19 August 2017

Ethiopia: How Much Is the Haircut for Banks' Capital Buffer

opinion

The capital requirement of banks has a more than two-decade long history with a rising trend over this period that begun early after the country was renamed the Federal Democratic Republic of Ethiopia by the new government, which broke up the defunct government state monopoly of the financial sector by opening up the banking sector to local private players. The capital buffer was updated twice after it was first introduced in the early 1990's, at 10 million Br (or 1.6 million dollars in the then Birr to dollar exchange rate).

Only five years passed before the central bank, National Bank of Ethiopia (NBE), raised the minimum capital requirement to start up a bank to 75 million Br (close to 10 million dollars in that time). But this did not stop 10 more private banks from joining the market, with Enat Bank being the last to do so. Nonetheless, the central bank moved yet again to raise the capital buffer to 500 million Br.

In line with the regulatory capital rule of the central bank, save for Debub Global bank, all the 15 private banks had fulfilled the minimum capital requirement by the end of June 2016. Debub bank, failing to meet the capital rule, had only a paid-up capital of 262 million Br, whereas Awash bank, raising more of its capital base had the largest paid-up equity holding close to 2.4 billion Br.

But while those banks that had less capital than the required were struggling to raise more capital from the public market by floating new shares and ploughing back shareholders dividend pay-outs, and those that already passed capital requirement were striving to grow their capital level, the central bank for the third time, through a circular it issued on September 26, 2015, called on all banks to significantly push -up their capital base.

To meet this new capital base level, banks are striving to grow their capital so that they would have sufficient equity funds to absorb any losses they suffer from operations and maintain their continuity.

And as the banks' preliminary financial performance results have come to flood in for the just ended fiscal year, Awash bank is reported to hold the largest paid-up capital amongst the sixteen private banks at the end of June 2017, amounting to 2.6 billion Br. Following this pioneer private bank of largest paid-up capital, Wegagen bank has also increased its paid-up capital substantially, reaching 2.1 billion Br.

The four other older mid-sized private banks namely, Dashen, Abyssinia, Nib International and United had paid-up capital accounts of 1.9 billion Br, 1.8 billion Br, 1.8 billion Br, and 1.5 billion Br, respectively. Hence, the three former banks may reach the desired two billion Birr capital base within a year; a couple of years ahead of the 2020 time line. United bank too has the capacity to reach that level before the given time.

Among the small- sized banks, Berhan International bank appears to show the fastest capital growth, raising its paid-up capital to 1.4 billion Br, up from 730.6 million Br, last year. Four other small-sized banks - Cooperative Bank of Oromia, Oromia International, Bunna and Abbay have also increased their paid-up capital to a billion Br or a little over that amount. The rest four small-sized banks namely, Lion International, Addis International, Debub and Enat have reported a paid-up capital ranging from 351 to 938 million Br.

On the other hand, it is needless to mention that Commercial Bank of Ethiopia (CBE), that commands two-thirds of the banking business in the economy, is seen growing bigger and bigger every year with rapid deposits, loan advances, investment and asset growth. Its capital base has also grown, surging to 40.0 billion Br paid-up capital, up from nearly 8.6 billion Br, yesteryear. This capital base at present appears to be close to double of all the paid-up capital held by the 16 private banks.

What the current capital base position of the private banks implies is that, though the time line for the two billion Birr capital rule has three more years, some small-sized banks would have to struggle hard to raise more equity from the public market and meet the desired paid-up amount. This is because raising greater equity from the public market is contingent upon the purchase of additional shares by the public and the increased annual earnings that the owners reinvest in the bank, building its reserves with the hope that the management will profitably invest those earnings, increasing the shareholders' future returns.

On the other hand, while the banks are striving to grow their paid-up capital, the central bank, underlining the importance of capital and the policy framework set for the financial sector, is reported to be in the preparation of a policy document which, amongst others things, includes a new higher capital rule that obliges all the banks to meet a certain threshold.

With this new envisaged capital requirement by the central bank, it becomes useful to examine the importance or role of capital to banks and how their capital adequacy or financial strength is measured.

The capital accounts play many pivotal roles in helping daily operations and ensuring the long-run viability of banks.

Firstly, capital provides a cushion against the risk of failure by absorbing financial and operational losses until management can address the bank's problems and restore its profitability. Capital also avails the funds required to charter, organize, and operate a bank before other sources of funds come flowing in. A new bank needs a start-up funding to acquire land, building, purchase equipment, hire officers and necessary staff before opening the business.

Thirdly, capital promotes public confidence and reassures depositors or creditors concerning the bank's strength. Capital must also be strong enough to reassure borrowers and the public that banks as lending financial institutions will be able to meet their growing needs even if the economy deflates.

Fourth, capital provides funds to use for the development of new banking services and facilities. Banks eventually outgrow the facilities they start with. An injection of increased capital will allow banks to expand into larger facilities or build additional branches in order to keep pace with the expanding banking business and follow their customers where ever they are.

Five, capital serves as a regulator of growth, helping the banks to ensure that growth is sustainable in the long-run and remain fit for the banking business.

So, the regulatory authorities of banks and the financial markets require that capital increases roughly in tandem with the growth of their risky assets. Hence, the cushion to absorb losses is supposed to increase along the banks growing risk exposure. For instance, a bank that expands its loans and deposits too fast will start receiving signals from the market and the regulatory body that its growth must either be slowed or additional capital be injected.

Thus, banks whose capital fails to grow fast enough, or declines far enough, will either find themselves losing market share to their competitors or, in the case of an economic downturn and global credit crises, go under.

On the other hand, as capital is the equity of banks that serves as a cushion to absorb any unresolved losses banks may incur, central banks have concerns on whether or not private banks have adequate capital to cover the losses they suffer in their operations. This adequacy is normally measured in percentage, banks are required to hold a minimum capital level of eight percent against the risk weighted assets on their books.

Total capital of banks is composed of equity capital, reserves, retained earnings, preference share capital, hybrid capital instruments and subordinated debt. And capital is split into Tier 1 capital and Tier 2 capital, in which Tier 1 constitutes equity capital, reserves and retained earnings. Tier 2 capital consists of the three remaining capital sources.

The quality of the capital in a bank reflects its mix of Tier 1 and 2 capital. Tier 1 or 'core capital' is presumed to be the highest quality capital, as it is not obliged to be repaid, and there is no impact on the bank's public trust if it is not repaid. It will solely be absorbed by shareholders bank capital. Tier 2 is not 'loss absorbing', as it is repayable, within a shorter time period than equity capital.

As Tier 1 capital ratio is considered in the measurement of the capital adequacy ratio of banks in Ethiopia, based on the recent data, it is reported that all commercial banks are found adequately capitalized exceeding the minimum 8 percent regulatory requirement. In fact, the Tier 1 capital ratio, which represents the amount of high-quality non-repayable capital available to the banks, is observed to be significantly greater than the minimum requirement, ranging from 12.11pc to 26.26pc.

However, though the banks are currently adequately capitalized, the regulatory body, NBE, is empowered to acquire banks to raise their capital level above the stipulated minimum level. Furthermore, as the banks continue to expand their loans and advances, deposits and assets, they will increasingly be exposed to risks in their business operations, which they have to manage.

The regulatory body is therefore obliged to constantly review the capital levels of banks under its authority, and act accordingly so that such levels don't fall below the level deemed sufficient to support the banks' business activity.

In addition, as the economy is steadily growing, at a stellar rate, in a trajectory that would require large supplies of credit, loans and financial liquidity, the banks need to constantly raise their capital. They need also to modernize their services through the application of financial technology (FinTech) and security mechanisms to address cybercrime.

The vital position banks occupy in the economy and the likelihood that the banking sector may one day be open to foreign competition, demands a growing capital that enables banks to remain afloat, continue unperturbed in the face of evolving complexities in the banking industry, and avoid any unresolved losses emanating from excessive risk or economic downturn.

In total, in view of the vital role capital plays in daily operations, and to ensure the long term viability of loans to big businesses, deposits and assets, the banks need to raise their capital level substantially to become stronger and more competitive in the constantly evolving banking industry.

Banks, more specifically the mid-sized ones - whose capital is failing to grow fast enough, are losing their market share to competitors for the largest borrowing customers, failing to meet the minimum capital buffers within the given time line and are thinly capitalized compared to market averages - may find mergers hanging over their heads.

Writer With a Solid Background in Finance and Whose Identity Fortune Withheld Upon Request

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