Addis Abeba — In November 2025, the National Bank of Ethiopia (NBE) issued a risk-based capital adequacy requirements directive for banks. Directive No. SBB/95/2025 has given recognition for Basel II and Basel III Accords as maintaining capital adequacy in line with internationally accepted standards and best practices by banks and bank groups, promoting and maintaining public confidence in the banking sector. The directive mandated a gradual transition to the new capital framework through a mixed approach that integrates Basel II and III frameworks.
The issuance of the Directive represents a seismic shift in the regulatory architecture of the Ethiopian financial sector. This directive explicitly recognizes the Basel II and Basel III Accords as the definitive international standards for maintaining capital adequacy, predicated on the belief that aligning with these global best practices will fortify public confidence and ensure the long-term stability of the nation's banking groups. However, the directive does not mandate an immediate leap; instead, it prescribes a transition period designed to manage the complexities of this overhaul.
Under Article 30(1) of the Directive, Ethiopian banks are required to begin submitting quarterly reports based on the new risk-based requirements starting from the quarter ending 31 March, 2026. Furthermore, Article 30(1) mandates that all banks must achieve full compliance with the prudential minimum capital requirements, such as a minimum paid-up capital of five billion birr, by 31 December, 2026. While the NBE argues that this 'mixed approach'--integrating Basel II's risk sensitivity with Basel III's capital quality--is essential for modernizing the sector, the global history of these accords reveals a pattern of technocratic failure and practical inapplicability that poses significant threats to the Ethiopian economy.
The historical development of banking regulation demonstrates that capital adequacy has become the primary tool for safeguarding financial systems, yet the effectiveness of this tool remains highly contested. In the early stages of global financial coordination, the Basel I Accord of 1988 established a simple 'risk-bucket' approach that assigned fixed weights to various asset classes.
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This system was eventually criticized for being too blunt and failing to keep pace with the rapid innovation in financial engineering and the growing sophistication of bank risk management. Basel II was subsequently introduced to provide a more granular and sensitive framework, relying on a three-pillar structure of minimum capital requirements, supervisory review, and market discipline. Following the catastrophic global financial crisis of 2008, which many experts argue was facilitated by the inherent flaws in Basel II, the Basel Committee on Banking Supervision introduced Basel III to enhance the quality of capital and introduce mandatory liquidity ratios.
For Ethiopia, a country currently liberalizing its banking sector and inviting foreign investment, the adoption of these standards is seen by policymakers as a mark of maturity. Yet, as this commentary will demonstrate, the difficulties in implementing such a complex system in an economy with limited data infrastructure and human capital may outweigh the perceived benefits of international harmonization.
Basel II and Basel III: Theoretical architecture
To understand the critique underlying the NBE's new directive, one must first explore the technical foundations of the Basel II and Basel III Accords. The Basel II Accord, introduced in 2004, was designed to link regulatory capital more closely to the actual risks incurred by financial institutions. It fundamentally shifted the regulatory paradigm from a static set of rules to a dynamic framework organized around three pillars.
The first pillar (Pillar 1) establishes the minimum capital requirements for credit, market, and operational risks. Under this pillar, banks are offered a choice between standardized approaches, which use external credit ratings, and internal ratings-based (IRB) approaches, which allow banks to use their own sophisticated models to determine risk weights.
The second pillar (Pillar 2) introduces the process of supervisory review, where national regulators evaluate the adequacy of a bank's internal capital assessment and can require additional capital buffers if they deem the bank's risk profile to be higher than what is captured in Pillar 1.
The third pillar (Pillar 3) focuses on market discipline by mandating transparent public disclosures, on the assumption that informed market participants will reward sound banks and penalize those with excessive risk.
The Basel III Accord, while maintaining the three-pillar structure of its predecessor, represents a significant tightening of these rules in response to the 2008 crisis. Firstly, it redefines the quality of capital, placing a greater emphasis on Common Equity Tier 1 (CET1) capital--primarily common shares and retained earnings--because this form of capital has the highest capacity to absorb losses during a 'going-concern' phase. Secondly, it increases the quantity of capital by raising the minimum CET1 ratio and introducing a mandatory capital conservation buffer of 2.5% of risk-weighted assets. Thirdly, Basel III addresses the 'shadow' of liquidity risk, which was largely ignored in previous accords, by introducing the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) to ensure banks hold enough liquid assets to survive a 30-day stress scenario.
Directive No. SBB/95/2025 reflects this evolution by requiring banks to maintain a CET1 ratio of 7%, a Tier 1 ratio of 9%, and a total capital ratio of 11%, all net of various regulatory adjustments for intangible assets and deferred tax assets.
The following table shows the capital ratio requirement under the directive in contrast with the Basel Accords:
The table above illustrates the heightened stringency of the NBE directive compared to the international minima, suggesting an aggressive regulatory stance that seeks to insulate the domestic sector from volatility. However, as historical data from other jurisdictions shows, the mere existence of high capital ratios does not guarantee financial health if the underlying calculation of risk-weighted assets is flawed or subject to manipulation.
Basel Accords Vs. Directive No. SBB/95/2025: The critique
The introduction of the directive essentially grafts a highly sophisticated, Western-centric regulatory model onto a developing financial system that lacks the requisite infrastructure. The primary critique of the Basel frameworks, as applied to Ethiopia, lies in the fundamental disconnect between the model's assumptions and the domestic reality. In the first instance, the reliance on internal ratings-based (IRB) approaches--even if initially limited to larger banks--presumes that financial institutions possess the technical expertise and historical data necessary to accurately model default probabilities. However, the A-IRB approach was developed during international negotiations and was essentially untested before its widespread adoption. Critics argue that this represents a 'leap of faith' that could become a 'leap off a cliff' for regulators who cannot properly validate these complex models. For Ethiopian banks, which are only now beginning to automate their core banking systems and formalize data collection, the requirement to develop 'continual measurement' systems for risk-weighted assets (RWA) is an immense operational burden.
Secondly, the Basel framework is inherently procyclical, a flaw that has been damaging to the global economy. Because capital requirements are tied to risk-weighted assets, they tend to fall during economic booms when perceived risk is low, enabling banks to lend more and fuel asset price bubbles. Conversely, during a downturn, risk weights rise, forcing banks to hold more capital and contract lending exactly when the economy needs liquidity. For Ethiopia, a country whose economy is highly sensitive to commodity price shocks and foreign exchange fluctuations, the adoption of a procyclical regulatory regime could lead to severe credit crunches. The National Bank's formula for Total Capital Ratio, which sums the RWA for credit, market, and operational risks, ensures that any spike in volatility will immediately constrain the ability of Ethiopian banks to support productive sectors like agriculture and manufacturing.
Thirdly, the directive's reliance on External Credit Assessment Institutions (ECAIs) for standardized risk weights is deeply problematic in the Ethiopian context. Directive No. SBB/95/2025 explicitly recognizes Standard and Poor's, Moody's, and Fitch Ratings as eligible ECAIs. However, the 2008 subprime crisis exposed profound shortcomings in the assessments of these agencies. Furthermore, very few domestic Ethiopian corporations or small and medium-sized enterprises (SMEs) have credit ratings from these international firms. Consequently, a vast majority of the domestic credit portfolio will likely be assigned a high, standardized 'unrated' risk weight, which could be as high as 100% or 150%. This penalizes domestic lending and incentivizes banks to invest in low-risk government bonds rather than supporting the growth of the private sector.
The introduction of the directive essentially grafts a highly sophisticated, Western-centric regulatory model onto a developing financial system that lacks the requisite infrastructure."
Fourthly, the operational risk requirements in the directive represent a triumph of complexity over practicality. The NBE requires banks to hold capital against losses from internal control failures, human error, fraud, and cyber events. While this is a laudable goal, the calculation of this charge is often arbitrary. Under the Basic Indicator Approach, banks must set aside a percentage of their gross income, which essentially penalizes banks for being profitable rather than for having high operational risk. Furthermore, the directive requires a minimum of five years of high-quality internal loss data for more advanced treatments. For many newly established Ethiopian banks, this data simply does not exist, leaving them trapped in simpler, more expensive capital regimes that hamper their competitiveness.
Fifthly, there is the issue of regulatory capture and the 'gaming' of the system by large banks. History shows that when regulators allow banks to use their own models, those banks inevitably calibrate the models to minimize capital and maximize dividends. Large international banks have 'hijacked' the Basel process to rewrite rules in their favor, creating an unlevel playing field where smaller institutions with simpler risk management systems appear to be more capital-intensive and less efficient. In Ethiopia, the entry of foreign bank subsidiaries and branches, which may use the advanced models of their parent groups, could lead to a situation where domestic private banks are outcompeted not by better service, but by more 'optimized' capital calculations.
Advice for Ethiopian stakeholders, learning from global lessons
Policy makers and bank executives in Ethiopia must approach the implementation of Directive No. SBB/95/2025 with significant skepticism and caution. The global experiences of other nations demonstrate that the Basel system is not a panacea for stability but a fragile edifice that requires constant, expert supervision. In the first instance, the National Bank of Ethiopia should prioritize the development of a simple leverage ratio as a non-risk-based backstop to the complex Basel formulas. A leverage ratio, which measures capital against unweighted total assets, is highly transparent and much harder for banks to 'game' than risk-based measures. The United States has successfully used a leverage ratio for decades as a regulatory safety net, and its inclusion in the Ethiopian framework would provide a blunt but effective defense against the failures of risk modeling.
Secondly, Ethiopian policymakers must be wary of the 'hubristic technocracy' that often accompanies Basel implementation. The 2008 crisis revealed that even the most 'well-capitalized' banks in the world, such as Bear Stearns, could fail overnight due to liquidity runs and the interdependency of financial actors. The lesson for Ethiopia is that capital regulation cannot bear the entire weight of prudential supervision. Regulators must focus equally on liquidity risk, counterparty risk, and the 'rat-catcher' approach of identifying specific institutional weaknesses through hands-on supervision rather than relying solely on automated reporting.
Thirdly, the Ethiopian banking sector must take heed of the Japanese experience in the late 20th century. During the Japanese banking crisis, supervisors allowed banks to report capital ratios that met international standards even as the institutions were essentially insolvent. This 'nationalistic opportunism' allowed problems to fester, leading to a decade of economic stagnation. The National Bank of Ethiopia must therefore ensure that its Pillar 2 supervisory reviews are rigorous, independent, and capable of identifying when a bank's reported RWA is untethered from reality.
Fourthly, bank boards of directors should recognize that the burden of compliance under Directive No. SBB/95/2025 falls squarely on their shoulders. Under Article 4 of the Directive, boards are primarily responsible for ensuring that their banks maintain capital at or above minimum levels at all times and for developing a comprehensive capital management strategy. This is not a task that can be delegated to IT departments or mid-level risk managers. As global failures have shown, a 'culture of compliance' that ignores the spirit of the law leads to catastrophic risk-taking. Ethiopian boards must invest heavily in human capital and risk governance to ensure they understand the 'black box' models they are being asked to implement.
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Fifthly, there is the risk that Basel standards will cut off access to lending for the most vulnerable sectors of the Ethiopian economy. Global studies have shown that when banks adopt the IRB approach, the capital charge for lending to unrated SMEs in developing countries can rise to over 47%, effectively pricing these borrowers out of the market. Policy makers in Ethiopia must therefore ensure that the transition to Basel standards does not inadvertently stifle domestic development goals. This may require the use of national discretion to adjust risk weights for critical sectors like agriculture, provided such adjustments are transparent and supported by domestic data.
Sixthly, the National Bank should consider the 'precommitment approach' as an alternative to detailed modeling for operational risk. Under this approach, a bank pre-commits to a maximum loss figure and pays a penalty if that loss is exceeded. This simplifies the regulatory process and places the onus of risk management directly on the bank's management, which is often more effective than following the rigid and often inaccurate formulas of the standardized approach.
Policy makers and bank executives in Ethiopia must approach the implementation of Directive No. SBB/95/2025 with significant skepticism and caution."
Seventhly, the implementation of Directive No. SBB/95/2025 must be accompanied by a massive investment in technological infrastructure. Modern banking technology estates are often poorly understood and prone to failure when complex changes are made. For Ethiopian banks, the move toward real-time RWA measurement requires high availability of core banking platforms and robust data lakes for analysis. If the technology function is not properly aligned with the business goals of the Basel transition, the result will be operational outages and reporting failures that incur significant administrative sanctions.
Conclusion
The NBE's decision to adopt Basel II and III standards under Directive No. SBB/95/2025 is a bold attempt to integrate the nation into the global financial fold. However, this transition is fraught with peril. The Basel Accords were designed by and for the G-10 countries, and their complexity often masks the reality of institutional weakness and market volatility. The transition period ending in December 2026 offers Ethiopian banks a brief window to modernize their systems, but it also creates a looming deadline that could lead to rushed and inaccurate implementation.
The success of Ethiopia's regulatory shift will depend not on the meticulous calculation of risk weights, but on the ability of policymakers and bank boards to look beyond the technocratic elegance of the Basel framework. They must prioritize simplicity where complexity fails, demand transparency where models become opaque, and maintain an unwavering focus on the stability of the domestic economy over the prestige of international harmonization. By adopting backstops like the leverage ratio, investing in human and technological capital, and remaining vigilant against the dangers of procyclicality and regulatory capture, Ethiopia can build a banking sector that is truly resilient--not just on paper, but in practice. AS
Editor's Note: Hassen Mama Muse is a lawyer based in Addis Abeba. He can be reached at hassenmama@gmail.com
