Lesson 1: Banking and Finance

Video lesson:

Competence(MLC)

Dear learner,

By the end of this lesson you will be able to:

• Define financial intermediation, financial markets and financial institutions
• List the benefits of financial intermediaries.
• Explain the banking system
• Analyze the roles of banks and treasury bills
• Describe the historical development of banks in Ethiopia
• Identify the non-banking financial institutions in Ethiopia

Brainstorming Question

• Think of financial institutions (e.g., banks) in your town. List out their benefits for the people in the town?
• What comes to your mind when you think of financial markets?
• What comes to your mind when you think of financial institutions?
• How old is the oldest Bank in Ethiopia?

Key Terms

1.1 Introduction

One of the basic factors of production in economics is capital. Capital is the amount of money the producer pays for the other factors of production (labor, land and entrepreneur) used in the production process.

Banks are one of the financial institutions that are used to transfer finance from those who have in excess to those that are in need of it. People with excess money will go to finance and put it in banks, this is called saving. People who faced shortage of money will go to the bank and ask for loans. Banks will give money as a loan according to their lending procedures. This activity of banks is one example of financial intermediation.

Thus, in this unit the issues that will be discussed concerning banks and other financial intermediaries. Therefore, students are expected to think of banks and other financial intermediaries in their locality and their functions as savers of excess money and as lenders to those who need the money.

1.2 Financial intermediary

Financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, for instance- Commercial Bank of Ethiopia. Financial intermediaries offer a number of benefits to the average consumer, such as safety, liquidity, and economies of scale involved in banking and asset management.

In other words, financial intermediaries mediate between the providers (with excess money) and users (with shortage of money) of financial capital. The transfer of funds from surplus spending unit to deficit spending unit through financial intermediaries is also called Financial Intermediation.

1.2.1 Benefits of financial intermediaries

For depositors

Financial intermediaries give safety and interest earning. Safety refers to the fact that the money of the depositors is free from any risk of loss. Banks also pay interest on the money saved at their banks by the depositors. These are the benefits to the depositors by financial intermediaries.

For the borrowers

People borrow money from banks and other financial intermediaries are known as investors. In the process of production, they may face shortage of finance and go to financial intermediaries (e.g., Banks), to get money or finance for their investment. The financial intermediaries will charge them annual interest on the money they borrow. The more money they borrow, the more investment (production) they undertake which is useful for the country.

Thus, finance (money) in the economy is like the blood circulating in the body. Any economy or country cannot function well without money (finance), just as the body cannot function without blood circulating in it. We use it to buy our day-to-day needs (demand = willingness + Ability; where ability is the money or finance, we have).

1.3 Financial Markets

Financial markets are markets that provide channels for allocation of savings to investment. They provide a variety of assets to savers as well as various forms in which the investors can raise funds and thereby decouple the acts of saving and investment. The savers and investors are constrained not by their individual abilities, but by the economy’s ability, to invest and save respectively. The financial markets, thus, contribute to economic development to the extent that the latter depends on the rates of savings and investment.

The financial markets have two major components:

1. Money market
2. Capital market

1.3.1 Money market

According to (Drake & Fabozzi, 2010), money market is the sector of the financial market that includes financial instruments with a maturity date of one year or less at the time of issuance. Money market instruments include:

• Treasury bills,
• Commercial papers,
• Negotiable certificates of deposit,
• Repurchase agreements, and
• Bankers’ acceptances.

I Treasury Bills:

Are financial instruments issued by the governments with maturity dates of three weeks, one month, three months or six months. The holder of a T-Bill realizes a return by buying these securities for less than the maturity value and then receives the maturity value at maturity.

II. Commercial papers:

Are promissory notes written promises to pay issued by a large, creditworthy corporation or a municipality having an original maturity that ranges from one (1) day to two hundred seventy (270) days. Commercial paper may be either interest bearing or sold on a discounted basis.

III. Certificates of deposit (CDs):

Are written promises by a bank to pay a depositor. They are issued by large commercial banks with original maturities between one month and one year. On the maturity date, the issuer repays the principal, plus interest.

1.3.2 The Capital market

Is the sector of the financial market where long-term financial instruments are issued by corporations and governments. They have an original maturity greater than a year and perpetual securities (those with no maturity). There are two types of capital market securities:

• Equity and
• Debt Obligations

Bank Loans

One form of such a bank loan is a syndicated bank loan. This is a loan in which a group (or syndicate) of banks provides funds to the borrower.

Debt securities

A debt security with a maturity at issuance of 10 years or less(Notes); and those with a maturity greater than 10 years (Bonds).

1.4 Financial Institutions

What are institutions?

Institution are norms that organize social, political and economic relations. They are ‘the underlying rules of the game’ in any society or organization. There are two forms of Institutions:

Formal institutions

Include the written constitution, laws, policies, rights and regulations enforced by official authorities.

Informal institutions

Are the usually unwritten social norms, customs or traditions that shape thought and behavior.

What are financial Institutions?

Financial institutions are institutions that serve as financial intermediaries.

There are three major types of financial institutions:

1. Depositary Institutions: Deposit-taking institutions that accept and manage deposits and make loans. Example: banks and credit unions.
2. Contractual Institutions: Insurance companies and pension funds; and
3. Investment Institutes: Investment Banks, underwriters, brokerage firms.

1.4.1  Banking

A bank is a financial intermediary that gives money (loan) to a borrower. They also accept deposits (savings) from depositors. The banking sector, being an intermediary in any economy, has a major role to play in enhancing development and growth through their activities of:

• Mobilizing saving
• Identifying good investment and
• Exerting through sound corporate control, particularly during the early stages of economic development and weak institutional environment.

Accordingly, the banks’ roles in an economy include;

1. Acquiring information about firms and managers and thereby improving capital allocation and corporate governance.
2. Managing cross-sectional, inter-temporal and liquidity risk and thereby enhancing investment efficiency and economic growth.

As an institution, the efficiency of bank depends on following two key factors:

1. Degree of competition that exists among banks and,
2. The nature of the regulation to which banks are subject to.

It is believed that a competition among banks in the economy will result in:

• Greater technical efficiency within deposit institutions,
• Lower interest rates for borrowers,
• Higher interest rates for depositors and
• A greater variety of services

1.4.2 Non- Banking institution

A non-bank financial institution (NBFI) is a financial institution that does not have a full banking license or is not supervised by a national or international banking regulatory agency.

NBFIs facilitate bank-related financial services such as investment, insurance, risk pooling, contractual savings, and market brokering.

Examples: insurance companies, pawn shops, cashier’s check issuers, check cashing locations, payday lending, currency exchanges, and microloan organizations.

1.5 Banking in Ethiopia

1.5.1 From 1905-1931

It was Emperor Menelik II (King of Ethiopia) that introduced modern banking in Ethiopia. There was an agreement signed between the King and the British owned National Bank of Egypt. The first modern bank, Bank of Abyssinia, was founded in 1906 as a result of this agreement. The Bank was totally managed by the Egyptian National Bank, a foreign bank. (National Bank Of Ethiopia, 2020/21).

According to (Mauri, 2003), The Bank was given a 50- years concession and was engaged in issuing notes, collecting deposits and granting loans, but its clients were mostly foreign businessmen and wealthy Ethiopians.

In the following couple of years after its foundation, Bank of Abyssinia opened branches in different towns of the country. Accordingly, the bank had opened branches in the following towns of the country:

• Harar town (1906)
• Dire Dawa town (1908)
• Gore Town (1912) and
• Dessie and Djibouti (1920)

Bank of Abyssinia was liquidated in 1931. (Mauri, 2003). According to (Nwanne, 2019), The Bank was a private bank whose shares were sold in Addis Ababa, New York, Paris, London, and Vienna. The Bank financed the Franco-Ethiopian Railway project which reached Addis Ababa in 1917.

1.5.2 From 1931 to 1936

In 1931, Bank of Abyssinia was liquidated and legally replaced by Bank of Ethiopia shortly after Emperor Haile Selassie came to power.

The new bank, the Bank of Ethiopia, was totally under Government control and retained the management, the staff, the premises and the clients of the previous bank, Bank of Abyssinia. (Mauri, 2003). Thus, the bank of Ethiopia became the first independent bank of Ethiopia, which was totally under Ethiopian government control.

Bank of Ethiopia took over the commercial activities of the Bank of Abyssinia and was authorized to issue notes and coins. The bank keeping the branches of the previous bank, added;

• Agency in Gambella and a transit office in Djibouti.

It was, however, short lived and was liquidated during the Italian occupation in 1936. (Mauri, 2003).

1.5.3 From 1936-1941

The following new banks were introduced by the Italians during their invasion of the country (Ethiopia) from 1936 – 1941:

• Banca d’Italia,
• Banco di Roma,
• Banco di Napoli and
• Banca Nazionale del lavoro

These were actually branches of the main Italian banks in Italy. They had branches which operated in the main towns of Ethiopia during the five year occupation period. Only Banco di Roma and Banco di Napoli (which were operating in Asmara) continued their operation after 1941.

1.5.4 From 1941 – 1943

There was another foreign bank introduced in 1941 (Barclays Bank) with the coming of the British troops and they organized banking services in Addis Ababa, until its early withdrawal in 1943.

1.5.5 From 1943 – 1963

The State Bank of Ethiopia was established in 1943 as the central Bank of Ethiopia with a power of issuing bank notes and coins as the agent of the Ministry of Finance. The Bank functioned as the principal commercial bank in the country and engaged in all commercial banking activities besides issuing bank notes and coins. (National Bank Of Ethiopia, 2020/21).

According to (Mauri, 2003), the establishment of the State Bank of Ethiopia, marked the rebirth of the Ethiopian independent banking. The bank was doing all the banking activities as the only bank: commercial banking activities providing loans and taking deposits and central bank activities issuing bank notes and coins. Until 1963, the State bank was the Central bank of the country.

The State Bank of Ethiopia had established 21 branches including a branch in Khartoum, Sudan and a transit office on Djibouti until it ceased to exist by bank proclamation issued on December 1963.

1.5.6 From 1963 – 1974

According to (Nwanne, 2019), The National Bank of Ethiopia was established in 1963 by Proclamation number 206 of 1963 and began operation in January 1964. This proclamation “The previous State Bank of Ethiopia” into two banks: National Bank of Ethiopia and Commercial Bank of Ethiopia.

In 1963, the Ethiopian government split the State Bank of Ethiopia (est. 1942) into the National Bank of Ethiopia, the Central Bank, and the Commercial Bank of Ethiopia (CBE). The government later merged Addis Bank into the Commercial Bank of Ethiopia in 1980 to make CBE the sole commercial bank in the country. The government had created Addis Bank from the merger of the newly nationalized Addis Ababa Bank, and the Ethiopian operations of Banco di Roma and Banco di Napoli. Addis Ababa Bank was an affiliate that National and Grindlays bank had established in 1963 and of which it owned 40%. At the time of nationalization, Addis Ababa Bank had 26 branches.

1.5.7 From 1974 to 1991

Following the declaration of socialism in 1974, the government extended its control over the whole economy and nationalized all large corporations. Accordingly, the three private owned banks:

• Addis Ababa Bank
• Banco di Roma and
• Banco di Napoli

Were combined (Merged) in 1976 and formed the second largest Bank in Ethiopia called Addis Bank.

Addis Bank

Then, in 1980, Addis Bank and Commercial Bank of Ethiopia S.C. were merged to form the sole Commercial bank in the country till the establishment of private commercial banks in 1994.

The Commercial Bank of Ethiopia started its operation with a capital of Birr 65 million, 128 branches and 3,633 employees, in the year 1980.

The Agricultural and Industrial Bank was formed in 1970 as a 100 percent state ownership, and which was under the umbrella of the National Bank of Ethiopia. Then after, in 1979, the bank was renamed Agricultural and Industrial Development Bank (AIDB). It was entrusted with the financing of the economic development of the agricultural, industrial and other sectors of the national economy extending credits of medium and long-term nature as well as short-term agricultural production loans (National Bank Of Ethiopia, 2020/21).

The financial sector constituted only three (3) banks and each enjoyed monopoly power in its respective market. The following was the three dominant banks in the country during 1974 -1991 period (according to the Gregorian calendar). This period was also known as the Socialist period in Ethiopian history.

• The National Bank of Ethiopia (NBE)
• The commercial Bank of Ethiopia(CBE)
• Agricultural and Industrial Development Bank (AIDB)

1.5.8 From 1991 to 1994   

In 1991 the country became a liberal economy system. The National Bank of Ethiopia (NBE) outlined its main functions separated from the previous total government control. The Licensing and supervision of Banking Business was formulated in 1994. (Monetary and Banking Proclamation No. 83/1994). The proclamation laid down the legal basis for investment in the banking sector.

1.6  Roles of Banks in Ethiopia

1.6.1 National Bank of Ethiopia (NBE)

National bank of Ethiopia, just like other countries’ national or central banks, control interest rates, manage the amount of credit available, and control the amount of money supply.

National Bank of Ethiopia, on behalf of the government, controls and regulates the activities of the financial sector, the commercial banks, insurance companies and microfinance institutions.

Commercial banks generate profit by depositing money, borrowing money from the national bank, and lending money to the public. National banks, however, are not profit making banks, rather they control the overall financial sector in the country. The objective of controlling the financial sector is to bring price stability or control inflation.

The following are the various roles that it plays to control the financial sector and bring price stability in the country:

• It prints the currency and mints the coins
• Issues bonds, treasury bills, and promissory notes on behalf of the government
• Maintains low levels of inflation
• Authorizes and controls micro and other financial institutions
• Deposits government money and provides direct advances to the government
• Lends money to commercial banks
• Regulates the money supply, interest rates and other charges
• Controls the creation of credit by commercial banks
• Formulates the monetary policy framework for the country
• Manages the international reserve of the country
• Regulates the foreign exchange of the country

1.6.2 Commercial Bank of Ethiopia (CBE)

The Commercial Bank of Ethiopia is the biggest and the leading commercial bank in the country. The current Commercial Bank of Ethiopia (CBE) was the result of the merging of Addis Bank S.C and the former commercial bank of Ethiopia 1980. As a government commercial bank, the bank has the following Roles and Functions mandated to it by the NBE:

• Saving/deposit for the households/individuals and firms
• Gives loans to households and firms
• Provides safe custody for valuables for households/individuals
• Sell and purchase foreign currencies
• Issue letters of credit (LC), traveler’s cheques, etc.

1.6.3 Development Bank of Ethiopia (DBE)

The development bank of Ethiopia (DBE) is one of the financial institutions engaged in providing short, medium and long term development credits/loans. It has a “project” based lending tradition. Project financed by the Bank are carefully selected and prepared through appraised, closely supervised and systematically evaluated.

Specifically, the Development Bank of Ethiopia (DBE), which took this last name in 1994 financial reform is mandated with the following roles in the country:

1. Provides loans for the development of the agricultural and industrial sectors
2. Supervises and controls the activities of projects financed by the bank