Ethiopia: What If Banks Were to Cultivate Potatoes?
By Binyam Mesfin, Addis Fortune
Since the 1994 opening of the financial sector, Ethiopian banks have enjoyed high profits and steady growth. Even government-owned banks, such as the Commercial Bank of Ethiopia (CBE), have managed to drag themselves out of the mess the Dergue era left them in, in order to survive.
The CBE – the largest bank in the industry – has also managed to have remarkable growth over the last decade. The industry remains closed to foreign competition and the country has a steadily increasing bankable population; both of which are to the benefit of commercial banks.
However, the industry has also been limited to commercial banking – banks accept deposits to lend, earning profits on the spread between interests paid to depositors and that collected from creditors. Rudimentary international banking, such as letter of credit (LC) services and currency exchange, have also been part of their services.
Direct investment in agriculture, commerce and industry have been off-limits to banks,, however, following the 1996 directive, which limited bank investments in non-banking industries. The directive also restricted their ability to invest in other financial institutions, including insurance companies. But, all that is to change, if a new draft bill repealing the 1996 directive is passed.
The draft directive, although worded as interest free loans, allows commercial banks to make direct investments in agriculture, commerce and industry projects through joint ventures (JVs) with clients.
This highly resembles private equity investment, common in developed financial systems, if not for two key differences. Instead of utilising their own money, or that of willing and informed investors, banks will use mobilised deposits. And, rather than investing in highly liquid securities, such as stocks (shares) and bonds, as their western counterparts do, they will commit depositors’ money to long term JVs.
Of course, if passed, it would not be without its merits. Permitting Ethiopian banks to become involved beyond their current boarders could allow them to increase their capacity.
They could also blend various new products into their services and increase their contribution to the country’s economy. The positive signal it sends to foreign investors is a bonus, too. Banks could also use information about the economy, industries and inside knowledge about clients’ businesses to provide cheaper project financing than previously.
Cross-selling other services to such clients is another potential benefit. For example, a bank jointly investing in a new industry could also provide international banking services to the new venture or make additional debt financing available. In fact, a recent study on 24 countries of the Organisation for Economic Cooperation & Development (OECD) showed that banks with such an arrangement report better interest revenue and net income. A desirable situation for both banks and their customers, it seems.
But, it is murky water, at best. As Franklin Roosevelt once said “investment banking is a legitimate business. Commercial banking is another, wholly separate business. Their consolidation and mingling is contrary to public opinion.”
This is worth noting. The ease of implementing the draft directive and the potential gain to banks could serve as a path into a quagmire, which could affect the whole financial industry.
The risk in equity investment is different to that usually assumed by commercial banks, both in amount and form. Investing in agricultural projects or a new textile factory has higher risk attached, than financing the same ventures through collateral-backed, commercial loans. By virtue of their equity exposure, banks will face more volatile returns compared to their conventional interest income.
In addition, compared to normal default risk, banks will also be exposed to other systemic, non-banking risks within the industry they invest in. The former is easily quantifiable and hedged through collaterals, whereas the latter is tricky to manage.
A commercial bank could finance a cement plant, against collateral, without direct exposure to the risks in the construction industry. The same is not true of banks, with the same cement factory, with respect to JVs.
Banks would naturally be willing to take these risks, so long as the risk-return trade-off warranted it. But, would it be fair practice for commercial banks to engage depositors’ money in pursuit of making above normal, yet volatile, returns, whilst only paying fixed returns to depositors? Thus, placing the whole risk in the pocket of depositors.
Depositors assume that putting money into a bank is risk-free. Knowing that their presumption is wrong and that banks are involved in risky trades, without extra benefits to depositors, could erode depositors’ confidence and bring about huge ramifications to the financial industry. The recent bank run in Cyprus is a clear illustration of this.
Another problem with allowing equity investment is that it could detract banks from their core competencies, which, in turn, deters their growth. Banking in Ethiopia is a lucrative business that kept its profitability during even the most disruptive financial disaster the world has seen in decades. Yet, there is plenty of room to improve before adding services outside their commercial banking realm.
The most notable is the lack of financing for small & medium enterprises (SMEs). These entities are usually the creative and entrepreneurial hubs of most advanced economies. They employ the majority of the labour force.
Their advances and declines in profitability usually signal an economy’s health and its future trajectory. However, it has always been underserved by commercial banks that prefer bigger companies, mostly those in trade, which naturally demand collateral backed, large, short-term loans.
The gap still thrives. Micro Finance Institutions (MFIs) could fill it, if it were not for their lack of financial muscle and efficiency. If commercial banks were to deviate from their ridged service classes and offer innovative products, they could easily tap this niche for massive gains.
For banks with a longer outlook, mortgage financing is non-existent at the moment. Consumable financials, such as car and furniture loans, have great potential.
So, why go astray when enough opportunities still exist within commercial banking?
The quality of commercial banking in Ethiopia is still undeveloped. Compared to their counterparts in Africa, let alone globally, their services are not up to standard.
To their credit, they are striving to use technologies, such as ATMs and branch networking, to improve services. But, they still struggle to provide gainful ventures, such as mobile banking, which many of their African counterparts do with ease. Whilst most banks are offering debit cards, they only have limited ATM machines – when they are working, and you can do so little with them.
With such gaps existing in their operations, would sidetracking them from their core business be prudent? Shouldn’t they work on having a firmer foot in commercial banking before Ethiopia’s World Trade Organisation accession and all the protection they currently enjoy vanishes?
Yet another challenge for the new directive would be in the regulation of new activities. Undertaking equity investment, joint venture or not, will increase banks’ balance sheets, where many new assets will need to be deciphered, in order to get a clear picture.
The Central Bank would not be able to use its old tools, such as percentage of non-performing loans, to gauge bank performance and health. Rather, it will have to evaluate each and every equity investment, from a variety of industries, that each bank makes, so as to assess the vigour of the financial sector.
Well, it could seek help from the Ethiopian Investment Authority (EIA) and the Ministry of Industry (MoI), but a multi-agency oversight of financial institutions is messy at best. In fact, there is enough research to argue that the 2008 financial meltdown in the United States finds its roots largely in the abolishing of a 1933 act, which banned the mingling of investment and commercial banking.
The new law of 1999, which allowed commercial banks to undertake investment banking services in the United States, resulted in “too big to fail” entities that were difficult to regulate. That exact reality could be the worst case scenario for Ethiopia’s Central Bank. The new law could cause commercial banks to be too big and too rooted within the economy; where a simple sneeze could cause an economic flu.
This regulatory difficulty has a second edge. Without full oversight by the Central Bank, banks could gamble with high risk and high return ventures. After all, depositors bear the whole risk.
With no federal deposit insurance- a proclamation issued in 2008 makes rudimentary provisions – the risk could be too great to keep depositors’ confidence in commercial banks. How can a depositor trust an entity that grants credit to businesses and uses the credit itself (i.e. depositors’ money) to make long-term equity investments?
The inherent conflict of interest in the new provisions is clear to see. Banks naturally would cross-sell other services to clients with whom they have JV investments. This makes them both part owner and creditor in the JVs.
Naturally, they would protect their debt exposure through collaterals. Problems arise whenever banks need to foreclose collaterals to recoup loans.
Would they be willing to forego their equity investment to collect money loaned? Can they objectively evaluate the health of JVs in times of trouble?
So the new directive can be nothing more than a quick fix for an artificial problem, which a profitable industry in a growing economy faces. Its need is limited and its costs could outweigh the benefits. Rather, with the aim of fostering a growing the banking industry, there are a few reasonable alternatives.
Relaxing the bond-purchase requirement, banks currently face in advancing loans, could have an immediate impact. Of course, this needs a delicate balance between the current demand of curbing inflation and accelerating economic growth.
Another alternative is to adjust the current directive to allow equity investment of a banks’ own shareholders capital, rather than deposits. The 1996 directive did this, and extending the percentage limit set may be enough for now.
However, this restricts the impact of the new directive to the dismay of regulators. Yet, it is needed for the sake of future stability. It could further encourage banks to raise extra shareholders’ capital, in order to join more profitable non-banking ventures.
A more comprehensive adjustment to the banking industry, however, would be to abandon the current ban on investment banking and allow limited-purpose private equity investment banks. They will be non-deposit taking; raising funds, instead, from well-informed wealthy individuals, pension funds and endowments, with the sole purpose of investing in long-term projects, like the ones recommended by the draft directive.
A quicker version of allowing limited purpose investment banking would be to permit current commercial banks to establish separate wings, specialising in private equity investments. Banks could combine private money with part of their shareholders’ equity through such divisions, quite possibly accruing huge investment potential. This, in turn, would allow them to aim for high returns, through high risk ventures that don’t risk the health of their commercial banking arm.
This also has a few further benefits. Commercial banks can use their current setup as a launch pad to implement it with haste. With a wall between the investment and commercial arms of banks, and private money obtained from able investors (compared to depositors), only a slight increase in supervision is required.
If the investment arm was to fail, the fallout on the economy would be relatively minimal. This could allow authorities to test the uncharted waters of investment banking, and limited purpose investment banking divisions could spin-off into fully-matured investment banks.
The grandest solution for a modern financial system, however, would be to institutionalise a fully-fledged capital market. If Ethiopia is to continue its fast economic growth, easy access to capital is important, which the current system cannot sustainably satisfy.
True, setting up a capital market is not easy and needs the utmost care a country can afford. It also takes time to have all the necessary institutions, technology and legal basis in place. But, the work has to begin to set the financial industry on a longer term development trajectory.
Binyam Mesfin – Binyammesfin@yahoo.com – an Independent Investment Advisor