The National Bank of Ethiopia (NBE) has recently introduced a directive aimed at managing and limiting banks’ investment activities. This directive is designed to mitigate risks, encourage diversification, and safeguard core banking operations. Key stipulations of the directive include a cap of five percent equity in insurance companies, full ownership in capital market service providers, and a 10 percent equity limit in non-banking businesses. Banks are now required to report their equity investments, establish comprehensive investment policies, and account for interest-free banking activities as outlined in the directive. The overarching goal of this directive is to promote investment while ensuring prudent risk management within the banking sector.
In an economy plagued by high inflation, low foreign currency reserves, significant unemployment, and liquidity challenges, commercial banks are encouraged to diversify their revenue streams and utilize excess liquidity effectively. Diversifying into non-core business areas not only improves financial resilience but also contributes to economic diversification, reducing reliance on dominant sectors and enhancing the economy’s adaptability to market fluctuations. However, this strategy comes with its own set of advantages and potential pitfalls.
Potential risks and rewards
While diversification can offer commercial banks new income avenues and bolster economic resilience, it can also expose them to unfamiliar risks and potential financial losses. The shift in focus to non-core business areas might detract from their primary banking functions, impacting service quality and competitiveness. Regulators may approach this diversification with caution, especially in a macroeconomic environment characterized by liquidity constraints. Moreover, non-core investments may not align with the nation’s broader economic goals, potentially leading to suboptimal resource allocation and missed opportunities. These investments might exacerbate existing liquidity issues, creating a domino effect that could destabilize the entire financial system. Therefore, careful evaluation, stringent regulatory oversight, and alignment with national economic priorities are crucial for commercial banks navigating these complexities.
Evolving banking landscape
Banks are increasingly exploring non-banking activities to diversify their revenue streams and seize emerging opportunities. Key areas of interest include wealth management, asset management, investment banking, capital markets, insurance, fintech, real estate, mortgage lending, and diverse consumer finance. This strategic shift enables banks to generate fee-based income, meet the growing demand for professional investment management services, remain competitive, and leverage emerging technologies and digital financial services. Investments in insurance and related products create cross-selling opportunities. Banks are also investing in fintech through direct investments, partnerships, or acquisitions, while real estate activities include mortgage lending and real estate investment services. Additionally, diverse consumer finance products—such as consumer credit, leasing, and installment financing—broaden consumer finance portfolios and provide additional income streams. Enhanced transaction banking and payment services, including digital payment solutions, cash management, and trade finance, further enable banks to generate fee-based income and maintain a competitive edge in the evolving payments landscape.
The primary motivations for these investments include reducing reliance on traditional lending, leveraging new trends and technologies, and boosting profitability and competitiveness in the rapidly evolving financial services sector. The banking industry also includes fully-fledged Islamic banks and those operating under a window model, governed by two directives. Interest-free banks have requested an expansion of the directive’s scope to encompass more products within their jurisdiction. However, the regulatory body remains cautious due to the knowledge gap, varying levels of practice, and the relative novelty of interest-free banking compared to conventional banking.
Lessons for Ethiopia’s interest-Free Banks
Interest-free banks and Islamic financial institutions in Ethiopia, such as those offering Murabaha and Mudaraba products, are essential in serving the community’s unique financing needs. Murabaha involves a sales contract setting customer prices and profit margins, while Mudaraba represents a partnership between banks for a pre-determined period. The NBE’s directives implicitly approved Musharakah—a joint venture or partnership structure where partners share profits and losses—though it was not explicitly included in earlier directives. Examining regional practices, it is clear that non-core business activities are customary and widespread. For instance, the KCB Group in Kenya has ventured into insurance, asset management, and real estate through its subsidiary, KCB Insurance Agency. Similarly, Equity Bank Group, operating in multiple countries, has expanded into digital financial services, insurance, and investment banking. Other banks like CRDB in Tanzania, Stanbic Bank across East Africa, and Absa Bank in several countries have also diversified into various sectors such as fintech, investment banking, and insurance. These examples illustrate that East African banks actively diversify to generate additional revenue streams and enhance competitiveness in the evolving financial services landscape.
Challenges, regulatory oversight, and mitigating risks
However, diversification is not without its challenges. Banks engaging in these activities may encounter significant difficulties requiring central bank intervention. A notable example is Absa Bank’s (formerly Barclays Bank Kenya) insurance venture in the early 2010s. The bank faced considerable losses due to its investment in First Assurance, struggling to gain traction in the competitive Kenyan insurance market. The Central Bank of Kenya intervened, expressing concerns about the risks associated with this diversification and ultimately pressuring the bank to exit the insurance business. This case underscores the challenges banks face when non-core investments diverge from their core competencies and risk profiles. The central bank’s role is crucial in monitoring these efforts and intervening when necessary to protect the financial system.
To address the challenges and risks associated with these business ventures, regulatory authorities can implement several measures. In the short term, these include enhanced monitoring and reporting, stress testing and scenario analysis, targeted liquidity support, and stringent transparency and disclosure requirements. These measures ensure that banks maintain adequate capital and liquidity buffers and remain accountable for their diversification strategies. In the long term, regulators should strengthen the regulatory framework for non-core business activities, developing comprehensive guidelines and policies to manage associated risks. Capacity building and skill development are essential to equip regulators with the expertise needed to oversee these ventures effectively. Contingency plans and crisis management strategies should be established to address potential failures or distress in non-core investments, collaboration with other government agencies and policymakers is vital to promote economic diversification and encourage sustainable investments, and incentives and guidelines for commercial banks to prioritize sustainable and socially responsible investments could contribute to the long-term stability and resilience of the economy.
In conclusion, while diversification into non-core activities presents significant opportunities, it also comes with inherent risks. The lessons from regional counterparts and robust regulatory oversight can help guide Ethiopian banks to navigate these complexities. Balancing short-term precautions with long-term strategies will be crucial in managing risks and promoting a stable, resilient financial system and broader economy. Birhane Girmai, a certified Trade Finance Specialist (CTFS) working in the banking industry, can be reached at: [email protected] Contributed by Birhane Girmai.
