New Capital Threshold, Small Inconvenience for Some, Existential Risk for Others

Apr 24 , 2021
By Abdulmenan M. Hamza

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Last week, the National Bank of Ethiopia (NBE) instructed private banks, both in operation and under formation, to increase their paid-up capital to five billion Birr in five and seven years, respectively. This measure seems to have been triggered by the increasing number of banks under establishment. A decade ago, a similar episode alarmed the NBE to increase the paid-up capital of banks from 75 million Birr to half a billion (effective June 2016), causing the dissolution of several banks in the pipeline.

Unlike other industries, the Ethiopian banking industry has certain features that induce newcomers. The industry is defined by rapid growth and confinement to rudimentary services. It has been thriving over the past decade. Despite a significant drop in returns, the earnings per share (EPS) of private banks still hovers around 30pc, which is much higher than the returns of other investments.

The banks are confined to providing basic services partly due to regulatory restrictions. They are limited to taking deposits and providing loans, arranging letters of credit, dealing in foreign exchange, money transfers and issuing letters of guarantee. This has resulted in an industry of homogeneous banks, with less product diversification and specialisation, albeit in different sizes.

These factors, combined with the tight regulation of the industry, have reduced the risk profile of mainly the private banks, resulting in decent returns, unlike in many other countries which have a liberalised financial sector. This situation, complemented by the implicit and explicit guarantee afforded to the Commercial Bank of Ethiopia (CBE) by the government, despite the concentration of considerable systematic risk within it, has enhanced the stability of the industry.

The stability and profitability of the industry combined with little entry barriers due to lack of specialisation and diversification has always attracted newcomers, leading to increased competition which has driven the returns of the shareholders down.

Generally, competition is good for dynamic and allocative efficiency. The competition encourages innovation, reduces prices, and increases access to finance, the result is better consumer welfare and increased financial inclusion. However, letting unbridled banking competition reign is naïve as the industry has specificities. Untamed banking competition could cause financial instability. The failure of a single bank would undermine the stability of other banks through contagion. The effect could often spill over into the real economy. That is why banking competition is dealt with cautiously.

Regulators are in favour of stability as the cost of a lack of it is too high. They often set rules that encourage concentration. But as the benefits of competition cannot be ignored, a certain degree is encouraged while setting the rules to tame its pernicious effects. Through control of branch opening, instituting deposit insurance schemes, setting higher capital requirements, and other measures, banking competition is harnessed.

Requiring a significant amount of capital serves as an entry barrier, enables banks to have a significant buffer against losses and discourages irresponsible lending. The problem with smaller capital is that it encourages ‘gambling for resurrection’ behaviour. This means that when banks have smaller equities, they are encouraged to take undue risks, displaying a gambling behavior. The more considerable equity a bank has, the more prudent a behaviour it tends to display as the shareholders have a significant stake in the bank's survival.

As the new directive benefits the industry by taming competition, it affects many of the banks. The directive will force either merger or dissolution of several banks which have been under formation. The shareholders of the banks that may be forced to dissolve will incur considerable costs which have been spent thus far. It is dismaying that the central bank has taken too long to develop some deterrents despite several warnings. What is more disappointing is that the NBE did not take a lesson from its abrupt measure taken a decade ago to halt a wave of banking formation, which led to the dissolution of several banks in the pipeline.

With a combined paid-up capital of 41.8 billion Br as of the end of the past fiscal year, the existing banks are required to raise 38.2 billion Br in half a decade. This means the industry will have to increase its paid-up capital by 15pc a year. Considering previous experiences, this does not seem problematic. The trouble is that banks with a capital of far less than two billion Birr may find it difficult to beef up to the minimum threshold within the prescribed period. Banks such as Debub Global (paid-up capital of 986 million Br by last June) needs to increase its capital by as high as 40pc annually. The growth of profit can not match such capital increase if we go by previous trends; the result is reduced returns to shareholders of the smaller banks. This makes achieving the industry average return over the coming years a daydream.

The brunt of the new directive seriously affects the banks under formation as well. Firstly, they will have to raise massive capital or merge unless the NBE comes up with some exceptions. Secondly, even if they tackle the first difficulty, the returns of their shareholders will be much smaller due to high capitalisation levels coupled with lower profitability due a learning curve.

Instead of relying on entry barriers for financial sector stability, Ethiopia can have a stable financial sector and at the same time reap the benefits of competition.

Currently, Ethiopia has a small number of banks and lower-level private sector participation in banking for its population size and gross domestic product (GDP). As a result, the country is not adequately enjoying the benefits of competition. One factor chiefly contributing to this situation is the excessive dominance of the CBE, controlling 64pc of credit and 60pc of deposits. This sets the Ethiopian banking industry apart from several of its African peers in which the state banks play little part. If the market share of CBE is reduced by half, a space for more than 10 banks could be created. This should be considered within the economic reform package.

Regulatory restrictions have played a great part in the lack of specialisation and diversification in the financial sector, the result is lower private sector participation. For instance, dealing in securities and investment in the insurance business is highly restricted. Relaxing the restrictions and developing a regulatory framework increases innovation, attracts new players and increases competition.

Finally, the NBE often uses a surprise and blanket approach to regulation. This instills unpredictability and is costly to the industry. Regulatory proactivity, predictability, and consideration of specific aspects of the industry players will help smooth out the evolution of the industry.

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PUBLISHED ON Apr 24,2021 [ VOL 22 , NO 1095]

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