Prepared by Yakob Gebreegziabher 2024

Chapter 6: Financial Regulation and Preliminary

Introduction to the Basel Accords

6.1. Introduction to Financial Regulation

Financial regulation in Ethiopia has undergone significant changes in recent years, reflecting the country's
economic growth and the increasing complexity of its financial sector. The regulatory framework is
primarily overseen by the National Bank of Ethiopia (NBE), established in 1963, which serves as the
central bank and main regulatory body for the financial sector.
A. Definition of Financial Regulation
In the Ethiopian context, financial regulation encompasses a comprehensive set of laws, directives, and
circulars issued by the NBE to govern banks, insurance companies, and microfinance institutions. These
regulations are designed to create a stable, efficient, and fair financial system that supports Ethiopia's
broader economic development goals.
Key components of Ethiopia's financial regulation include:
1. Banking Business Proclamation No. 592/2008
2. Insurance Business Proclamation No. 746/2012
3. Microfinance Business Proclamation No. 626/2009
4. National Payment System Proclamation No. 718/2011
5. Various NBE directives and circulars addressing specific aspects of financial operations
These legal instruments provide the foundation for financial regulation in Ethiopia, covering areas such as
licensing requirements, capital adequacy, risk management, corporate governance, and consumer
protection.
B. Purpose of Financial Regulation
The primary purpose of financial regulation in Ethiopia is to ensure the stability and integrity of the
country's financial system, which is crucial for achieving the nation's economic development goals as
outlined in various national development plans, including the Ten-Year Development Plan (2021-2030).
Specific purposes include:
1. Maintaining public confidence in the financial system
2. Protecting depositors and policyholders
3. Preventing systemic risks that could destabilize the economy
4. Promoting fair competition and market integrity

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5. Supporting financial inclusion and access to financial services

6. Combating financial crimes, including money laundering and terrorism financing
7. Aligning the financial sector with national development priorities
For example, the NBE's directive on loan portfolio composition (Directive No. SBB/69/2018) aims to
channel more credit to priority sectors of the economy, such as manufacturing and export-oriented
businesses, reflecting the government's focus on industrialization and export promotion.
C. Key Objectives
1. Financial stability:
The NBE works diligently to maintain confidence in the Ethiopian birr and prevent systemic risks in the
banking sector. This involves:
- Regular stress testing of banks to assess their resilience to economic shocks
- Monitoring of key financial stability indicators
- Implementation of macro-prudential policies to address system-wide risks
For instance, in response to the economic challenges posed by the COVID-19 pandemic, the NBE
implemented measures such as providing liquidity support to banks and temporarily relaxing certain
regulatory requirements to maintain financial stability.
2. Consumer protection:
Regulations are in place to protect the interests of depositors and borrowers in Ethiopian financial
institutions. These include:
- Deposit insurance scheme (in development)
- Disclosure requirements for financial products
- Complaint handling mechanisms
- Regulations on fair lending practices
The NBE has issued directives on transparency and disclosure in the banking sector (Directive No.
SBB/68/2018) to ensure that customers receive clear and accurate information about financial products
and services.
3. Market integrity:
The NBE oversees fair practices in Ethiopia's emerging financial markets. This involves:
- Regulations against insider trading and market manipulation
- Licensing and supervision of financial institutions
- Enforcement actions against institutions violating regulations

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As Ethiopia works towards establishing a stock exchange, maintaining market integrity will become
increasingly important. The planned Ethiopian Capital Market Authority will play a crucial role in this
area.
6.2. Types of Financial Regulation
A. Prudential Regulation
The NBE implements prudential regulations to ensure the safety and soundness of Ethiopian banks. These
regulations aim to minimize the risk of bank failures and protect depositors.
Key aspects of prudential regulation in Ethiopia include:
1. Capital requirements:
- As of 2023, the minimum paid-up capital for new banks is 5 billion birr, a significant increase from the
previous requirement of 500 million birr.
- This increase aims to strengthen the banking sector and encourage consolidation.
2. Liquidity requirements:
- Banks are required to maintain 5% of their net current assets as reserves with the NBE.
- A 15% liquidity ratio is imposed on commercial banks.
3. Asset quality:
- The NBE has issued directives on asset classification and provisioning (Directive No. SBB/71/2019).
- Banks are required to classify their loans into five categories: pass, special mention, substandard,
doubtful, and loss.
4. Risk management:
- Banks are required to establish comprehensive risk management frameworks.
- The NBE has issued risk management guidelines covering credit risk, liquidity risk, and operational
risk.
5. Limits on large exposures:
- The NBE has set limits on banks' exposure to single borrowers and related parties to prevent
concentration risk.
Example: In 2011, the NBE issued a controversial directive requiring private banks to purchase NBE bills
equivalent to 27% of their loan disbursements. While this directive was aimed at channeling resources to
priority sectors, it was criticized for its impact on banks' profitability and lending capacity. The directive
was eventually lifted in 2020 as part of financial sector reforms.

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B. Conduct of Business Regulation

The NBE has issued directives on corporate governance and risk management for banks, insurance
companies, and microfinance institutions to ensure fair treatment of customers and maintain market
integrity.
Key aspects include:
1. Corporate governance:
- Directive No. SBB/70/2019 on corporate governance for banks outlines requirements for board
composition, responsibilities, and committees.
- Similar directives exist for insurance companies and microfinance institutions.
2. Customer due diligence:
- Financial institutions are required to implement Know Your Customer (KYC) procedures to prevent
money laundering and terrorism financing.
3. Fair lending practices:
- Regulations prohibit discriminatory lending practices and require transparent disclosure of loan terms.
4. Complaint handling:
- Financial institutions are required to establish mechanisms for handling customer complaints.
5. Consumer education:
- The NBE conducts financial literacy programs to educate consumers about their rights and
responsibilities.
Example: In 2019, the NBE issued a directive on mobile and agent banking services (Directive No.
FIS/01/2019) to regulate the growing fintech sector and ensure consumer protection in digital financial
services.
C. Systemic Risk Regulation
Given Ethiopia's relatively small financial sector, systemic risk regulation is less developed compared to
more advanced economies. However, the NBE monitors the overall health of the banking sector to prevent
system-wide issues.
Key aspects include:
1. Identification of systemically important banks:
- The NBE has not yet formally designated systemically important banks, but it closely monitors larger
banks that could pose systemic risks.
2. Stress testing:
- The NBE conducts periodic stress tests to assess the resilience of the banking sector to various shocks.
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3. Macro-prudential policies:
- The NBE has tools to address system-wide risks, such as adjusting capital requirements or imposing
lending restrictions.
4. Crisis management and resolution framework:
- The NBE is working on developing a comprehensive framework for managing potential financial
crises.
Example: During the COVID-19 pandemic, the NBE implemented several measures to address systemic
risks, including providing liquidity support to banks and temporarily relaxing certain regulatory
requirements to maintain financial stability.
6.3. Regulatory Bodies
A. Central Banks
The National Bank of Ethiopia (NBE) is the primary regulatory body for the financial sector in Ethiopia.
Established by the National Bank of Ethiopia Establishment Proclamation of 1963, the NBE has evolved
to take on a comprehensive role in regulating and supervising the financial sector.
Key responsibilities of the NBE include:
1. Monetary policy:
- Formulating and implementing monetary policy to maintain price stability
- Managing foreign exchange reserves
- Issuing and managing the Ethiopian birr
2. Banking supervision:
- Licensing and regulation of banks, microfinance institutions, and other financial entities
- Conducting on-site and off-site supervision of financial institutions
- Issuing directives and guidelines for the financial sector
3. Financial stability:
- Monitoring systemic risks in the financial sector
- Implementing macro-prudential policies
- Serving as a lender of last resort for banks
4. Payment systems:
- Overseeing and regulating the national payment system
- Promoting the development of modern payment technologies

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5. Research and policy advice:

- Conducting economic research to inform policy decisions
- Advising the government on economic and financial matters

Example: In recent years, the NBE has played a crucial role in implementing financial sector reforms as
part of Ethiopia's broader economic liberalization agenda. This has included easing restrictions on foreign
investment in the financial sector and working towards the establishment of a capital market.
B. Securities and Exchange Commissions
Ethiopia does not yet have a fully developed capital market or a dedicated securities regulator. However,
plans are underway to establish the Ethiopian Capital Market Authority to oversee the development of
capital markets in the country.
Key developments in this area include:
1. Capital Market Proclamation:
- A draft proclamation for the establishment of a capital market has been prepared and is awaiting
approval.
2. Ethiopian Securities Exchange:
- Plans are in progress to establish the country's first stock exchange, expected to be operational in the
coming years.
3. Regulatory framework:
- The planned Ethiopian Capital Market Authority will be responsible for developing regulations for
securities issuance, trading, and market participants.
4. Capacity building:
- The government is working with international partners to build regulatory capacity for capital market
supervision.
Example: In 2020, the National Bank of Ethiopia, in collaboration with the Ethiopian Ministry of Finance,
initiated a project to establish the Ethiopian Securities Exchange. This initiative aims to provide alternative
financing options for businesses and investment opportunities for the public.
C. Other Regulatory Agencies
While the NBE is the primary financial regulator, other agencies also play important roles in specific areas
of financial regulation:
1. Ethiopian Insurance Authority:
- Established by the Insurance Business Proclamation No. 746/2012
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- Responsible for regulating and supervising the insurance sector

- Issues licenses to insurance companies and insurance intermediaries
- Sets standards for capital adequacy, solvency, and reserving in the insurance sector
2. Financial Intelligence Center:
- Established under the Prevention and Suppression of Money Laundering and Financing of Terrorism
Proclamation No. 780/2013
- Responsible for combating money laundering and terrorism financing
- Collects and analyzes financial intelligence
- Cooperates with the NBE and other agencies in enforcing anti-money laundering regulations

3. Ministry of Finance:
- While not a direct regulator, it plays a crucial role in financial sector policy-making
- Oversees fiscal policy and public financial management
- Coordinates with the NBE on matters of economic policy
4. Ethiopian Investment Commission:
- Regulates foreign investment in the financial sector, in coordination with the NBE
Example: In 2019, the Ethiopian Insurance Authority issued new directives on corporate governance and
risk management for insurance companies, aligning the insurance sector's regulatory framework more
closely with international standards.
6.4. Key Areas of Financial Regulation
A. Capital Requirements
The NBE has progressively increased capital requirements for banks to strengthen the financial sector and
encourage consolidation. This approach aims to create stronger, more resilient banks capable of supporting
Ethiopia's economic growth.
Key aspects of capital regulation in Ethiopia include:
1. Minimum paid-up capital:
- As of 2023, the minimum paid-up capital for new banks is 5 billion birr.
- Existing banks were given a timeline to meet this requirement through organic growth or mergers.
2. Capital adequacy ratio:
- Banks are required to maintain a minimum capital adequacy ratio of 8% of risk-weighted assets.
- The NBE uses a modified version of the Basel I framework for calculating risk-weighted assets.
3. Tier 1 and Tier 2 capital:
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- The NBE defines eligible capital components, including common equity (Tier 1) and supplementary
capital (Tier 2).
4. Capital conservation buffer:
- Banks are required to maintain an additional capital conservation buffer of 2.5% of risk-weighted
assets.
5. Leverage ratio:
- A minimum leverage ratio of 4% is required to complement the risk-based capital requirements.
Example: The recent increase in minimum capital requirements has led to consolidation in the banking
sector. For instance, in 2022, Awash Bank and Dashen Bank announced merger plans to meet the new
capital requirements and create a stronger, more competitive entity.
B. Liquidity Requirements
Ethiopian banks are subject to various liquidity requirements to ensure they can meet their short-term
obligations and withstand potential liquidity shocks.
Key liquidity regulations include:
1. Reserve requirement:
- Banks are required to maintain 5% of their net current assets as reserves with the NBE.
- This reserve requirement is primarily held in local currency (birr).
2. Liquidity ratio:
- The NBE imposes a 15% liquidity ratio on commercial banks.
- This ratio is calculated as liquid assets divided by total deposits and short-term liabilities.
3. Foreign exchange liquidity:
- Banks are required to maintain adequate foreign exchange liquidity to meet their foreign currency
obligations.
4. Liquidity stress testing:
- Banks are required to conduct regular liquidity stress tests and report the results to the NBE.
5. Contingency funding plans:
- Banks must develop and maintain contingency funding plans to address potential liquidity crises.
Example: During the COVID-19 pandemic, the NBE temporarily reduced the reserve requirement from
5% to 4% to provide additional liquidity to the banking system and support lending to the real economy.
C. Risk Management
The NBE has issued risk management guidelines for banks, covering various types of risks. Ethiopian
banks are required to establish risk management committees and implement comprehensive risk
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management frameworks.
Key aspects of risk management regulation include:
1. Credit risk:
- Banks must implement credit risk assessment and monitoring systems.
- The NBE has issued guidelines on loan classification and provisioning.
- Banks are required to set exposure limits and monitor concentration risks.
2. Market risk:
- Banks must have systems to measure and manage interest rate risk and foreign exchange risk.
- The NBE requires regular reporting on market risk exposures.
3. Operational risk:
- Banks must implement operational risk management frameworks.
- This includes policies and procedures for identifying, assessing, and mitigating operational risks.
4. Liquidity risk:
- Banks are required to have liquidity risk management policies and procedures.
- Regular liquidity stress testing is mandatory.
5. Cyber risk:
- The NBE has issued guidelines on cybersecurity for banks.
- Banks must implement measures to protect against cyber threats and report any significant incidents.
Example: In 2019, the NBE issued a comprehensive Risk Management Guideline for banks (Directive No.
SBB/71/2019), which outlines detailed requirements for managing various types of risks and establishes
the responsibilities of the board of directors and senior management in risk oversight.
D. Corporate Governance
The NBE has issued corporate governance directives for banks, insurance companies, and microfinance
institutions, specifying board composition, responsibilities, and internal control requirements.
Key aspects of corporate governance regulation include:
1. Board composition:
- Banks are required to have a minimum of seven and a maximum of twelve board members.
- At least one-third of board members must be independent directors.
- Board members must meet fit and proper criteria set by the NBE.
2. Board committees:
- Banks are required to establish various board committees, including audit, risk management, and
nomination committees.
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3. Internal controls:
- Banks must implement robust internal control systems.
- The board is responsible for overseeing the effectiveness of internal controls.
4. Compliance function:
- Banks are required to establish an independent compliance function.
- The compliance officer reports directly to the board or a board committee.
5. Remuneration policies:
- Banks must have transparent and prudent remuneration policies for directors and senior management.
Example: The NBE's Corporate Governance Directive for Banks (Directive No. SBB/70/2019) introduced
more stringent requirements for board composition and responsibilities, aiming to improve governance
standards in the Ethiopian banking sector.
E. Disclosure and Transparency
Ethiopian banks are required to

The major topics to be covered are: The structure of financial system, The time-value of money,
Introduction to financial instruments, Risk and return, Portfolio theory, Capital allocation, Pricing models,
such as the Capital Asset Pricing Model and Index Model, Market efficiency, Equity valuation, Bond
pricing and the Term Structure of Interest Rates and Derivatives- Pricing and Use.

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