
participants quickly understood the concept of insurance and did not have a problem with the
possibility that their premium will not be returned if no claim occurs. One agro-pastoralist
explained: “We don’t care if the premium is not refunded. We aren’t allowed to withdraw what
we have contributed for iddir if death does not occur. A person may contribute to iddir the whole
of his life and not get anything if he wants to change his residence to other areas.” The potential
market for micro insurance What, then, is the potential for the development of the micro
insurance market in Ethiopia?

The formally employed market in Ethiopia constitutes 2.4m individuals, or about 5% of adults2 .
While all of these individuals may not have sufficiently large incomes to be able to afford a
typical life insurance policy, most will have regular incomes, while a sizable proportion is likely

22 | P a g e
to be wealthier than the average Ethiopian. 40% (about 1m) of these individuals are employed by
the Ethiopian government or parastatal organisations. Cross-selling insurance to those currently
banked: Based on information of the Central Bank of Ethiopia and our own estimates, it is likely
that up to 2.9m Ethiopians (about 6% of adults) have some type of bank account. This implies
that there is a relatively easy premium collection mechanism or point of client contact in place.
The fact that these individuals have bank accounts also signals a potentially good level of
financial understanding which would make the insurance sales process easier. Formalising the
informal insurance market: As discussed above, it is likely that up to 2.1m (nearly 5% of adults)
people have some form of informal insurance cover through their MFI or SACCO. If insurance
companies were to work together with these financial institutions, it would mean that potentially
another 2.1m people could be formally insured. The available data does not allow for the
consideration of overlap between these groups. However, if a conservative approach is used, it is
likely that in the short-term up to 3m people could be added to the currently insured market.
Medium-term opportunities: Cross-selling insurance to iddir members: The focus group research
highlights that some iddir members are interested in supplementing or, in some cases, even
replacing their iddir membership with a formal insurance products. While we do not have
nationally representative data on iddir membership in Ethiopia, it is clear that the majority of
Ethiopians belong to iddir. The potential for the development of the microinsurance market can
also be considered by category of insurance: Life insurance: The above discussion on estimates
of market development opportunities indicates that up to 3m Ethiopians are within immediate
reach of the insurance sector. If all these opportunities were to be successfully pursued over the
short-term , it would mean that the number of individuals served could grow up to 1,000%, i.e.
the insurance sector could grow up to ten-fold. Given that life and credit life insurance are
relatively simple products to develop and imply lower levels of risk than some other products,
this would be a good starting point to expand the sector. All of the 3m individuals that are
currently within the relatively easy reach of the insurance sector could be considered the
potential target market for small life insurance products. However, it is important to bear in mind
that this estimate does not include the full group of individuals that currently belong to iddir.
While it is unlikely that insurance will be able to fully replace iddir membership due to its
importance social function, it is possible that some members will choose to supplement their
iddir 2 According to the Ethiopian Labour Force Survey of 2005. The survey used a total

23 | P a g e
population estimate of 63.2m individuals. However, here we use a total population estimate of
83m Ethiopians (2008) and 45m adults (CIA World Factbook, 2008), to calculate an estimate of
percentage of adults. xi membership with life insurance and some may even give up their iddir
membership if an appropriate life insurance product was available. Credit life insurance: Simply
formalising the current informal insurance market is likely to add at least up to 2.1 m individuals
to the currently insured. This includes the clients of MFIs and SACCOs. Agricultural insurance:
On the client side, the success of agricultural insurance (cattle and crop) is dependent on there
being a group of farmers with sufficiently large land and/or cattle holdings to yield surplus
income for the purchase of these products and to make insuring the sources of their agricultural
livelihood worthwhile. Ethiopia has a very fragmented agricultural landscape, with many farmers
having only a very small landholding or few cattle. Only 17% (2.3m) of all households with land
holdings in Ethiopia (13.3m) have land holdings of a size of more than 2 hectares3 . Of this
group, the majority (2m) have land holdings of 2-5 hectares, with only 0.2m having landholdings
in excess of 5 hectares. In terms of cattle holdings, only 6% of all cattle holdings have 10 or
more heads of cattle, equating to about 0.8m cattle holdings out of a total of 13.1m. Of this
group, only about 0.13m have holdings of 20 cattle or more. We therefore estimate the potential
market for crop insurance to be no larger than 2.3m potential policyholders, while the market for
crop insurance is unlikely to exceed 0.8m farmers. Health insurance: A successful health
insurance market is not only dependent on the income of potential insurance clients, but also on
the availability (and proximity) of health infrastructure necessary for the servicing of clients.
Health infrastructure in Ethiopia is limited, with services mainly provided by government (but
not with sufficient reach) and some limited private sector presence. This implies that long-term
investment in the development of health infrastructure and facilities would be a prerequisite for
the development of a vibrant health microinsurance market. At this stage, it would also be
difficult for Ethiopian insurers to successfully develop and sell health microinsurance products
on a commercially viable basis, given their limited capacity in even more basic types of
insurance. Despite the strongly articulated need for health insurance, we do not foresee
immediate opportunity in the area of health microinsurance.

3.2 .1. 3 Microfinance institutions in

Microfinance can be defined as provision of a broad range of client-responsive financial

services to poor people through a wide variety of institutions. Microcredit activities in rural and

24 | P a g e
urban Ethiopia were initiated by local and international NGOs. NGOs in Ethiopia who were
delivering micro credit services but concentrated in urban areas. Although the NGOs had
contributed to testing innovative methodologies and products, they had the problem of
combining the humanitarian objectives of the NGOs with the financial objectives of the micro
credit program. In Ethiopia integration of the credit schemes initiated by local NGOs like the
Relief Society of Tigray (REST) and Organization for Rehabilitation and Development in
Amhara (ORDA) into the formal financial system contributed to the formulation of a regulatory.

To further stimulate economic activities and provide opportunities for the majority of poor
to escape poverty through availing more and appropriate financial services, the Government has
been refining the regulatory framework for the microfinance operations. The regulation that put a
ceiling on the interest rate that micro financial institutions could charge from their credit clients
no longer exists and a new liberal system is in operation. Most MF includes National Bank
reach poor people, it has become increasingly apparent that they rarely serve very poor people.
Most MFIs reach the “upper poor” in much greater numbers than the “very poor.”

Ethiopian microfinance industry has been growing in terms of its outreach as well as its
asset and capital base. By the end of 2013/14, the number of micro-finance institutions (MFIs)
operating in the country reached 31. Their overall performance was encouraging as their total
capital and total asset increased by 24.6 and 38.6 percent and reached Birr 5.6 billion and Birr
24.5 billion, respectively. At the same time, their deposit mobilization and credit provision have
expanded remarkably. Deposit mobilization of MFIs went up by 54.8 percent and reached Birr
11.8 billion while their outstanding credit rose by 31.9 percent indicating their expanded
outreach. The four largest MFIs, namely

 Amhara credit and saving institution (

 Dedebit,
 Oromiya and
 Omo Credit and Savings institutions
They are accounted for 74.9 percent of the total capital, 84.0 percent of the savings, 80.6
percent of the credit and 81.6 percent of the total assets .

By meeting the needs of small scale borrowers in income generation schemes. It was initiated
by the Organization for the Rehabilitation and Development in Amhara (ORDA), an
indigenous NGO engaged in development demonstrates the universal need of the population,
particularly the rural, of finical services and the ability of the professional operators to provide
some of these services under different circumstances as a financially viable occupation.

2.2 Informal Financial institution

The informal sector accounts for most of the rural financial services provided to the
rural areas in Ethiopia .In his study of micro- finance development in Ethiopia, describes the

25 | P a g e
different informal professional financial services operated in Ethiopia. There are various types
of informal organizations in Ethiopia .These include private sector rotating saving and credit
groups such as

 Iddir
 Iqqub
 Mahebers
 Debo,

That are initiated and organized by the people themselves, under the premise of
financial relations based on reciprocity. In Ethiopia lddir, Mahebers, Eqqqub, Debo, elders’
group, women’s association, money lenders, friends and relatives, pawn brokers, money
keepers and tradesman are the most important informal organizations and explained below in
detail:

A/ Iddir: Is one of the informal local institutions in Ethiopia established voluntarily by the
community and involved in self-help and other social activities. Iddir is established primarily
to provide mutual aid in burial matters but also to address other community concerns. It is an
association established by a group of persons united by ties in families, friendship,
neighborhood, or belonging to the same job . Furthermore, Iddir is a local association with
long history, most widespread, commonly known in rural and urban settings of Ethiopia such
as: Addis Ababa, South Wello, Wag Hemra, Sothern Gonder, Sothern Tigray, Siltie, and
others. It organizes people according to gender, generation, wealth, education, religion,
kinship, ethnicity and some other special relations. To mention some of the associations the
Iddir formed:

 Iddirs based on professions like the teachers’ Iddirs, on gender such as women’s
Iddirs, or on ethnicity or clanship such as those
 Formed by migrants from specific areas. However, with regard to membership
structure,
 Iddirs are the most democratic and egalitarian social organizations which people are
free to join and become a member regardless of their differences in religion, sex,
and ethnic affiliation .
 Iddir as an informal financial and social institution that is almost ubiquitous
throughout Ethiopia.
 Iddir is also defined as an association made up 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, and as an object of providing mutual aid and financial
assistance in certain circumstances.

26 | P a g e
  Iddir is a sort of insurance program run by a community or a group to meet
emergencies.
 The original purpose of Iddir was the burial of the dead. Today, the Iddir provides a
much wider range of services including financial and material assistance and
consolation to a member in the event of difficulties as well as entertainment as
the case may be.
 The expansion of Iddir to urban areas is perhaps associated with growing social
insecurity. ‘

B/ Mahbers:

 Are voluntary and mutual aid community (religious) associations peculiar to

Orthodox religion followers. The members gather together at church or in one of the
member’s house so as to pray together to get blessing from God and saint and discuss
their problems and further share information. In doing so, the members bring food
and drinks to church to feed the poor and themselves and discuss matters of common
interest
 Mahbers are also very crucial informal institutions involved in various community
activities such as risk coping, provision of information, addressing manpower and
traction force and conflict resolution.

C/Eqqub:

 Is an informal institutions established voluntarily to collect a specific amount of money

from the members on a specific date to be paid on round and lottery basis to the
members.
 The trust each other to make the Eqqub function smoothly Interestingly enough,
 Eqqub also lends a hand to the members in many aspects such as provision of credit and
sharing important information.
 ’Eqqub’ is conceived as traditional social organization in which members come together
for the purpose of savings in cash or in kind. The normal practice is that members
contribute money or materials on a regular period of time and lots are drawn so that the
one who wins the chance gets the total sum. This process continues at a regular period
until the last member receives his/ her share , or what he/ she has been saving through the
months and the whole process starts again.
 Eqqub has perhaps evolved over centuries out of ancient customary institutions (e.g.
community level labor exchange arrangements) although some
 ‘Eqqub’ pre-dates the emergence of the modern banking system in the country. The
Eqqub consists of homogenous groups: people from the same work place, ethnic
background trade schooling background or neighborhood.

27 | P a g e
 The ‘Eqqub’ is not limited in urban areas: it is also common in rural areas though
perhaps practiced to a lesser degree,
 People prefer ‘Eqqub’ to the formal financial sector because of the following
reasons: the intimate integration between the financial service offered by the
‘Eqqub’ and the strengthening of the solidarity and friendship in the group, the forced
savings of a contractual nature , the provision of credit services particularly suited to the
needs of the participants and the flexibility and adaptability of ‘Eqqub’ to various
situations and needs , low risks of default the low or practically non- existent costs of
administration and transactions, the absence of minimum investment threshold,
probable tendency to gamble .

D/ Ebo/Webera /Jigie/Wonfel/

 Oxen or labor sharing- are arrangement of agricultural work groups in rural

Ethiopia that create structures for “pooling the labor of a number of people from
an area to assist one or more individuals with building a house, cultivating a large
piece of land, or ploughing, harvesting crops, clearing forests for ploughing and
similar tasks through promises of future reciprocity among member participants .
 Debo or Wobera, a form of festive labor, where a person will provide food and
drink for a large work party in order to carry out a time-sensitive agricultural
task, there is no reciprocity.
 These informal institutions contribute a lot to the group like manpower
mobilizing to the community. Elder’s group/Senbete: It is commonly called
“Shimagelay in Amharic language” is a traditional association of Elders
people who are elected by the local community in order to serve the society
in times of disagreements and coordinate them in common resource
management like water and forest and disseminate information
 Women’s Association- is a voluntary association of women group who have
explicit agreement to help each other in a specified way when well-defined
events occur. These associations help the members in cash or in kind, in capacity
building and by sharing of information

E/ Moneylenders Others /known as arata- abadari/

28 | P a g e
 Loans from moneylenders are typically short-term and are extended to clients of long standing
business relationships usually exploit the poor through interest and unfair seizure of collateral.
The money lender (known as arata- abadari) has been active in Ethiopia for centuries
and until the beginning of the twentieth century represented the only source of. He also notes
that in towns, reduced lending by the financial institutions has created a potential for the
development of informal lending because even persons who in the past were familiar with bank
credit turned to moneylenders to replace bank loans. Before 1974 , moneylenders were often
rich landowners, but following the nationalization of land, land lords disappeared as a social
class and their roles as moneylenders were replaced by rich traders. The financial operations of
moneylenders are simple, cost effective, and flexible compared to that of the banking
system. Interest rates, which are never stated in the agreement made with the borrower are
influenced by the extent members know each other.

and thus trust each other to make the Eqqub function smoothly (Dessalegn and Aklilu,
1999; Desta, 1995).
Interestingly enough, Eqqub also lends a hand to the members in many aspects such as provision
of credit and
sharing important information.
In the literature ,’Eqqub’ is conceived as traditional social organization in which members come
together
for the purpose of savings in cash or in kind. The normal practice is that members contribute
money or materials
on a regular period of time and lots are drawn so that the one who wins the chance gets the total
sum. This process
continues at a regular period until the last member receives his/ her share , or what he/ she has
been saving through
the months and the whole process starts again. As noted by Dejne (1993), Eqqub has
perhaps evolved over
centuries out of ancient customary institutions (e.g. community level labor exchange
arrangements) although some
writers (e.g Pankhurst and Endreas, 1958: Comhaire, 1966) attempted to trace its origins to the
period of Italian
occupation, i.e. 1936-41. Moreover, it is possible that the ‘Eqqub’ pre-dates the emergence of the
modern banking
system in the country. The Eqqub consists of homogenous groups: people from the same
work place, ethnic
background trade schooling background or neighborhood. The ‘Eqqub’ is not limited in urban
areas: it is also
common in rural areas though perhaps practiced to a lesser degree.
According to Mauri ( 1987) , people prefer ‘Eqqub’ to the formal financial sector
because of the
following reasons: the intimate integration between the financial service offered by the
‘Eqqub’ and the
strengthening of the solidarity and friendship in the group, the forced savings of a contractual
nature , the provision

29 | P a g e
of credit services particularly suited to the needs of the participants and the flexibility and
adaptability of ‘Eqqub’
to various situations and needs , low risks of default the low or practically non- existent costs of
administration
and transactions, the absence of minimum investment threshold, probable tendency to
gamble on the part of
members and the consequent attraction which the lottery holds for them, and secrecy which
surrounds the ‘Eqqub’
and the member’s involvement in it.
Further, to the importance of ‘Eqqub’ in the Ethiopia society, Mauri (1987) indicates that the
annual
contribution of Eqqubs amounted to Birr 139 million, which is 15.2 percent of total household
savings deposited
in the commercial Bank of Ethiopia in 1986. Following his estimate, Dejene (2004) has
estimated for the rural
areas of three major regional states that the size of savings generated through ‘Eqqub’ to be
approximately Birr
396.5 million per year. Saving through rural lqqub amounted to an equivalent of 30 percent of
outstanding loans
to the agricultural sector by the banking system. There are distinct types of lqqub in Ethiopia
each has its own
specific features. The big “traders lqqub”, for example is different from other types of lqqub in
that the big “traders”
‘Eqqub’ has a stronger linkage with banks: it is business – oriented. It has developed
sophisticated mechanisms
for compensating those members with longer waiting time for collecting the pool its
transaction costs are
considerable and its operations are quite complex, participation in the ‘Eqqub’ is affected
by household
characteristics . For example, poorer households have access to ‘Eqqub’ and not to
banks. The Better off
households use the banking system more than poorer ones. People from different age
groups and levels of
education participate in ‘Eqqub’s.
Debo/Webera /Jigie/Wonfel/oxen or labor sharing- are arrangement of agricultural work groups
in
rural Ethiopia that create structures for “pooling the labor of a number of people from an area to
assist one or more
individuals with building a house, cultivating a large piece of land, or ploughing, harvesting
crops, clearing forests
for ploughing and similar tasks through promises of future reciprocity among member
participants (Getachew,
1998; Daniel, 2003). But in Debo or Wobera, a form of festive labor, where a person will
provide food and drink
for a large work party in order to carry out a time-sensitive agricultural task, there is no
reciprocity. These informal

30 | P a g e
institutions contribute a lot to the group like manpower mobilizing to the community.
Elder’s group/Senbete: It is commonly called “Shimagelay in Amharic language” is a
traditional
association of Elders people who are elected by the local community in order to serve the
society in times of
disagreements and coordinate them in common resource management like water and
forest and disseminate
information (Frankenberger et al., 2007; Spielman et al., 2008).
Women’s Association- is a voluntary association of women group who have explicit agreement
to help
each other in a specified way when well-defined events occur. These associations help the
members in cash or in
kind, in capacity building and by sharing of information (Dercon et al., 2005).
Moneylenders: Loans from moneylenders are typically short-term and are extended to clients of
long
standing business relationships usually exploit the poor through interest and unfair seizure of
collateral.
The money lender (known as arata- abadari) has been active in Ethiopia for centuries
and until the
beginning of the twentieth century represented the only source of loan ( Mauri, 1987). He also
notes that in towns,
reduced lending by the financial institutions has created a potential for the development
of informal lending
because even persons who in the past were familiar with bank credit turned to moneylenders to
replace bank loans.
Before 1974 , moneylenders were often rich landowners, but following the nationalization
of land, landlords
disappeared as a social class and their roles as moneylenders were replaced by rich traders
( Dejene, 19993). The
financial operations of moneylenders are simple, cost effective, and flexible compared to
that of the banking
system. Interest rates, which are never stated in the agreement made with the borrower are
influenced by the extent

Chapter 4

REGULATION OF FINANCIAL SECTOR IN ETHIOPIA

31 | P a g e
 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.

4. 1. Types of regulation

4.1.1. 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:

1. Creating partial concentration of ownership and control.

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

32 | P a g e
 3. Delegation of concentration of control in the board of directors
4. By making the compensation plan of executives clear align managerial interests with
investors
5. 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.

4.1.2. Restrictions on Banks, and on Links to Commerce

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4.1.2.1. What is a “bank”?

Countries may limit banks to a specific range of activities, or allow them to engage in 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.

4.1.2.2. 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%.

4.1.3. Limitations on Foreign Entry in the banking industry:

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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).

4.1.4. 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:

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 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 ithas succeeded admirably” (Zenawi, n.d).

4.2. 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 assets.

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4.2.1. 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.

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4.2.2. 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

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cannot generate the desire result.

EFERENCE

 National Bank Of Ethiopia Page

 Journal of Economics and Sustainable Development www.iiste.org ISSN 2222-1700 (Paper) ISSN
2222-2855 (Online) Vol.5, No.17, 2014
 African Development Bank (2011), Federal Democratic Republic of Ethiopia, Country Strategy
Paper, April 2011. African Economic Outlook (2012), Ethiopia, 2012.
 Alemayehu G., Kibrom T. and Melekt A. (2011), Remittance and Remittance Service Providers in
Ethiopia, Institute of African Economic Studies, IAES Working Paper Serious NO. A02/2011
 Getnet Alemu (2010) Challenges and Prospects of Agriculture Development Led Industrialization
in Transforming the Economy and Promoting Private Sector Development, CIDA, Addis Ababa

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