The National Bank of Ethiopia (NBE) is heightening its regulatory oversight of microfinance institutions, fortifying a sector that has proliferated but faces mounting risks due to inadequate financial audits and loose supervision.

Regulatory oversight has been insufficient, with no statutory supervision to define auditors' operating procedures. The NBE's move comes as microfinance institutions, which hold substantial deposits and increasingly compete with commercial banks, have been found to engage unqualified auditing firms that fail to adhere to international standards. Authorities fear this practice threatens their stability and depositor confidence.

Regulators have introduced a specialised audit process, empowering them to direct external auditors to conduct specific audits in the 53 microfinance institutions (MFIs) nationwide.

These institutions witnessed an increase in total assets and deposits, reaching 46.1 billion Br and 27.9 billion Br, respectively, as of June 2023, a growth of 33.7pc and 28.8pc compared to the previous year. While agriculture loans declined by 10pc, accounting for 18.7pc of the total, loans to the trade sector increased by six percent, reaching 37.4pc. A loan-to-deposit ratio of 140.4pc uncovered that the industry heavily relies on borrowing from depositors and domestic banks.

A recent report by the NBE revealed high credit risk concentration, making the microfinance sector susceptible to adverse economic shocks. The sector's close links to the banking industry also increase its vulnerability to potential spillovers. The total assets of the financial sector grew to around 3.1 trillion Br, more than a third of the GDP. The 31 banks account for about 96pc of the asset base, with the state-owned Commercial Bank of Ethiopia (CBE) contributing almost half.

Microfinance institutions accounted for two percent of the total, while insurance companies held a mere 1.6pc share.

According to Sintayehu Desalegn, acting director of the MFIs supervision directorate at the NBE, the new directive's goal is to ensure that audits conform to international financial standards, identify recurrent shortcomings, and conduct risk-based assessments to strengthen the industry's transparency and risk management.

This crackdown mirrors measures taken several months ago when the NBE enforced five directives to oversee corporate governance, asset classification, and risk management within commercial banks. These directives require banks to maintain detailed records of related-party transactions and up-to-date credit profiles, promoting transparency and effective risk management. External auditors are now designated specific responsibilities to ensure that risk assessments and financial estimates are accurately reflected in year-end financial statements, which should conform with International Financial Reporting Standards (IFRS) and regulatory requirements.

The directives also incorporate provisions for suspending or revoking licenses in cases of breaches of contractual obligations or failures to fulfil obligations. External auditors are mandated to submit regular risk management and financial reports to the NBE, tightening the regulatory noose around financial institutions that previously operated with relative space. A series of reforms are underway in the microfinance sector, driven by new mandates from the NBE targeting risk management, transparency, and operational efficiency.

A directive introduced last month focuses on the oversight, quality, and administration of external auditors, signalling a shift toward regulatory prudence, hoping to boost depositor confidence and ensure financial stability.

"The reforms will continue in microfinance institutions," Sintayehu confirmed to Fortune. "Microfinance institutions mostly belong to depositors."

According to Sintayehu, rules that consider the industry's evolving nature are needed to improve transparency and risk management.

Last year, the NBE unveiled a three-year strategic plan outlining objectives to restore fiscal and monetary stability. Coupled with a new proclamation to re-establish the Central Bank's autonomy, these moves are considered by many observing the financial sector as denoting a clear intent to strengthen the NBE's role in ensuring financial stability, marking a departure from its 62-year history. Under the new directive, auditing firms should be licensed by the Accounting & Auditing Board of Ethiopia (AABE), secure IFRS certifications, and have at least three years of experience auditing financial institutions.

The directive raises the bar for auditors in a country where only 230 are licensed, and competence and capacity shortcomings have been major issues.

Zerabruck Tirfe, a financial consultant, doubted the availability of a sufficient number of auditors to meet the demands of the many MFIs. Most face credit risk due to high non-performing loans (NPLs), with repayment rates less than 80pc, 10 percentage points lower than the Central Bank's requirement.

"There is a need for qualified auditors, as financial statements have a 50pc possibility of increasing or downplaying the financial risk of MFIs," said Zerabruck, recognising that microfinance institutions' operational challenges and observed a gap in the reasonable valuation of borrowers' financial statements, exposing them to risks. "The financial soundness of MFIs is under risk."