\

Term-Paper:Financial Markets and Institutions

Title: Ethiopian Financial Markets and Institutions
Group Members ID No.

1. Abdisa Biftu RVU/0055/15

2. Ermias Dessalegn RVU/0067/15
3. Tesfaye Yifru RVU/0020/15
4. Tesfahun Tessema RVU/0068/15

Submitted to: - Mokonnen S. (Assistant Professor)

Rift Valley University

Faculty of Business and Social Science

Department of Accounting and Finance

Program: Master in Accounting and Finance (MSC.)

\

January, 2017 Adama-Ethiopia

TABLE OF CONTENTS
Acknowledgments ............................................................................................................... 2
Acronyms and Abbreviations
Introduction ......................................................................................................................... 5
PART-I: NATURE OF FINANCIAL INSTITUTIONS
1. ETHIOPIAN FINANCIAL INSTITUTIONS
1.1. Overview............................................................ 6
1.2. The Ethiopian Financial Sectors
1.3 Nature of Ethiopian Financial Sectors
1.3.1 Formal Financial Sector
1.3.2 Semi-formal Financial Sector ................................................. 7
1.3.3 Informal Financial Sector ....................................................... 9
ART-II: NATURE OF FINANCIAL MARKETS
2. ETHIOPIAN FINANCIAL MARKETS
2.1. Overview of financial markets............................................................ 6
\

2.2. Money Markets .............................................................................. 11

2.1.1. Types of money markets instruments............................................................................... 11
2.1.2. Money market trading practice
2.1.3. Money market valuation issues
2.3. Participants of the Market............................................................................. 14
PART-III: FINANCIAL MARKETS REGULATION
3. ETHIOPIAN FINANCIAL MARKETS REGULATION
3.1. Overview of Financial Market Regulation............................................................ 6
3.2. Financial Market Regulation of listed Financial Assets...................................................... 15

Acknowledgments
This paper adapts materials from various work of analysis. First we would like to express our
deepest gratitude and sincere appreciation to our instructor Mokonnen S. (Assistant Professor)
for his suggestions, constructive advice and posse talent of illuminate the ways to make students
researches.
\

Second our deepest feeling also goes to Mati computer center for its technical, typing and
material support.
Finally we would also delighted to express our gratitude to Abyan Internet, for giving us
constructive information that should be collected to allow us for access analysis of target paper.

PART-I: NATURE OF FINANCIAL INSTITUTIONS

1. Ethiopian Financial Institutions
\

1.1. Overview of Financial Institutions

The term “institution” is a broad concept and had been the center of discussion of developmental
economics. Oxford English Dictionary defines institutions as: “the giving of form or order to a
thing; orderly arrangement; regulation." Related to this is "an established law, custom, usage,
practice, organization, or other element in the political or social life of a people; a regulative
principle or convention subservient to the needs of an organized community or the general ends
of civilization." An institution could be economic (Banking, Commerce & Finance and
Entrepreneurship, Management, & Leadership subjects.), legal (constitutions, laws and
regulations) financial (Banks, credit unions, insurance or trust companies), public (Institutions
which are supported primarily through public funds), social (A set of organized beliefs, rules,
and practices that establishes how a society will attempt to meet basic needs.), religious,
organizational, political etc.
Financial institutions are what make financial markets work. Without financial institutions,
financial markets would not be able to move funds from who save to people who have
productive investment opportunities; and thus have important effects on the performance of the
economy as a whole. The most important financial institution in the financial system of an
economy is the central bank, the government agency responsible for the conduct of monetary
policy. In addition to this, institutions in the financial system include; commercial and savings
banks, insurance companies, mutual funds, stock and bond markets, credit unions and non-
formal financial institutions (that are common in least developed countries particularly in Africa,
Sub-Saharan Africa including Ethiopia). The financial system channels funds from savers to
people with productive investment opportunities in two different ways. In a flow of funds
(money) in a world without financial institutions, we have a direct transfer of funds (money)
from suppliers of funds to users of funds and financial claims (equity and debt) in the reverse
order. In an economy without FIs the level of funds flowing between suppliers of funds and users
of funds through financial markets is likely to be quite low. FIs provide various services to an
economy and the actors in the economy. So, they have to be regulated by the government
because failure to provide the required services to the economic actors in the financial market/
capital market can be costly to the financial market (ultimate suppliers of funds and users of
funds in particular) and to the overall economy. For example bank failure may destroy household
savings and restrict a firm’s access to credit and in general individual FI failures may create
doubts in savers' minds regarding the stability and solvency of FIs and the financial system in
general cause panics and even withdrawal runs in sound institutions as well. FIs are regulated to
prevent such types of market failures.
Financial institutions such as MFIs (usually in the form of saving and credit associations) and co-
operative banks which are the common FIs in rural areas of most African countries particularly
those in Sub-Saharan Africa (SSA) including Ethiopia are the means through which these
countries could mobilize financial resources from the rural community. However, FIs are not
developed yet in most African countries.

1.2 The Ethiopian Financial Sectors

1. 2.1 The Financial Sector in Ethiopia: Recent Developments
\

In order to create awareness about capital markets in Ethiopia among investors, financial
institutions (Commercial banks, insurance companies, credit unions, micro finance institutions,
and non-formal savings institutions), the business community, and the public at large, studies on
the establishment of capital markets have to be conducted vigorously and seminars and
workshops as well. There seems a pressure from IMF and the World Bank to liberalize the
financial sector of Ethiopia. Ethiopia is also queued for membership in the World Trade
Organization (WTO). These organizations may consider liberalizing the financial sector
(banking and insurance) and establishment of capital market as a precondition for the country to
get further development assistance and co-operation. As per the National Bank of Ethiopia
(NBE) Annual Report (2006/2007); the financial sector in Ethiopia mainly consists of the
banking system, insurance companies and microfinance institutions. There are eleven banks
operating in the country of which eight are private commercial banks. The total number of bank
branches throughout the country is 487. The ratio of bank branches to total population is about
158,372 which still shows that Ethiopia is one of the under banked countries in Sub- Saharan
Africa (SSA).
The distribution of bank branches indicates that 38 percent are located in Addis Ababa, the
capital city. Out of the total number of bank branches, the share of private banks is 47.6 percent.
And the total capital of the banking system reached 9.3 billion birr of which the share of private
banks is 31.5 percent. The numbers of insurance companies in the country are nine with 146
branches. This means that in Ethiopia one insurance branch serves over 520,000 people. Of the
total, 48.6 percent of the insurance branches were located in Addis Ababa, the capital city.
Private insurance companies accounted for 75.3 percent of the total branches. The total capital of
the insurance industry is only 522 million birr. The share of private insurance companies in total
capital is 59.4 percent.
The number of microfinance institutions (MFIs) in the country is 28 out of which 11 (or 39.3
percent) were located in Addis Ababa, the capital city and mobilized total deposits of 1.04 billion
birr and their total assets also reached 3.48 billion birr. MFIs are increasingly playing a role in
contributing to poverty reduction by providing loans to and mobilizing savings from the low
income groups. There are around 4 commercial banks under establishment. One of these banks,
Access Bank had also proposed a new product (Investment banking) to the traditional Ethiopian
banking service.
1.2.2 Resource Mobilized by Banks and Microfinance Institutions (MFIs) in Ethiopia
As per the National Bank of Ethiopia Annual Report 2006/07; the financial sector in Ethiopia
mainly consists of the banking system, insurance companies and micro-finance institutions.
Banks operating in the country are 11, out of which three are state-owned and 8 privately owned.
The bank branches are 487 of which 38% (185 branches) are located in Addis Ababa, the capital
city. As per this the same report, the total number of population served by a bank branch is
158,372 persons, which shows that Ethiopia is one of the under-banked countries in sub-Saharan
Africa. There are 9 insurance companies with a total branch of 146 of which 48.6% (71
branches) were located in Addis Ababa, the capital city. The numbers of Microfinance
Institutions operating in the country are currently 28. Microfinance Institutions mobilized
deposits close to Birr 1.0 billion and advanced loans amounting to Birr 2.7 billion by the end
2006/07. The banking system mobilizes resources in the form of deposits, collection of loans and
borrowings. Total resources mobilized by the banking system reached Birr 23.3 billion in
2006/07. Deposit liabilities of the banking system reached Birr 53.9 billion at the end of June
2007.
\

1.2.3 Deposits Mobilized by Ethiopian Financial Institutions

The objective of this chapter and one of the objectives of this study is to show that the resources
mobilized through the existing financial institutions (banks and microfinance institutions in this
case) in the form of deposits would have been much more productive had there been a capital
market in Ethiopia. In Ethiopia deposits pay 4% on average. The objective in this chapter is thus,
to consider the deposits mobilized by the commercial banks and some nonbank financial
institutions of the country (in this case microfinance institutions- MFIs) and the corresponding
estimated earnings obtained from interest (4%) on these deposits and compare it with the average
returns of publicly held companies (commercial banks in this case- publicly held companies by
the law in Ethiopia) and to show that savers (mainly households) will be beneficiaries had there
been a capital market that could make use of the deposits mobilized either with the direct
participation of the savers (households and others) or through an intermediation of financial
institution like mutual funds and pension funds.

Deposits mobilized by the banking sector (demand, savings and time) 10

Table 1: Deposits Demand Deposits Savings Deposits Time Deposits Total

and Borrowings
of Commercial
Banks and
Specialized Bank
((2006/07) (In
millions of Birr:
$1=8.86Birr)
Bank
Commercial Bank 21,323.4 13,147.0 302.0 34,772.4
of Ethiopia (CBE)
Development 18.3 3.6 551.9 573.8
Bank of Ethiopia
(DBE)
Construction & 182.6 722.3 231.4 1,136.3
Business Bank
(CBB)
Dashen Bank 1,360.9 2,842.9 656.8 4, 860.6
(DB)
Bank of Abyssinia 510.7 1,898.1 312.2 2,721.0
(BOA)
Wegagen Bank 1,231.5 802.9 711.2 2,745.6
(WB)
United Bank (UB) 399.0 854.7 420.2 1,673.9
Nib International 423.0 1,084.6 371.4 1,879.0
Bank (NIB)
Awash 603.3 2,223.5 285.8 3,112.6
International Bank
(AIB)
Cooperative Bank 166.2 86.1 25.0 277.3
of Oromia (CBO)
Lion International 48.6 53.2 11.1 112.9
Bank (LIB)
\

Total 26,267.6 23,718.8 3,878.9 53,865.3

 \

Demand deposits (checking accounts) pay no interest and can be withdrawn upon demand.
Savings deposits pay interest typically below market interest rate (4% in the case of Ethiopia),
do not have a specific maturity, and usually can be withdrawn upon demand. Time deposits, also
called certificate of deposits, set a fixed maturity date and pay either a fixed or floating interest
rate.

Deposits mobilized by microfinance institutions (MFIs)

Table 2: Micro Finance Microfinancing institutions Region Savnings Credit

Institutions Operating in
Ethiopia as of (2006/07)
(Amount in Thousands of Birr:
$1=8.86Birr) No.
1 Amhara Credit & Saving Ins. Amhara 447,649.0 874,160.00
2 Dedebit Credit & Saving Ins. Tigray 261,329.60 853,259.60
3 Oromia Credit & Saving S.C Oromia 135,087.80 407,271.30
4 Omo Credit & Saving Ins. SNNP 62,768.80 135,418.50
5 Specialized Finan. & Pro.Ins. A.A 10,691.00 24,602.80
6 Gasha Micro-fin. Ins. A.A 5,128.20 13,448.20
7 Wisdom Micro-financing Ins. A.A 14,374.00 57,194.00
8 Sidama Micro-finance Ins. SNNP 7,096.80 20,781.40
9 Aser Micro-financing Ins. A.A 245.20 311.40
10 Africa Village Financial Service A.A 2,458.00 7,924.40
11 Bussa Gonofaa Micro-fin. Ins. Oromia 3,379.00 18,474.00
12 Peace Micro-finance Ins. A.A 7,091.20 30,024.80
13 Meket Micro-financing Ins. Amhara 507.80 2,165.10
14 Addis Credit & Saving Ins. A.A 51,529.00 166,037.00
15 Meklit Micro-financing Ins. A.A 4,948.00 14,181.90
16 Eshet Micro-financing Ins. Oromia 3,554.50 33,004.60
17 Wasasa Micro-financing Ins. Oromia 6,487.70 29,809.80
18 Benishangul-Gumz MFI Benishang 7,687.80 25,004.40
ul
19 Shashemene Idir Yelmat Agar Oromia 819.10 2,581.10
MFI
20 Metemamen MFI A.A 820.10 4,984.70
21 Dire MFI Dire 1,457.90 4,295.70
Dawa
22 Agar MFI A.A 1,720.30 3,807.10
23 Harbu MFI Oromia 1,612.00 3,849.0
24 Ghion MFI Amhara 310.60 348.10
25 Leta MFI Oromia 57.50 464.20
26 Digaf MFI A.A 778.50 583.40
 \

27 Harar MFI 372.20 1,673.90

28 Lefayeda and Saving Institution*
Total 1,039,961.60 2,735,660.40
 \

On average the deposit mobilized by the Ethiopian financial institutions (only the formal sector)
which is about 54,905.9 billion Birr: $1=8.86Birr), could earn 4% interest in the form of deposits
in commercial banks; the minimum rate set by the National Bank of Ethiopia. Private Banks and
Insurance Companies are some of the publicly held companies (share companies) by the
Ethiopian Law. By considering the financial statements of the commercial banks the average
return on equity (ROE) could be computed. However, for some of the banks data is not available
to do so (which is the major problem in most African countries). The following summary data
which was taken from a “comparative study on the profitability and performance of commercial
banks in Ethiopia: Fifth International Conference” – Ethiopian Economic Association - Addis
Ababa, Ethiopia; a study conducted by Dhanuskodi, Thangavelu, Dr. Venkatachalma, and Dr.
Sudalaimuthu could be used serve as a bench mark.

Table 3: Return Banks 2000 2001 2002 2003 2004 Average (ROE)
on Shareholders’
Equity (ROE) of
Banks in
Ethiopia
(Percent) No
1 Commercial Bank of 40.41 1.49 (56.8) 39.6 28.4 10.62
Ethiopia (CBE)
2 Construction and Business 0 (4.73) 0.77 5.45 8.08 1.91
Bank (CBB)
3 Awash International Bank 12.41 13.58 6.88 11.3 17.6 12.35
(AIB)
4 Dashen Bank (DB) 14.21 24.26 21.26 20.6 32.7 22.59
5 Bank of Abyssinia (BOA) 9.94 13.33 (1.69) 3.64 19.9 9.02
6 Wegagen Bank (WB) 5.48 10.85 10.09 11.8 24.6 12.55
7 United Bank (UB) 6.99 8.05 4.33 5.72 6.96 6.41
8 Nib International Bank (NIB) 2.15 17.86 12.89 10.4 19.3 12.53
Total 87.98
Average (ROE) 10.99
\

Note: Currently there are 11 commercial banks in Ethiopia. In addition there are also around 4
banks under formation. The banking sector is booming unlike insurance companies. The deposit
rate (usually the savings and time deposits) being 4% and on average the return on equity (ROE)
10.99% could give a hint that savings mobilized and tied up to banks are not as such productive.
In most developed nations the strength of their economy one way or another is the result of the
strength of their financial sectors (banks, life insurance companies, other insurance companies,
pension funds, mutual funds, capital markets). The financial sector of an economy determines the
strength of the other sector of the economy. Thus, the growth and development of the financial
sector one way or another determines the development and growth of the economy.
Comparing the average deposit rate and the average ROE Comparing the average deposit rate
and the average ROE of the commercial banks we can see that if resources are mobilized through
the formal sector (e.g. banking and nonbanking) and informal financial institutions and put into
productive investments (that could be possible with an active capital market) instead of tiding up
to banks in the form of savings and to nonproductive non-financial assets, it could play a
significant role in strengthening capital markets (attracting more participants-households,
companies etc.). Integration of the banking and nonbanking financial institutions (MFIs) with
capital markets is also vital for the capital markets to play a significant role towards the growth
and development of the real economy of African countries in this case Ethiopia.

1.2.4 The development of financial system and its transition

The development of the financial system in Ethiopia could be categorized into three regimes.
1) The development of private banking system during Haile Selassie
2) The complete ownership of banks by the state in the Derg era; Nationalization of banks in
January 1977
3) The transition to private banking system after the economic liberalization, 1992
The need for supervision of the banking sector emerged in the transition period due to the fast
growth of private banks and insurance companies. This required rebuilding the regulatory
framework for the financial sector and the issuance of:
 Monetary and banking proclamation (Proclamation no. 83/1994). Which increased the
autonomy of the NBE to supervise banks and insurance companies
 Licensing and supervision of banks and insurance companies (Proclamation No. 84/1994)
 As a result a separate supervision department was set up in early 1996 under the NBE.
 When the microfinance law was issued in 1996 (proclamation 40/1996), the NBE was
empowered supervise the MFIs
1.2.5 Regulatory and Supervision issues in the Microfinance Industry in Ethiopia
The Federal Democratic Republic Government of Ethiopia has issued a proclamation No.
40/1996 for the Licensing and Supervision of the Business of Micro financing Institutions.
According to the proclamation, the purpose and duty of Micro-financing Institutions are: 1)
Granting credit, in cash or in kind, the maximum amount shall be determined by the National
Bank. 2) Subject to conditions set under this proclamation
The motives of regulating the microfinance industry include:
- Promoting the microfinance industry to alleviate poverty
- Protecting the safety of depositors
- Increasing the barriers to NGOs which mix charting and the delivery of financial services
\

- Introduce a strong financial discipline in the delivery of financial services to the poor
- Increase the mobilization of savings
- MFIs should be free to set their own saving interest rates (No regulated interest rate ceiling)
- The regulation should provide higher minimum capital requirements for MFIs
- The regulations should explicitly provide capital adequacy ratios and reserve requirements that
fit the nature of microfinance industry in Ethiopia
- The regulation and supervision of MFIs in Ethiopia should fit to the various stages of the
development of microfinance institutions
- The National Bank of Ethiopia should increase its capacity to effectively supervise the
microfinance activities in Ethiopia
- The National Bank should promote the microfinance law
- Favorable tax treatment should be provided to develop the microfinance industry in Ethiopia
- The National Bank should enforce the requirement of annual external audit and regular
reporting
- The regulation should facilitate direct access to foreign loan (facility foreign concessional loans
foreign exchange permit, and bearing the exchange risk)

1.3 Nature of Ethiopian Financial Sectors

The concept of “Informal and formal” enterprises are the other terms need some contextual
definitions as used in this survey. To begin with, although there are no universally accepted
definitions of what constitutes an “informal enterprise”, there is consensus that they are small
scale, and operate outside registration and tax and frameworks. They may pay tax when caught
by the tax man, otherwise known for evading taxpaying and other required regularities.

1.3.1 Formal Financial Sector

Formal enterprises are defined as establishments principally engaged in production of marketed

goods and services but formally registered at respective government agencies to undertake the
business and hence have licenses to operate. They are commercial banks.

The formal microfinance industry began in Ethiopia in 1994/1995 with the government’s the
Licensing and Supervision of Microfinance Institution Proclamation designed to encourage
Microfinance Institutions (MFIs) to extend credit to both the rural and urban poor of the country.
By 2005, there were 23 MFIs with almost 1 million clients.
Since the government prohibits any foreign national from providing banking services in
Ethiopia, MFIs in the country must be established as share companies with capital wholly owned
by Ethiopian Nationals or by organizations wholly owned and registered under the laws with a
head office in Ethiopia. This has led to lack of transparency in the sector since much of the
initial capital comes from foreign donors who must enlist “nominal” shareholders to act as
fronts. (MFIs are licensed under the central bank). Gobezie (2005) notes,
These shareholders are precluded from selling or transferring their shares and "voluntarily
forsake" their claim on dividends, if any, declared by the MFI. Such shareholders do not have a
real stake in the organization and would be unlikely to lend it support at a time of financial crisis.
\

Interest rates charged on loans are not fixed, but a minimum interest rate of 3% to depositors is
required by law, which sometimes discourages mobilization in hard‐to‐reach areas (where
administrative costs added to the cost of capital make investment too expensive). Such high
transactions costs mean that most MFIs operate in urban or semi‐urban areas, leaving the rural
poor underserved. On the other hand, MFIs are exempt from Income and Sales Tax on their
profits.
Other than the formally‐licensed MFIs, there are NGOs informally involved in the delivery of
microfinance. Their practices include subsidized interest rates, charity and lax delinquency
penalties, which Gobezie notes may undermine the health of the microfinance industry as a
whole.
The formal sector (banking) has also capital inadequacy and inefficiency and the insurance
sector, performance problems. Thus, the central banks should be made better at bank regulation
and supervision and strengthening the informal sector as well. Ethiopia for establishing capital
markets first the availability and capacity of financial institutions must be taken in to
consideration. The central bank of the country; National Bank of Ethiopia (NBE), the
commercial banks (state and private), insurance companies and MFIs, credit unions and co-
operative banks should be strengthened before embarking on the establishment of capital
markets. Specialized banks (such as investment) and mutual and pension funds need to be in
place and their capacity strengthened by creating favorable working environment and finance
specialists and brokers needs to in place as well.

1.3.2 Informal Financial Sector

Informal enterprises are defined as establishments whose members or operators are mainly
engaged in production of marketed goods and services but formally unregistered at any
government agencies to undertake their business and hence have no licenses.
Informal financial system includes entities operating outside of the domain of the National Bank
of Ethiopia. It includes the financing from family and friends, supplier credit, and commercial
moneylenders. Money-lending is a high risk form of financing, since the client is required to
repay the loan, usually at the end of each trading day, whether they have sold all of their goods
or not, Interest rates and repayment terms are often quite flexible, but could be as high as 200 per
cent. In Ethiopia are informal lenders (money lenders, trade credit, friends, relatives, etc).
1.3.3 Semi- formal Financial Sector

Are lending institutions, such as the Rotating Savings and Credit Associations, are the dominant
and sustainable traditional institutions that meet the financial and social needs of the poor. Equb,
the dominant form of credit and savings in urban and rural areas, is the most popular and
provides a lending option for MSEs willing to mobilize in savings groups. Example: NGOs;
Micro finance institutions (MFIs). NGOs Many donors provide funds to NGO's for distribution
to needy MSEs.

Since declaration of proclamation 40/96, NGOs are prohibited from involvement in credit and
savings, unless registered as an MFI. Most of their programmes take the form of community-
based lending and saving co-operatives, with high interest rates and inflexible repayment terms.
\

MFI The main objective of micro finance institutions is the delivery of financial services (micro-
loans, micro-savings, micro-insurance, money transfer, etc) to a large number of productive but
resource-poor people in rural and urban areas, including MSEs in a cost effective and sustainable
way. The interventions of the micro finance institutions are intended to make a positive and
measurable impact on the lives of the poor. Programs offer group-based lending and require
guarantees.

PART-II: NATURE OF FINANCIAL MARKETS

\

2. ETHIOPIAN FINANCIAL MARKETS

2.1 Overview of Financial Markets establishment in Ethiopia
History tells that share market has existed in Ethiopia during the Imperial regime. Before the
nationalization of private property in 1975, there had existed a rudimentary share market in Ethiopia.
Share dealing was handled by the National Bank of Ethiopia, department of Share Exchange and
later the bank allowed other financial institutions and few private share dealers known under the
name of ―Share Dealing Group‖ to participate in shares trading. The Share Dealing Group was
engaged in facilitation of transaction of shares and other services in the share markets. The financial
institutions that played an intermediary role in transferring and delivery of traded shares were the
Addis Ababa Bank, the Commercial Bank of Ethiopia and the Ethiopian Investment Corporation.
They provide over-the-counter2 share dealing services and enjoyed a significant confidence of the
private investing community. The volume of shares expanded at a faster rate from Birr 152,300 in
1959 to Birr 1,159,090 in 1963. The major development seen during this period was that there had
been an excess of sales to the public over purchases from the public exhibiting an increasing interest
of the private saving community in the investment of shares.
\

In the over-the-counter market, trading occurs via a network of middlemen, called dealers, who carry
inventories of securities to facilitate the buy and sell orders of investors, rather than providing the
order matchmaking service seen in specialist exchanges A short-lived stock market started informally
in the late 1950s and was formally instituted in 1965. The stock market was administered by the
National Bank of Ethiopia which was the known regulatory body in the JBAS Vol. 4 No. 1 June 2012
3 Ethiopian financial sector. The Imperial government tried to improve resource mobilization
through the National Bank tried by establishing a share-dealing group – which served as the
connecting link for buyers and sellers in an auction process. The National Bank laid out the
rudimentary rules and regulations for the auction market. According to Asrat (2003) the stock market
was moderately successful in its pioneering efforts to provide an organized market for companies
whose shares were relatively widely held. Workable trading practices and standards had been
developed and a smoothly operating market mechanism had been created. Since the abolition of the
Addis Ababa Share Dealing Group in 1974 by the military government ruling Ethiopia at that time,
no capital market has been in place in Ethiopia. For more than forty years, Ethiopia has been trying
to have its own financial market but didn‘t succeed. The need for financial markets, as the next step
in the ongoing financial liberalization is gaining consensus among various stakeholders in the
country. A number of efforts, notably by scholars from academia, Addis Ababa Chamber of
Commerce and Sectoral Association (AACCSA) and National Bank of Ethiopia (NBE) are being
made towards institutionalizing the financial market. Virtually all of the researchers came up with
findings in favor of establishing financial markets in Ethiopia. It was also indicated by Ruecker
(2011) that the National Bank of Ethiopia reportedly undertook a study on the ―Feasibility of
Establishing Securities Exchange Market in Ethiopia‖ and also prepared a draft Securities and
Exchange proclamation. Furthermore, the Addis Ababa Chamber of Commerce and Sectoral
Association (AACCSA) has produced a research on the ―Market Potential Assessment and Road
Map Development for the Establishment of Capital Markets in Ethiopia‖ where 4 Tiruneh Legesse the
findings highlighted the significance and inevitability of financial market in Ethiopia. The universal
vision of governments is to become ‗strong‘ through economic growth and modernization. This
vision is realized when there is an increase in GNP, Per Capita income, national efficiency and
employment. Contemporary literatures argue that stock markets provide services that boost economic
growth and contribute to the achievement of these national goals. Some literatures also argue against
importance of JBAS Vol. 4 No. 1 June 2012 7 stock markets for economic growth. The popular
researchers in the area, Levine and Zervos (1996) conducted an empirical study and found out that
there is a strong positive correlation between stock market development and long-term economic
growth. In countries like Ethiopia, bank loans are the most important source of capital, but are
limited by the amount of deposits banks are able to mobilize. As a result, banks tend to be very
conservative in their lending policies, thereby penalizing younger or emerging companies whose
business risk is higher than those faced by established firms, and yet contribute to the dynamism and
future growth potential of the economy through innovations. Thus, the role of the private sector is
limited due to the banks unwillingness in granting loans to risky investments on long term basis.
Since banks in emerging economies are also mostly owned and run by governments, they extend
loans to priority sectors in response to government directives without due regard to quality, and often
at interest rates below the bank‘s cost of funds. This leads to inefficient resource allocation and
widespread loan delinquencies. The prevalence of these problems reduces the level of private
investments, productivity of capital and the volume of savings (Asrat, 2003).
\

Leads to improved corporate governance and promotion of specialized financial institutions and
services Financial market development necessitates the creation of a legal and regulatory framework
incorporating increased transparency and information dissemination. It is imperative to consider that
establishing financial markets warrants paying due attention for fiscal and regulatory environment,
improvement of corporate financial reporting and disclosure, and the promotion of specialized
financial services and institutions such as stock brokerage firms, money market firms, investment
banks, leasing companies, etc.
Rewards sound economic policies and create tools to conduct monetary policy In recent decades, a
well-developed securities market has been the principal channel through which governments carry
out their fiscal and monetary policies to stabilize the economy, avoid hyperinflation, shape the public
borrowing and spending plans, growth of jobs, production and pricing of goods and services. If open-
market operation is not available, the only effective tools are direct credit controls, ceilings on loans
and interest rates, as well as reserve requirement manipulations. Also, deficit financing is carried out
by either borrowing directly from the National Bank or by selling bonds to commercial banks.
Consequently, deficit financing puts pressure on the money supply and leads to inflationary
pressures. As a result, financial repression is common in countries with banking-oriented financial
systems. Full-scale financial sector reform (liberalization) may be impossible unless the economy has
well-developed securities markets (Asrat, 2003). Help in resource allocation In a market economy,
issues of securities help raise capital for projects whose outputs are in the highest demand by society,
and those enterprises which are most capable of raising productivity. One of the most pressing issues
for developing countries is to channel existing scarce resources into productive investment so that
they can stimulate productivity, create employment, provide individuals and enterprises with basic
utilities, contribute to efficient natural resource management and ultimately maximize overall health
of the economy (Dahou, Omar and Pfister, 2009). Allow deconcentration of ownership Equity sales
provide for a wider participation in enterprise management and for a wider distribution of corporate
profits. These factors would help allay the fear that a few individuals or groups would dominate the
private sector. Wider distribution of corporate profits develops a general sense of ownership and an
assumption of responsibility on the part of the citizen. People will now be united by their common
defense of their business interests, ethnic and religious differences would gradually dissipate (Asrat,
2003). Improve accounting and auditing standards Securities purchasers rely in part on corporate
information provided in financial reports to make their investment decisions. The development of
securities markets is usually accompanied by increased reporting standards and requirements, which
contribute to the efficiency of the markets and their mobilizing and allocating functions. A regular
disclosure of adequate, reliable and timely information makes it possible to compare performance of
various companies. The development of widely accepted accounting procedures, checked by
independent external auditors is also an important benefit derived from the development of securities
markets. Availability of good information helps corporations make better decisions and provides
better statistics for economic policy makers. Good information may even help tax authorities collect
taxes in a more efficient and equitable fashion. The need for disclosure of financial information is a
strong incentive for the improvement of accounting and auditing standards.
\

Does Ethiopia need to have financial market now? Excessive dependence on bank loan limits the
growth of private investment which is considered as ―the engine of economic growth‖. But if
securities markets are established, they promote economic efficiency by channeling money from
those who do not have an immediate productive use for it to those who do. A well-functioning
financial market, coupled with a developed financial sector, is the main asset for every national
economy since it promotes economic growth and supports the eradication of poverty (Elias, 1995).
Securities markets also create better opportunities for small emerging companies to raise funds in the
venture capital market since venture capitalists would be more comfortable investing in new ventures
with the knowledge that possible future divestment can take place through a public offering at a
potentially substantial profit (Asrat, 2003). Many scholars and researchers indicated that if countries
establish a well-functioning securities market, it will provide substantial benefits for economic
developments. More specifically, capital market and financial sector development promotes growth
in different ways as identified by (Asrat, 2003; Applegath, 2004; Ruecker, 2011; Elias, 1995; Yishak,
2000; Kibuthu, 2005; Dahou, Omar and Pfister, 2009). Promotes private sector development Public
investments vastly exceed private investments in developing economies amongst which the
Government of Ethiopia is one of the front liners in public investment and the last in terms of private
investment (Yishak, 2000). Financial markets provide for access to and easy movement of financial
resources which fundamentally influences the prospects for private sector growth in developing
country economies. Existence of financial markets enhances the extent that existing firms can borrow
and grow, the ability of emerging firms to act entrepreneurially, their willingness to invest in assets,
and the ability to allocate their assets freely. All these enhancements ultimately lead to economic
growth. Liquidity function Financial markets enable security holders to easily convert their
investment in securities into cash at the prevailing market price. Increased number of players,
number and amount of financial transactions, generates liquidity and promotes active trading.
Liquidity has a proven relationship with economic growth; studies have found that countries with
liquid markets experience faster rates of capital accumulation and greater productivity gains
(Applegarth, 2004). Helps mobilize local savings and makes resources available for local decision
making The system of financial markets provides a conduit for more public‘s savings. Bonds, stocks,
and other financial claims sold in the money and capital markets provide a profitable, relatively low-
risk outlet for the public‘s savings. An increase in domestic investor interest originates from the
availability of profitable options for saving within the local economy (Ruecker, 2011). Enhances
competition among financial institutions/banks and develops a greater diversity of financial
institutions
\

Studies show that the competition among financial institutions/banks is weak in the Sub-Saharan
Africa as it is reflected in the large gap between deposit rates for savers(which tend to be very low)
and interest rates for borrowers (which tend to be very high). Establishing financial markets
cultivates channels for firms to issue various debt instruments and raise equity, while simultaneously
providing more long-term options for saving and asset management for investors that will benefit
enlarging economies by increasing market efficiency. Therefore, financial markets are presumed to
stimulate competition and speed up economic growth (Applegarth, 2004). Increases remittances and
facilitate their use Instead of depositing their money in the banks, the Diaspora community can
invest in corporate bonds and stocks which yield attractive returns compared to the interest income
on bank deposits. An investment in such securities is helpful in coping with price fluctuations as
security prices can be adjusted to changes in prices. Remittance is one of the rapidly emerging
sources of private capital in developing countries. As indicated by Ruecker (2011) in 2008, Ethiopia
recorded an inward remittance flow of 387 million USD as compared to the outward remittance flow
of 21 million USD. Remittances offer a promising and single potential for increasing domestic
savings and fostering domestic investment. A developed financial market with a variety of financial
instruments will increase the overall attractiveness of Ethiopia as a place for investments, especially
for Diaspora.

Promote efficient financial system Securities markets break the oligopoly that would be enjoyed by
the banks in the absence of securities markets. The government does not automatically have
privileged and subsidized access to funds and must compete on equal terms. Securities markets
provide impetus for the establishment of financial prices based on scarcity values rather than on
administrative fiat. Such market-determined financial prices and investment options, in turn, attract
more savings, creating a virtual circle of innovation and mobilization that contributes to the overall
efficiency of the financial system (Asrat, 2003). Despite the aforementioned significances, there are
no secondary securities markets in Ethiopia. Thus, one of the key institutions missing in Ethiopia is
the Ethiopian Securities Market. With regards to the specific roles that the Market can play in
Ethiopia, Petros (2009) stated that the stock exchange will benefit Ethiopia by serving as governing
instrument, making exit for minority shareholders from underperforming or oppressing companies,
raising country‘s competitiveness in post World Trade Organization (WTO) accession, and
facilitating liquidity of securities. Moreover, the transfer of risk and transfer of waiting ,
marketability and valuation of securities and firm, protection of financial investors under what is
called a self-regulatory scheme and improving the financial sector‘s growth as additional source of
capital with banks are also the other purpose of financial markets for Ethiopia (Mohammed, 2010).
\

There is an increasing number of share companies and shareholders in the Ethiopian economy, which
is estimated to be much more than 60,000 (this is the 2011 figure) shareholders (Abera, 2011). This
number clearly indicates that there is a wide-ranging prevalence of share illiquidity which signifies
the need for secondary financial markets in Ethiopia. If this illiquidity persists, it will frustrate
existing shareholders and discourage the market for new offerings (Mohammed, 2010; Petros, 2009).
Critics on financial markets The role of financial markets in economic development continues to
attract increasing attention both in academia and among policy-makers. Evidence from recent
empirical studies suggests that deeper, broader, and better functioning financial markets can
stimulate higher economic growth (Loayza and Beck, 2000). Although evidence on Africa is still
limited, the results from existing empirical work supports the view that financial development has a
positive effect on economic growth in African countries (Ndikumana, 2000). To the contrary,
scholars also stated some arguments against financial markets saying that establishing financial
markets is a mixed blessing, rather it has considerable limitations. The first critic is that financial
market prices do not accurately reflect the underlying fundamentals when speculative bubbles
emerge in the market. In such situations, prices on the financial market are not simply determined by
discounting the expected future cash flows. Under this condition, the financial market develops its
own speculative growth dynamics, which may be guided by irrational behavior. This irrationality is
expected to adversely affect the real sector of the economy. Critics further argue that financial market
liquidity may negatively influence corporate governance because very liquid financial market may
encourage investor myopia. Since investors can easily sell their securities holdings in more liquid
financial markets, their commitment and incentive to exert corporate control may be weaken. It also
generates perverse incentives, rewarding managers for their success in financial engineering rather
than creating new wealth through organic growth. This is because prices react very quickly to a
variety of information influencing expectations on financial markets. Therefore, prices on the
securities market tend to be highly volatile and enable profits within short periods. Moreover,
because the stock market undervalues long-term investment, managers are not encouraged to
undertake long-term investments since their activities are judged by the performance of a company‘s
financial assets, which may harm long run prospects of companies. In addition, empirical evidence
shows that the takeover mechanism does not perform a disciplinary function and that competitive
selection in the market for corporate control takes place much more on the basis of size rather than
performance. Therefore, a large inefficient firm has a higher chance of survival than a small
relatively efficient firm. These problems are further magnified in developing countries especially
sub-Saharan African economies with their weaker regulatory institutions and greater macroeconomic
volatility. The higher degree of price volatility on stock markets in developing countries reduces the
efficiency of the price signals in allocating investment resources. These serious limitations of the
stock market have led many analysts to question the importance of the system in promoting
economic growth in African countries. Supply and demand prospects for securities market The
Ethiopian finance sector is dominated by the commercial banks (private and public) whose focus is
on mobilizing short-term liabilities and extending short term loans. These banks have limited
capacity and are less reliable to support Project Financing. The banks, expected to extend loans for
projects with long-term pay back have limited resources of their own to sustainably support long-
term credit supply to the economy. This clearly shows that a securities market is a missing element in
the financial structure of the country (Yishak, 2000). This part of the report shows the potential
demand and supply sides of the financial market. Demand side (investor base) There is a growing
demand for securities markets in Ethiopia. Among many others the following are identified by
Yishak (2000). Asset portfolio adjustment
\

Thus far Ethiopians used to hold their assets in the form of cash, bank deposits, physical assets in the
form of land, buildings, livestock, precious metals (like gold, silver), vehicles, and hard currency.
These are the traditional forms of asset holdings available to Ethiopians. Establishment of securities
markets will create another form of asset holding and incentives to diversify asset portfolio for
individuals and companies. Investors can buy securities of listed companies and diversify their
investment in marketable securities. Besides to portfolio adjustment, the securities market transforms
resources from passive forms of asset holding to more active and productive activities and long-term
investments. Cope with inflation If securities markets exist in Ethiopia, investors can put their assets
into savings accounts, government bonds, corporate bonds, and stocks. As the inflation rate is much
higher than the return of the savings account and the government bonds, local investors currently do
not have an adequate investment possibility to achieve returns higher than the current inflation. This
is a strong indicator for the theoretical demand of alternative investment opportunities such as equity
securities. Individuals and institutional savers Under the current legal and policy environment,
small savers have limited choice how to hold their savings. The main avenue for them is to put in the
banks in the forms of saving and time deposits. The size of private companies and individual saving
in the banking sector is surpassing the ongoing liberalization process. What does this imply? The
savers are either motivated by the rate of return offered by the banks or the protection motive. If a
well functioning and rewarding securities market is established, both of the motives will be satisfied
with the securities market. The investment in securities generates more returns compared to the
bank‘s interest. Supply side (issuer base) Issuer base refers to the potential number of issuers of
securities and the amount of capital to be raised. The following are some of the identified potential
issuers of securities in the Ethiopian context. Government securities Regarding debt securities, the
only issuer is the Government of Ethiopia. The government is issuing short term (treasury bills) and
long term debt securities to finance mega projects (bonds). There are not corporate bonds currently
issued in the market. Even in the absence of the corporate bonds, there is a huge supply of
government bonds to finance mega projects (e.g. the Great Renaissance Dam). Annual regular
infrastructure needs for a country like Ethiopia (excluding the Great Renaissance Dam) are expected
to be between ETB 41 billion (USD 2.4 billion) and Birr 53 billion (USD 3.1 billion), creating a
potential for a remarkable and sustainable government bond supply (Ruecker, 2011). It is also noted
that the Government of Ethiopia is heading to privatization except the big five state owned
enterprises i.e., Commercial Bank of Ethiopia, Ethiopian Airlines, Ethiopian Electric Power
Corporation, Ethiopian Insurance Corporation, and Ethiopian Telecommunications which are
considered as the most profitable public enterprises. Privatization
The Privatization and Public Services Agency (PPESA) has transferred 314 state owned enterprises
through direct sales as of May 2012 and earned 12.8 billion birr (Elleni, 2012). Nine enterprises have
been transferred through a joint venture agreement and five have been leased to private investors.
The environmental foundations to establish financial markets in Ethiopia
Financial managers, investors and investees don‘t operate in a vacuum—they make decisions within
a large and complex environment.3 The prerequisite environmental factors for a well-functioning
financial markets and system are macroeconomic stability, adequacy and independence of the
judicial system, political stability, security, good corporate governance, accounting and auditing
standards, transparency and availability of information, institutional framework, initiation and
promotion of privatization, potential investor base, potential issuer base, financial literacy,
technological factors, etc.
2.2. Money Markets
\

Money markets trade debt securities or instruments with maturities of one year or less. In the
money market economic agents with short-term excess supplies of funds can lend funds (i.e., buy
money market securities) to economic agents who have short-term needs of funds (i.e., they sell
money market instruments).
For a country to start with the establishment and development of financial markets, money
markets could serve the initial purpose. As per Saunders and Cornett (2004) money markets, due
to their short-term nature (considering United States money markets) do not operate in a specific
location rather, transactions occur via telephone, wire transfer and computer trading. That is,
money markets are over-the -counter (OTC) markets. They do not need a trading place as such.
A Treasury Bills market, in which bills are auctioned fortnightly, is the only regular market
where securities are transacted in Ethiopia. There is no secondary market in Ethiopia.
Government bonds are occasionally issued to finance government expenditures and/or to absorb
excess liquidity in the banking system. Participants in the Treasury bill bid are commercial
banks. As per the annual report of National Bank of Ethiopia (NBE) 2006/07 of the total T-bills
sold (69.5 billion birr) 89.7 percent was purchased by commercial banks (http://nbe.gov.et/). The
financial instruments or securities in a capital market are bonds and stocks. As per Mishkin and
Eakins (2006) a bond is a debt security that promises to make payment periodically for a
specified period of time. A bond in this study refers to long-term corporate and government
bonds. A stock (common stock) is a financial instrument that represents a share of ownership in a
corporation. Issuing stock (new issue or seasoned issue) and selling it to the public is a way for
corporations to raise funds to finance their activities. Secondary markets: Already issued
securities trade (rebought and resold) in the secondary market. The theme of this study, "capital
market establishment”, is intended to mean establishing a secondary capital market in Ethiopia.
Fabozzi and Modigliani (2003) enumerated the functions of secondary markets as:
(1) Secondary market provides an issuer of securities, whether the issuer is a corporation or a
governmental unit, regular information about the value of the security. The periodic trading of
the security reveals the consensus price that the asset (security) commands in an open market.
Thus, firms can discover the price of their bonds and the implied interest rates investors expect
and demand from them. Such information helps issuers how well they are using the funds
acquired from earlier primary market activities and it also indicates how receptive investors
would be to new offerings in the future. (2) Secondary markets provide the opportunity for the
original buyers of the asset (security) to reverse their investment by selling it for cash (liquidity).
Unless investors feel confident that they can shift from one financial asset to another as they may
deem necessary, they would naturally be reluctant to buy any financial asset. Such reluctance
would harm potential issuers in one of two ways: either issuers would be unable to sell new
securities at all or they would have to pay a high rate of return, because investors would demand
greater compensation for the expected illiquidity of the securities. (3) Secondary markets also
offers investors liquidity for their securities as well as information about the assets' (security) fair
or consensus value (price discovery function). (4) Secondary markets bring together many
interested parties and so can reduce the cost of searching for likely buyers and sellers of
securities. It also makes costs of transacting low.
2.2.1Types of money market instruments
The assets traded in money market include: Treasury-bills, commercial papers, medium-term
notes, Bankers acceptance (LC), short-term federal agency securities, short-term municipal
obligations, certificate of deposits, repurchase agreements, floating-rate instruments and federal
funds.
\

A). Treasury Bills (T-bills)

Treasury-bills are issued by governments backed by the full faith and credit of the government.
As a result market participants perceive treasury securities to carry no risk of default. There are
three types of treasury securities Bills, notes and bonds. At issuance bills have a maturity of one
year or less, notes more than two years but not more than 10 years to maturity and bonds more
than 10 years to maturity.In this topic we will discuss treasury securities treasury-bills because
they fall into the category of money market instruments (instruments with maturity of one year
or less).

(A) T-bill is a discounted security. It does not make periodic interest payments rather the security
holder receives interest at the maturity date when the amount received (Principal value)
(Maturity value) is larger than the purchase price.

E.g. suppose an investor purchases a 6-month T-bill having a principal of 100,000 for 96,000 by
holding the bill until maturity date, the investor will receive $ 100,000 the different amount
(4000) between the proceeds received at maturity and the amount paid to purchase the bill
represents the interest. T-bill is the only one example of a number of market instruments that are
discounted securities.

THE PRIMARY MARKET FOR T-BILLS

Treasury securities typically are issued on an auction basis according to regular cycles for
specific maturities. Three month and 6-month T-bills are auctioned every Monday. The one year
(52-weeks) T-bills are auctioned in the 3rd – week of every month.

B). Commercial Papers (CP)

CP is a short-term unsecured promissory note that is issued in the open market and represents the
obligation of the issuing corporation. In US since 1988, there have been some years in which the
size of the commercial paper market has exceeded that of the T-bill market. In the 1980s,
medium and low-quality corporate issuers were able to raise funds via the commercial paper
market, how ever since 1989 such issuers have not found a respective market for their issues and
with draw from the market.

The issuance of commercial paper is an alternative to bank borrowing for large corporations with
strong credit rating. The original purpose of commercial paper was to provide short-term funds
for seasonal and working capital needs. It provided a less expensive form of short-term
borrowing for high credit quality corporations than from borrowing at the bank.

Commercial papers are also used for “bridge financing” E.g. suppose that a corporation needs
long-term needs to build a plant or acquire equipment. Rather than raising long term funds
\

immediately, the corporation may elect to postpone the offering until more favorable capital
market conditions prevail. The funds raised by issuing the commercial papers (CP) are sued until
long-term securities are sold. As merger and acquisition activities increased in 1980s commercial
paper was used as a bridge financing to financial corporate takeovers.

CHARACTERISTICS OF COMMERCIAL PAPERS

The maturity date of the CP is typically less than 270 days and the most common maturity range
is 30-50 days or less. The security act of 1933 requires that securities be registered with the SEC.
special provisions in the act exempt CPs from registration so long as the maturity does not
exceed 270 days. Hence, to avoid costs of registering in the SEC, firms rarely issue commercial
paper with maturity exceeding 270 days.

The fourth distinction is the greater diversity of dealers in the Euro CP market. In the US only a
few dealers dominate the market.

Finally, because of the longer maturity of the Euro CP, it is traded more often in the secondary
market than the US CP. In US, investors of commercial paper are typically buy-and-hold, and the
secondary market is thin and illiquid.

C). Bankers Acceptances/ Letter of Credit/

Simply, a bankers acceptance is a vehicle created to facilitate commercial trade transactions. The
instrument is called a banker’s acceptance because a bank accepts the ultimate responsibility to
repay a loan to its holder. The use of bankers acceptance to finance a commercial transaction is
referred to as “acceptance financing”.

The transactions in which bankers acceptance are created include:

i) Importing and exporting goods into and/or from the US

ii) Storing & shipping goods between two US entities or between two foreign
countries where neither the importer nor the exporter is a US firm.
Bankers acceptance are sold on the discounted basis as treasury bills and CP. The major
investors in the bankers acceptance are: - Money market

iii) Mutual funds and

iv) Municipal entities
Accepting Banks: Banks that create bankers acceptances are called accepting banks. These banks
maintain their own sales forces to sell bankers acceptances rather than using the services of a
dealer. The larger regional banks such as Harris Trust and Pittsburgh National Bank all accepting
banks. They maintain their own sales forces to sell the bankers acceptance they create but will
use dealers to unload those they can not sell.
\

Japanese city banks are now major issuers of bankers acceptances. Because they do not have
sales force to distribute the bankers acceptance they create directly to investors, Japanese
accepting banks use the services of dealers.

D). Repurchase Agreements (Reop)

A Repo is the sale of a security with a commitment by the seller to buy the security back from
the purchaser at a specified price at a designated future date. It is a collateralizing loan, where the
collateral is a security (T-bill).

The transaction is referred to as a repurchase agreement because it calls for the sale of the
security and its repurchase at a future date. Both the sale price and the purchase price are
specified in the agreement. The difference between the purchase (repurchase) price and the sale
price is the dollar interest cost of the loan.

2.2.2 Money market trading practice

2.2.3 Money market valuation issues

\

2.3. Participants of the Market

Include central banks, financial institutions, non-financial corporations.
Central banks conduct short-term REPO transactions on bonds of any residual maturity as a
means of influencing money market interest rates. ‘
Non-financial companies, private financial institutions are more likely to utilize reverse REPOs
to earn interest on their cash balances during the periods of high interest rates.
Speculative REPO and reverse REPO transactions are attractive to financial institutions with the
increased volatility of interest rates. Money market funds often take the other side of REPO
transactions and hold reverses in their assets portfolios as flexible short-term investment
vehicles. Individuals, owning shares in these funds, earn interest on the reverses. The fund
managers may speculate on interest rate fluctuations using REPOs and reverse REPOs without
being subject to the limitations on speculative derivative transactions. Important participants of
the REPO market are security dealers. They make markets by carrying inventories of marketable
securities, and can use these securities as collateral on REPO loans. Thus they can reduce the
cost of financing, utile REPOs to take positions on interest rates, finance their securities
portfolios.
Interest yields for REPOs of different terms reflect a term structure of interest rates which is a
market consensus on forecasted interest rates. The REPO rate is significantly lower than other
money market rates, however higher than the rate of government securities. It is maintained by
possibility to substitute different money market instruments. There is no REPO secondary
market.

PART-III: FINANCIAL MARKETS REGULATION

3. ETHIOPIAN FINANCIAL MARKETS REGULATION
3.1. Overview Financial Market Regulation
In general, financial market regulation is aimed to ensure the fair treatment of participants.
Many regulations have been enacted in response to fraudulent practices. One of the key aims of
regulation is to ensure business disclosure of accurate information for investment decision
making. When information is disclosed only to limited set of investors, those have major
advantages over other groups of investors. Thus regulatory framework has to provide the equal
access to disclosures by companies.
3.2. Financial Market Development, Policy and Regulation of listed Financial Assets
Market regulating institutions: namely, those that deal with externalities, economies of scale,
and imperfect information. Examples include regulatory agencies in telecommunications,
transport, and financial services. • Market stabilizing institutions: namely, those that ensure
low inflation, minimize macroeconomic volatility, and avert financial crises. Examples include
central banks, exchange rate regimes, and budgetary and fiscal rules. • Market legitimizing
institutions: namely, those that provide social protection and insurance, involve redistribution,
and manage conflict. Examples include pension systems, unemployment insurance schemes, and
other social funds.
Emphasizing the critical role of institutions to the development process of a nation the study also
warn; institutional solutions that perform well in one setting may be inappropriate in a setting
without the supporting norms and complementary institutions. In other words, institutional
innovations do not necessarily travel well.
3.2.1 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 twelve private banks, eleven 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. 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 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;
- 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 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 dominance.
- make clear distinction between the initial capital requirement for market entry and the ongoing
capital adequacy requirement for operation in the banking and microfinance supervision laws
and enforcement;
\

- fix the initial capital requirements on the banks and microfinance institutions in the law (as in
the case of the insurers) and leave the ongoing capital requirements on both institutions to
decision of the regulator (i.e. the NBE);
- make the ownership spreading requirements on the banks, insurers and microfinance
institutions less restrictive on investment choice and ability of the financial institutions to raise
capital;
- make the NBE exercise pre-business commencement examinations on applicants for license in
order to make sure that the disclosures and proposals made by the applicants are appropriate and
practical;
- remove the licensing rules that require the insurance auxiliaries to start afresh annually;
- list the grounds for license refusal and make the obtaining of license legal right expressly;
- regulate the procedure of licensing by requiring the NBE to adhere to principles of
administrative law including the conduct of hearing, the reasoning of decisions, the making of
decisions transparent, and the proper handling of complaints during licensing;
- increase the speed of licensing;
- require the NBE to keep register of licensees in which it has to record the particulars about the
licensees that are useful for the conduct of prudential and other supervision; and
- remove the annual license (and registration) renewal requirement from the financial regulatory
regime and allow the NBE to focus on the use of the license revocation and other instruments for
its prudential regulation.
2. The nationality requirement needs to be reconsidered so that the country will:
- give attention to the roles foreign financial institutions can play in the enhancement of
competition and the development of the quality and types of the financial services;
- build its regulatory and market capacities;
- open the financial market for foreign investment gradually and in a way that will not necessitate
capital account liberalization until it becomes able to absorb international risks; hence, following
the steps of:
- first, develop fiscal and monetary control (i.e. limit government spending, have broad based tax
system, reduce tax rates, control inflation, and stabilize prices);
- second, enhance banking, insurance and microfinance regulation and develop domestic capital
market (with institutional investors and the necessary regulation);
- third, liberalize the banking and capital markets without opening up of the international capital
account; and
- fourth, open the international capital account and allow free convertibility of foreign exchange;
- make the liberalization to the financial institutions of the countries with which it has the largest
trading relation (until it becomes member to the
WTO and liberalizes fully under the GATS); and
- design a regulatory system that can discourage the potential problem of hit and run and
encourage the contribution of the foreign financial institutions to the development of its financial
system.
3. The capital adequacy, reserving, provisioning, liquidity and solvency regulations need to be
improved to:
- relate all the ongoing capital adequacy requirements to risk types in accordance with
recommendations of the BCBS;
\

- require the insurers to maintain a risk weighted capital adequacy level in the fashion this is
done for the banks and the microfinance institutions and in accordance with the international
recommendations of the IAIS, and thereby ensure the continued growth of the risk absorption
capacity, competitiveness and stability of the insurers;
- include liquidity rules in the solvency requirement on insurers in accordance with
recommendation of the IAIS; and
- make the NBE take into account the compliance situations of the banks, insurers and
microfinance institutions in setting the reserving and provisioning requirements.
4. The accounting, balance sheet and valuation rules need to be improved to:
- expressly prohibit the creation of hidden reserves through undervaluation of assets and
overvaluation of liabilities; and
- standardize and enact the accounting and valuation rules which the banks, insurers and
microfinance institutions have to follow instead of making general reference to internationally
accepted accounting principles.
5. The functional and ownership separation regulation needs to continue to separate the banking,
insurance, microfinance, securities, pension and other markets in the short run and the case for
financial market conglomeration needs to be considered in the long run in order to make the
financial market consistent with the international experience as the banking, insurance,
microfinance, securities and pension markets grow.
6. The risk diversification regulation needs to be improved to:
- make the rules on investments of the financial institutions less restrictive; and
- set regional, sectoral and deposit diversification requirements that will enhance both the
diversification of risks and the dissemination of services of the financial institutions.
7. The risk transferring regulation needs to be improved to:
- require the commercial banks and microfinance institutions to insure themselves against the
insurable risks associated with their operations;
- regulate the terms and conditions of collaterals of the banks and microfinance institutions in
order to prevent abuse and enhance prudence;
- require the insurers to re-insure a defined threshold of their liabilities; and
- promote and regulate the undertaking of domestic re-insurance.
8. The information acquisition and exchange regulations need to be strengthened to:
- require and empower the credit recording and information exchange centre at the NBE to
collect, record, analyze and disseminate information on the general financial circumstances of
borrowers on top of the indebtedness reports from the banks;
- make the insurers and microfinance institutions members to the credit recording and
information exchange centre at the NBE;
- subject the businesses in the non-financial sector to accounting and auditing requirements as
part of the effort to formalize and regulate them and the financial services; and
- require the banks and microfinance institutions to review the financial statements of all the
businesses before they extend credit facilities of any size to them.
9. The competition regulation needs to be improved to:
- fully enable the making of market based interest and foreign exchange rates by the banks and
microfinance institutions;
- take measures against the conscious parallelism of the banks and insurers and the market
division tendencies of the microfinance institutions;
\

- correct the market dominance already created in the financial market and strictly enforce the
general competition law rule that prohibits the creation of market dominance;
- enhance competition by imposing geographic diversification requirements;
- make the banking, insurance and microfinance markets more contestable;
- permit foreign competition;
- enforce codes of conduct and incentives for competitively desirable behaviors; and
- adopt specific rules for the financial market that will remove the shortcomings in the general
competition law regime (such as the non-definition
of market share, non-regulation of anti-competitive merger, non-determination of choice between
the per se and the rule-of-reason approaches, and non-proactiveness of enforcement) until the
general competition law and enforcement are improved to remove these shortcomings.
10. The insider dealing and market manipulation regulations need to be improved to:
- make them applicable on all insiders and secured and unsecured loans of all the financial
institutions, and
- balance between the interests of controlling abuse and promoting competition.
11. The contract terms regulation needs to be strengthened to cover not only the long-term
insurance contracts but also the general insurance, banking and microfinance contracts.
12. The product distribution regulation needs to be improved to:
- remove the rule that restricts the introduction of new services by the banks by a requirement of
prior authorization by the NBE;
- include product diversification, automation and networking and regional and sectoral service
distribution requirements; and
- make the product distribution regulation applicable on all the financial institutions and
auxiliaries.
13. The governance and auditing regulations (and the licensing requirements related to them)
need to be improved to:
- set the minimum standards and principles for governance and auditing in line with the
international recommendations of the OECD, IFAC and others;
- avoid the use of restrictive governance rules (such as the requirements on office terms of
members of the boards of the banks);
- make the managerial qualification and experience requirements more stringent than they are
now and applicable on all the managers other than the chief executives of the financial
institutions;
- make the limits on outside managerial engagement applicable on all members of the boards of
directors, executives and managers of all the financial institutions and ensure undivided attention
of the leadership of all the financial institutions;
- set maximum age limit on the board members, executives and managers of the financial
institutions and enhance governance quality;
- institutionalize capacity building program and a national testing or certification centre which
will examine, and check continuity of, the competence of existing and future leaders of the
financial institutions;
- make the supervision departments of the NBE consider the legality, need and feasibility of the
instruments they use whenever they implement requirements on the shareholding and leadership
of the financial institutions;
- allow participation of employees and stakeholders in the governance of the financial
institutions in line with the international recommendations;
\

- strengthen the financial criminal tracing mechanism and bar all criminals and unreliable
persons from managing and owning the financial institutions; and
- make the NBE follow a proactive as opposed to reactive approach of regulation in order to
make the banks, insurers and microfinance institutions improve on their limitations.
14. The information disclosure regulation needs to be improved to:
- require the banks, insurers and microfinance institutions to make sufficient, reliable and timely
reporting and disclosure of all information not restricted by law;
- require the NBE and the financial institutions to automate the off-site reporting processes;
- require the NBE to publish its supervisory reports to the public except for information restricted
by law;
- define the information that should be restricted from public disclosure for the reason of privacy
or public interest; and
- encourage the creation of information processing and rating agencies that will assist the public
disclosure of information.
15. The interest, foreign exchange and premium regulations need to be improved to:
- encourage the NBE to continue to shift its roles from direct to indirect controls of interest,
foreign exchange and premium;
- make the interest, foreign exchange and premium determinations market based;
- urge the NBE and the banks, insurers and microfinance institutions to build their interest,
foreign exchange and premium risk absorption capacities;
- make the premium regulations applicable on the premiums of both the longterm and the general
insurers; and
- formalize and regulate the hitherto existing informal foreign currency exchange market which
is often known as black or parallel market.
16. The payments and settlement systems regulation needs to be improved to:
- make the NBE and its supervision departments act proactively and work with the banks and
other financial institutions in order to develop the national payments and settlement systems;
- require the banks, insurers and microfinance institutions to plan and work on modernization of
the country’s payments and settlement systems (including the spread of commercial instruments
and development of electronic payment and settlement systems) more actively than they do now;
and
- upgrade the Cheque Clearing Office in Addis Ababa to a National Clearing Office to facilitate
the use and clearance of all commercial instruments across the financial institutions as long as
these instruments continue to be important.
17. The fund guarantee, liquidity support, lender of last resort and state ownership regulations
need to be improved to:
- subject the banks, insurers and microfinance institutions to fund guarantee and deposit
insurance requirements;
- enable (and require) the NBE to exercise the role of lender of last resort during crisis situation;
- establish (and regulate the scope, nature and adverse effects of) the deposit insurance, fund
guarantee and lender of last resort schemes according to international experience;
- enhance the use of the current inter-bank lending and emergency liquidity support schemes for
temporary illiquidity problems;
- build the problem resolution capacity of the NBE; and
- remove government ownership of the banks, insurers and microfinance institutions in the long
run and gradually and focus on the use of indirect instruments of regulation.
3.2.2 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;
- 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
- 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.
Ethiopia also needs to learn from the history of its own share market of the 1960s. This market
originated in the absence of dependable number of companies, experience on public offering,
and a law that would regulate it. It was, however, successful until it was closed because of policy
change in 1974.
The country need not also be in fear of the perceived problems of regulatory incapacity, pressure
for rapid liberalization, and economic crisis due to rapid in and outflow of foreign capital. First,
the international experience also shows that regulatory capacity is something that grows along
with development of a market.
Secondly, the international community has become cognizant of the need for gradual
liberalization of financial markets and control of the potential problems of huge capital inflow,
economic overheating, sudden repatriation and crisis through prudential regulatory requirements
and capital transfer controls until full liberalization is viable. Thirdly, international portfolio
investment is made these days through internationalised depository certificates that have to be
managed by international custodian companies and Africa’s experience shows that only few
international investors are interested in portfolio equity investment in the continent despite the
development of securities markets with elimination of foreign exchange controls, removal of
restrictions on foreign participation, and institutionalisation of securities custodian services.
Ethiopia’s investment data also shows that domestic investment is much more significant than
foreign investment and it is unlikely that the situation will change suddenly as the country
creates the securities market. The 2008 financial and economic crisis has also slowed down the
flow of international capital to developing countries and it is unlikely that huge capital inflow
and sudden repatriation (hence, crisis) will occur in the near future.
The country need not also make the creation of corporate bond market condition precedent to
creation of the fully fledged securities market. This is not valid given that there are no corporate
bonds issued and circulated in the country while there are lots of equity shares and outstanding
government bonds that can be circulated in a fully fledged securities market.
Hence, the country needs to create the market and do the following in designing its structure and
regulation.
1. It needs to design the market and its regulation based on the exchange-as-firm approach in line
with the international trend; make the market structure consistent with the structure of the
existing banking, insurance and microfinance markets; and align the regulation with the
international approach in order to benefit from regulatory experience and attract foreign
investment in the long run. It needs to retain the exchange-as-public-market approach and the
market failure grounds of regulation in order to allow creation of limited number of exchanges
and regulate the potential damages that may follow the profit motive.
\

It needs to allow the creation of only one national exchange in the capital city in order to
concentrate on market and regulatory capacity building as it starts; and allow the creation of
competing regional exchanges in order to increase decentralization and achieve balanced
economic development as regulatory capacity and the securities and investment businesses grow.
It also needs to organize the securities market with wings for primary and secondary trading, for
government and private securities, and for debt and equity securities since these will need
separate treatment as the international experience has shown.
2. It needs to make the company law more complete than it is now in order to set the rules for the
varieties of securities of the share companies and enhance the corporate financing, governance,
accounting and auditing regimes. It also needs to eliminate the rules in its current regime that
discourage the issuance and trading of securities such as the restrictions on portfolio investments
of the banks, insurers and microfinance institutions and the rule of the NBE that requires the
trading of securities through subsidiary companies of the banks.
3. It needs to enact a securities market law that will do the following among others by way of
learning from the international experience:
i. Make competition promotion, market development, investor and consumer protection,
systemic risk reduction, and enhancement of market efficiency, integrity and transparency the
main objectives of regulation;
ii. Mix between merit and disclosure regulation;
iii. Introduce and regulate the modalities of public issuance and trading of securities without
ruling out the possibility of issuing securities through the methods other than the public issuance
method;
iv. Require the securities market and its intermediaries to meet licensing requirements, including
incorporation, initial capital, professional competence, behavioural integrity, ownership
spreading, and governance quality;
v. Require:
- the securities market to be incorporated as demutualized share company whose shareholding
will be open to anyone who may or may not be securities market actor;
- the intermediaries to be incorporated as private or public limited companies with share capital,
to be members of the recognized (incorporated) securities market, and to have staff that need to
meet competence and integrity related requirements; and
- the individual securities market actors to be employees of the incorporated intermediaries;
vi. Control the danger of monopoly of the securities market by the financial and other companies
and ensure its separate existence from the other financial markets such as by imposing ownership
ceilings and/or diversification requirements;
vii. Require the securities market and the intermediaries to meet ongoing financial and non-
financial requirements, including capital adequacy, reserving, accounting, auditing, reporting,
public disclosure, and contribution to industry guarantee fund;
viii. Require separate registration of the public and private issues by the securities market
regulator and others;
ix. Require registration and listing of the companies and securities that use the public issuance
method by the regulator and the securities market; and restrain trading of the listed securities
outside the recognized market;
x. Sanction insider trading, price manipulation and fraud; allow the follow up, suspension and
cancellation of trading; and enable ongoing supervision of the listed companies and securities,
the securities market, and the intermediaries by the securities market regulator;
\

xi. Require compulsory accounting and auditing of all the companies that use the securities
market;
xii. Require disclosure of all material information to the regulator, the securities market and the
public through publication of prospectus (during initial issuance) and reporting (during
subsequent trading) by all issuers of securities that will use the public issuance method; and
xiii. Regulate the trading of securities issued outside the public issuance method on the securities
market.
Automation of the securities market is, however, a matter of access to technology.
The country needs to work on it. The experience with some of the newly created securities
markets suggests that the country can start with automated trading if it cooperates with the
advanced exchanges. The country also needs to upgrade the
Addis Ababa Check Clearing Office at the NBE to make it provide centralized securities
custodian, clearing and settlement services as it starts the securities market; and require the
dematerialization and central custodian of securities and automation of the clearing and
settlement services by a national company to be incorporated outside the securities market as the
securities businesses and the communication infrastructure of the country grow. It also needs to
consider the experience with the agricultural commodity market in these regards.
The adoption of self-regulation in the securities market of the country is also a matter of
prudence, capacity and ethics of the future market actors as this has also been the case in the
other countries. The country needs to start with a principle of government regulation and
consider the case for self-regulation as these conditions mature.
It also needs to make its tax regime non-discriminatory and contributory to the development of
the securities market. It needs to reconsider the current exorbitant capital gains tax on sale of
shares and treat the equity market in the way he debt market and the existing financial services
(and transactions) are treated. It also needs to treat the interest incomes from debt securities of
the private companies in the way it treats the incomes from government bonds and treasury bills.

3.2.3 The Development, Policy and Regulation of Private Pensions

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;
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
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 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 of learning from the
international experience and addressing the domestic situation:
1. Make the immediate objectives of regulation to be i) expanding coverage, ii) reducing
retirement poverty, iii) enhancing saving, and iv) making the pension contributory to the
development of the financial market (including the future securities market) since the majority of
the population are living without retirement pension and there is lack of long term saving to
finance investment;
\

2. Make the long run objectives of regulation to be i) enhancing adequacy, sustainability,

competitiveness and prudence of the pensions; ii) assuring protection of consumers; and iii)
eliminating the information asymmetry and moral hazard problems that may follow the pension
provision since the international experience also shows that these are also important when
private pensions grow; and
3. Make the content of regulation to be related to the assets, liabilities and governance matters of
the pensions in order to regulate the funding, portfolio composition, surplus ownership,
insurance, vesting, and portability of the pensions by licensing, ongoing monitoring, and ex-post
supervision rules that will:
- include qualification, legal form, initial and ongoing capital, reserve, minimum guarantee,
insurance, asset segregation, investment, asset custodian, actuarial valuation, external audit, risk
prevention, reporting, public disclosure, and related governance requirements; and
- be enforced through proactive and reactive measures of the regulator by way of learning from
the international experience.
It also needs to restructure the governmental pension agency and subject it to the future pension
regulation in order to enhance competition and performance.
It also needs to encourage creation of the private pensions through the tax regime by treating the
private pension contributions, benefit payments and investment returns in the same way as the
existing pension and provident fund contributions, benefits and returns are treated.
It also needs to promote the pension annuity businesses of the insurance companies through
interventions in both the supply and the demand sides (including compulsion, tax incentives and
raising awareness).
The country also needs to take the following two additional measures which will contribute to
the aforementioned:
1. It needs to develop and transform the informal saving institutions of society (such as the Edir
and Equb) and the saving and credit cooperatives in the labour market into formal mutual
companies by enacting a law that will require this and giving them tax incentives. This will
contribute to the functions of enhancing and mobilizing private savings since these institutions
are closest to households and individuals. It will also mean revolutionizing a sector which has
lived for long as informal and unknown.
2. It needs to enact minimum wage law. This will cure the cases of low payment by the private
sector employers and the government and thereby enhance the saving potentials of individuals
for deployment to the private pensions.
These two measures need not, however, be considered as pre-conditions for creation of the
private pensions. They are peripheral measures that can contribute to the enhancement and
mobilization of saving and, hence, the creation and development of the private pensions.

3.2.4 The Design of Means of Enforcement of Regulation

\

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 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 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:
1. The existing regulatory enforcement machinery needs to be enhanced by:
\

- entrusting the NBE with dispute adjudicating powers regarding regulatory matters between the
regulated institutions without, of course, ruling out the possibility of making recourse to the
judiciary;
- indicating the measures the NBE should take during crisis situation;
- refining the grounds for receivership of the banks and microfinance institutions;
- requiring and empowering the NBE to:
- design and enforce its regulation proactively,
- promote diversification of the financial market,
- defining the grounds and mechanisms for accountability of the NBE (as the financial market
regulator) to the legislature and the chief executive of government; and
- enabling and requiring the NBE to work with national and international networks of
cooperation including the BCBS and IAIS in order to enhance the tasks of building capacity,
refining regulation, preventing systemic crisis, and controlling illicit financing.
2. The competition enforcement machinery needs to be enhanced by:
- re-establishing the general competition law enforcement organs as independent competition
authorities with the complete powers of rule making, inspecting, examining, intervening,
adjudicating and sanctioning; and defining their accountabilities to the legislature and the chief
executive of government;
- enhancing the proactive and competition advocacy roles of these organs; and authorizing their
participation in the formulation of economic policies by the government in order to check the
consistency between the competition and other policies;
- making the financial market regulator responsible for enforcement of the competition objective
in the financial market (along with the general competition law enforcement organs);
- defining the work relationship and coordination between the financial market regulator and the
general competition law enforcement organs; and
- enabling and requiring the competition law enforcement organs to work with national and
international networks of cooperation including the ICN in order to enhance the tasks of building
capacity, refining the competition law, increasing advocacy, and strengthening the competition
law enforcement.
3. The regulatory sanction and legal protection mechanisms need to be improved by:
- giving attention to the problems criminal and tort sanctions face in connection with regulatory
and competition law enforcement and balancing between the need for ensuring compliance and
legal protection; - limiting the use of criminal law and its guilt requirement to the most serious
contraventions;
- making the imprisonment of corporate managers, fine and forced closure of business the main
forms of criminal sanction for the most serious contraventions (since corporate probation is not
feasible in the current legal situation of the country);
- making all the regulatory and competition law contraventions civil fault that will result in strict
civil (tort) liability without need to prove mental situation;
- subjecting the majority of the regulatory and competition law contraventions to strict
administrative (regulatory) sanction;
- requiring the financial market regulator and the competition enforcement organs to exercise
their powers according to defined substantive and procedural principles of good administration;
- requiring the financial market regulator and competition enforcement organs to include public
consultation in their regulatory and competition enforcement processes;
\

- subjecting the rules, decisions and actions of the financial market regulator and the competition
enforcement organs to judicial review expressly; and
- indicating the applicants and the judicial organs that will have the power to make review;
- including the regulated financial institutions and actors, a defined number of the consumers as a
group, and other interested parties including the government in the list of applicants for judicial
review;
- collecting and standardizing the substantive and procedural grounds of review;
- defining the procedure and remedies of review;
- demarcating the line of jurisdiction between the reviewer and the financial market regulator and
competition enforcement organs; and
- adopting a comprehensive administrative procedure law for the judicial review;
- allowing individual suits for extra-contractual compensation against the regulators and
competition enforcement organs when the regulators and competition enforcement organs violate
the bounds of their legal authorizations and cause damage on individuals;
- defining the roles of the Ombudsman Office against the financial market regulator and the
competition enforcement organs; and
- building the mechanism for tracing violators of regulation.
The country also needs to empower and encourage the NBE, the competition enforcement
organs, the business community and the other stakeholders to contribute to the development and
diversification of the financial system (including development of the future securities market and
private pensions). It also needs to do the following in respect of the future securities market and
private pensions:
1. It needs to create the securities market and pension regulators with financial and operational
autonomy from the executive in government and the following powers and functions:
- making rules and adjudicating cases;
- inspecting, investigating and sanctioning abuse and violations;
- evaluating, preventing and correcting institutional failures;
- enforcing disclosure requirements;
- encouraging the making of ratings;
- keeping and publishing data about the market institutions and operations;
- conducting research;
- building their own capacities and the capacities of the market actors; and
- advising the government on policy matters.
2. It needs to define and scale the measures the securities market and pension regulators will take
against the securities market and pension operators during regulatory violation and crisis
situation and leave discretion to the regulators on the choice of particular measure as in the case
of the banking, insurance and microfinance markets.
3. It needs to make the securities market and pension regulators work with the international
organizations working in the respective fields including the IOSCO and IOPS in order to
facilitate the enhancement of their regulatory functions and align the regulatory enforcement
regimes with the principles and standards of the international organizations.
It also needs to consider the case for integrating the financial market regulators outside the NBE
when the securities market and pension regulators are created so that the existing and future
regulatory functions will be coordinated and the NBE will not be suffocated by integrating the
regulatory functions in it.
\