revisiting the regulatory and supervision framework of the

Revisiting the Regulatory and Supervision Framework of the Micro-finance Industry in Ethiopia

Report No. 13 March 2001 Bekele Shiferaw1 Wolday Amha2

1 Department of Economics and Social Sciences, Agricultural University of Norway 2 Association of Ethiopian Micro-Finance Institutions

Background and Vision The Drylands Coordination Group (DCG) is a forum for cooperation that promotes the quality assurance of development projects dealing with food security and environmental rehabilitation in the drylands of Africa. DCG was established by the Norwegian NGOs responsible for running development projects previously funded under the Sahel-Sudan-Ethiopia (SSE) Programme.

The SSE Programme: In response to the catastrophic drought in the Sahel region in 1984-1985, the Norwegian Ministry of Foreign Affairs established the Sahel-Sudan-Ethiopia Programme (SSE). The main objectives of the programme were food security and environmental rehabilitation. The countries that have received support through the SSE Programme are Mali, Sudan, Ethiopia and Eritrea. The average annual funding during the last three years of the programme amounted to NOK 140 million, of which almost half was channelled through multilateral institutions (UN system), a small percentage through research activities, and more than half through NGOs. The SSE Programme was phased out in 1996, but the work of the NGOs continues through the Drylands Coordination Group (DCG).

The members of the DCG are ADRA Norge, CARE Norge, Norwegian Church Aid, Norwegian People’s Aid, Strømme Foundation and the Development Fund. Noragric, Centre for International Environment and Development Studies, Agricultural University of Norway, functions as the group’s secretariat and technical advisor. The DCG activities are funded by NORAD. The DCG’s overall objective is to improve the livelihood security of vulnerable households in drought-prone and marginal areas, especially in Africa. The DCG believes that Norway through the SSE experience has developed special competence within development assistance in drought-prone countries and that this competence should be fostered and advanced. The DCG will: • Contribute to assuring the quality of Norwegian development assistance in the drylands • Contribute to the fulfillment of Norwegian responsibilities to the Convention to Combat Desertification • Assist NORAD in its increased efforts in sustainable agriculture and natural resource management • Promote the effectiveness of Norwegian development cooperation. • Promote cooperation with partner institutions working with dryland management issues The Drylands Coordination Group and Noragric Noragric provides the DCG with the following services: • Quality assurance and technical assistance to individual projects. planning, reviews and special assignments • Seminars and workshops • Research and study reports • Secretariat

A Sampling of DCG’s Activities • Seminar on sustainable agricultural development and natural resource management in the drylands • Case studies in gender issues in agricultural and natural resource management projects • Study of decentralisation, institution building and phasing out of Norwegian project involvement • Study on Integrated Plant Nutrition Management

Revisiting the Regulatory and Supervision Framework of the Micro-finance Industry in Ethiopia

Report No. 13 March 2001

Bekele Shiferaw* Wolday Amha**

The views expressed in this study are those of the authors’ and do not necessarily reflect the views of their host institutions.

i

ACRONYMS AND ABBREVIATIONS

ACDI/CEE - Agricultural Cooperative Development International Corporation of Ethiopia Entrepreneurs ACSI - Amhara Credit and Saving Institution S.C ADLI - Agricultural Development Led Industrialization AIDB - Agricultural and Industrial Development AEMFI - Association of Ethiopian Microfinance Institutions BCEAO - Central Bank of West African States BDS - Business Development Service CBE - Commercial Bank of Ethiopia CEO - Chief Executive Officer CGAP - Consultative Group to Assist the Poorest CIDA - Canadian International Development Agency DECSI - Dedebit Credit and Saving Institution S.C DCG - Drylands Coordination Group BOD - Board of Directors IDA - International Development Association MBP - Microenterprise Best Practices MFIs - Microfinance Institutions MIS - Management Information System NBE - National Bank of Ethiopia NCA - Norwegian Church Aid NGO - Non-Governmental Organizations ORDA - Organization for Rehabilitation and Development in Amhara OCSI - Oromia Credit & Savings Institution S.C REST - Relief Society of Tigray SACCDO - Saving and Credit Cooperative Development Office SAP - Structural Adjustment Program SCA - Saving and Credit Association SCCA - Saving and Credit Cooperative Societies SSE - Sahel-Sudan-Ethiopia UNCCP - Office of National Committee for Central Planning USD - United States Dollar

ii

PREFACE

Since the 1990s, the MFIs are by and large considered as effective financial intermediaries in the delivery

of scare investment capital to the urban and rural poor. During the era of central planning, the financial

system in Ethiopia was entirely controlled by the state after the private banks and insurance companies

were nationalized just after the outbreak of the revolution in 1974. During this period, there were some

interventions to deliver financial services to the rural and urban poor through conventional banks (CBE and

AIDB-DBE), NGOs and cooperatives. However, the performance of these institutions in delivering micro-

finance services to the needy was disappointing due to a variety of reasons. After the change in

development strategy and a move towards liberalized markets since the early 1990s, financial sector

reforms were introduces as part and parcel of the structural adjustment process. This shift in development

policy allowed participation of private investors in the financial system, which was hitherto under state

monopoly. The weak integration of micro-financial services extended by various projects and NGOs and

the poor financial discipline necessitated the need to streamline and better integrate the delivery of micro-

finance in the country. To this effect, Ethiopia issued a new legislation (Proclamation 40/1996), which

allowed for licensing and supervision of micro-finance services. Only MFIs established as per the

provisions of this legislation are now allowed to engage in the delivery of micro-finance services in the

country. Whereas a number of MFIs have been established under the new legal framework, a number of

NGOs and donors, which were providing financial services in the past, have either limited their

involvement or frozen their engagement entirely. The mushrooming of MFIs as private share companies

has also necessitated formulation of a suitable regulatory framework. The new regulatory framework

proposed prudential practices to ensure accountability and increase the safety of the resources managed by

MFIs.

Although Ethiopia has established a well-defined regulatory and supervision framework for the micro-

finance industry, no systematic assessment and evaluation has yet been carried out regarding its

performance and effectiveness. This study, sponsored by the DCG, is an attempt to fill this gap and

generate policy-relevant information regarding the performance of the new regulatory and supervision

framework and issues that may require improvement. The information was generated through consultations

with practitioners, policy makers and other stakeholders. Without the keen interest, generous support and

participation of these stakeholders, the study may not have been completed on time. The study team is very

grateful to all the resource persons who gave us their valuable time for discussion and tirelessly answering

our, often exhausting, questions, and to the MFIs and their leadership who took their precious time to fill

out the lengthy questionnaire. We have greatly benefited from the discussions and the insights provided by

all the respondents.

iii

TABLE OF CONTENTS

Page ACRONYMS i

PREFACE ii

TABLE OF CONTENTS iii

1. INTRODUCTION 1

1.1 Mission and objectives 2

1.2 Methods 3

1.3 Roadmap 4

2. THE FINANCIAL SYSTEM AND MICRO-FINANCE IN ETHIOPIA

6

2.1 The financial system and its transition 6

2.2 The structure of micro-finance in Ethiopia 10

2.3 The demand for credit and performance of MFIs in Ethiopia 16

2.4 Weaknesses of the financial system 19

3. REGULATION AND SUPERVISION IN ETHIOPIA 21

3.1 The rationale to regulate the micro-finance industry in Ethiopia 21

3.2 Main features of the regulatory framework in Ethiopia

27

3.3 Comparing the Ethiopian legal framework with other countries 36

4. REGULATORY AND SUPERVISION ISSUES FOR MICRO- FINANCE

4.1 Governance 41

4.2 Supervision 44

4.3 Operational modalities 47

4.4 The role of NGOs and foreign donors 50

4.5 Internal control and sound information management system 52

iv

4.6 Interest rate 53

4.7 Monitoring and evaluation of the regulatory framework 54

4.8 Supervising the saving and credit cooperatives 55

4.9 Other issues 55 5. CONCLUSION AND RECOMMENDATIONS 58

5.1 Enabling policy environment 59

5.2 Licensing and entry 60

5.3 Competitiveness 60

5.4 Corporate governance 60

5.5 Loan ceiling and repayment period 61

5.6 Group lending vs. individual liability 62

5.7 Re-registration 63

5.8 Supervision 63

5.9 Enforcement 64

5.10 The role of donors and foreign NGOs 64

5.11 Taxation and foreign aid 66

6. REFERENCES 68

7. ANNEXES 71

Annex I: A List of Stakeholders Consulted During the Fieldwork in Ethiopia

71

Annex II: The questionnaire used in the survey.

72

Annex III: Distribution of Commercial Banks and Insurance Companies in Ethiopia

79

Annex IV: Proclamation No. 40/1996

82

Annex V: Comparison of the Ethiopian regulatory framework with other selected countries

92

v

List of Tables

Page Table 1.1: The ownership structure of micro-finance institutions in Ethiopia. 5

Table 2.1: Allocation of CBE credit by ownership (%age share, 1980/81-1991/92) 7

Table 2.2: Distribution and share of banking business in Ethiopia, 2000 8

Table 2.3: Sectoral breakdown of outstanding claims of commercial banks (% shares) 10

Table 2.4: Active clients, share of women, rural and urban clients of MFIs in Ethiopia,

January 2001.

14

Table 2.5: Potential demand for rural finance by the rural poor in Ethiopia (000 Birr) 15

Table 2.6: The unmet demand or gap of rural finance (in 000 Birr) by the rural poor, 1999 17

Table 3.1: Repayment rate, outstanding and arrears of rural credit of agricultural and

industrial development bank (1985-93)

21

Table 3.2: Active clients, average loan size, rate of interest on loans and saving/deposits for

MFIs in Ethiopia, January 2001.

33

Table 3.3: The basic elements of the regulatory framework of West African countries and

Ethiopia

39

Table 4.1: Active clients and the rate of loan recovery for MFIs in Ethiopia, January 2001. 49

Revisiting the Regulatory and Supervision Framework

1

1. Introduction

In Ethiopia the majority of the population is dependent on smallholder agriculture, which

contributes over 50 per cent of the GDP in any single year. The rural population, which accounts

for about 85% of the population, is located in areas where communication and transportation

facilities are poorly developed. Ethiopia has one of the lowest road and telephone densities per

inhabitant in sub-Saharan Africa. The rugged terrain of the country further complicates the

problem of accessibility and increases transaction costs in reaching the rural population. The high

operational costs under conditions of poorly developed rural infrastructure have thus contributed

to the underdevelopment of the formal financial system in the country. The covariate risk, limited

social differentiation of the rural population and public ownership of land have also limited the

functioning of the informal financial system in the rural areas. Availability of credit for annual

agricultural activities, investment in production and conservation methods, small-scale businesses

and consumption smoothing has therefore been very limited. Since the early 1980s, some formal

credit in kind has been provided mainly for the purchase of fertilizer, and to a limited extent for

improved seeds and financing purchase of oxen for traction. The Commercial Bank of Ethiopia,

the Construction and Business Bank (formerly Housing and Saving Bank), and Development Bank

of Ethiopia (formerly the Agricultural and Industrial Development Bank) catered to the needs of

large and medium scale enterprises (including state farms) and industrial establishments. The

supply of formal credit for small-scale enterprises in remote rural locations, which includes the

majority of the rural poor, has been extremely limited. Some non-governmental organizations

(NGOs) have tried to narrow this gap by providing soft loans and grants to small-scale enterprises

in urban and rural areas.

There is a widespread agreement among development economists and practitioners about the vital

role that micro-financing institutions can play in facilitating the process of agricultural

transformation and bringing about sustainable rural development. In realization of the need for

micro-financing services in the country, Ethiopia has established a legal framework for licensing

and operation of micro-financing institutions (MFIs) that provide credit and savings services to the

poor. This proclamation, known as the Licensing and Supervision of Micro-Financing Institutions

(Proclamation No. 40/1996), came to effect on 5 July, 1996. Following this legal provision, some


2

18 micro-finance share companies have been established. The ownership structure of MFIs

indicates a diversity ranging from a combination of regional governments and NGOs to

individuals and NGOs (see Table 1.1). Prior to the issuance of this proclamation a number of

NGOs and donor organizations provided small-scale credit at concessionary rates to the rural and

urban poor and micro-enterprises. Apart from lack of a framework for coordination and

supervision of financial services offered in this way, many of the micro-credit programmes lacked

financial sustainability as they were mainly run on the basis of humanitarian grounds than on

sound financial principles. The proclamation for licensing and supervision of MFIs allowed for the

establishment of formal financial institutions as profit-oriented share companies owned by

Ethiopian nationals and/or organizations and laid out a regulatory framework for operation of such

companies under the National Bank of Ethiopia (NBE).

1.1 Mission and Objectives

This study has been commissioned by the Drylands Coordination Group (DCG), a forum for

cooperation that promotes quality assurance of development projects dealing with food security

and environmental rehabilitation in the drylands of Africa. Norwegian NGOs responsible for

running the development projects funded under the Sahel-Sudan-Ethiopia (SSE) Program

established the DCG in 1997. The current members of the DCG in Norway include ADRA Norge,

CARE Norge, Norwegian Church Aid, Norwegian People’s Aid, Strømme Foundation, and the

Development Fund. This study is expected to help the member organizations of DCG in Ethiopia

to position themselves, and their credit and savings programmes, in relation to the proclamation

issued by the Ethiopian government (Proclamation No. 40/1996). The main objectives of this

study thus are:

• To assess the regulatory framework

• To assess the legislation’s range of applications

• To analyse the legislation’s effect on different forms of credit and savings programs.

The Terms of Reference (TOR) for the study outlines the following specific issues to be covered

as part of the investigation.

1. To assess the existing status of the financial sector in general and the MFIs in particular in

the country,


3

2. To assess and evaluate the legal environment under which the MFIs are operating,

3. To compare the Ethiopian regulatory framework for micro-financial operations with those

of some other countries that have sound legislation,

4. To analyse the positive impacts as well as constraining factors of the legislation on the

micro-financing operations,

5. To recommend the legislative or regulatory issues demanding avocation and lobby for

changes.

1.2 Methods

In order to address these issues, a team of researchers was set up to carry out the study for a period of

five weeks. The team carried out a three-week fieldwork (in December 2000 and January-February

2001) and widely consulted with various practitioners in the field of credit and savings (micro-

finance institutions established pursuant to the licensing proclamation), the National Bank of Ethiopia

(NBE), the Commercial Bank of Ethiopia (CBE), the Ministry of Finance, NGOs and other

stakeholders (see Annex I). Given the limited time and resources made available for the study, this

investigation was not able to design a very detailed framework for gathering a statistically analyzable

dataset. The relevant information was gathered through informal discussions, consultations as well as

using a structured questionnaire. In general the data used in writing up our findings is collected from

three sources:

a) Questionnaire-based survey: Feedback obtained from MFIs using a structured questionnaire

with several open-ended questions. The response rate for the survey questionnaire was very

high. Twelve of the sixteen MFIs that were asked to fill the questionnaire responded on time

for the study. The study team would like to note the great enthusiasm and interest that the

majority of the MFIs have shown for successful and timely completion of the survey. The

questionnaire used in the survey is given in Annex II.

b) Discussion and consultations: Detailed discussion and consultation with selected MFIs,

NGOs representing the donors, the Supervision Department of the NBE and other

stakeholders. The preliminary findings of the study team were presented for discussion to an

exert panel from DCG-Ethiopia in Addis Ababa on Feb 7, 2001. This presentation provided a

forum for exchange of views and discussing a number of vital issues related to the regulatory

and legislative framework in micro-finance affecting the donors and NGOs in the country.


4

This was followed by a detailed consultation with members of the DCG to learn about their

own experiences in micro-finance activities in the country and problems encountered in

relation to the introduction of the regulatory framework since 1996.

c) Secondary data: Whenever necessary, we have drawn from the results of previous studies

which were conducted by the various researchers, consultants and the Association of

Ethiopian Micro-Finance Institutions (AEMFI). The existence of previous studies and

preliminary investigations on the regulatory framework has helped us in quickly identifying

the gaps and designing questions to fill the missing data. Proper referencing is given to all the

secondary information used in this report.

Whenever possible, we have synthesized the responses into descriptive tables using frequency

counts and other simple statistics. For better exposition and due to the limited focus on

quantitative aspects in this study, we have preferred to emphasize the qualitative and subtle issues

of the regulatory framework for micro-finance in Ethiopia.

1.3 Roadmap

The rest of the paper and findings of the study are presented as follows: Part two reviews the

current status of the financial system and the micro-financing sector in the country. Part three

presents the legal and regulatory framework for the micro-financing businesses in the country.

Part four discusses the basic results of the fieldwork with special emphasis on the constraints and

opportunities that the micro-credit and savings institutions in the country face under the existing

legal and regulatory framework. In the final section, we present major recommendations and

policy implications of the major findings. The executive summary, which briefly integrates the

major elements of the research, the core findings and recommendations, is provided at the outset.

Obviously, the study does not attempt to answer all the important questions that should be

answered in relation to the regulatory framework and its effects on micro-finance in Ethiopia. We

have tried to highlight several complex issues that require a more detailed investigation in the

future. In order to improve and strengthen the micro-finance sector in the country, it will be very

useful to address not only the recommendations and highlights provided in the study but also these

unanswered questions in future research.


5

Table 1.1. The ownership structure of micro-finance institutions in Ethiopia.

Year of

Ownership Structure (% of Equity Capital)

Micro-finance Institutions Establishment Regional Government

Associations and NGOs

Individuals Total

Amhara Credit & Savings Institution S.C (ACSI)

1995 25 75 - 100

Dedebit Credit & Savings Institution S.C (DECSI)

1994 25 75 - 100

Oromia Credit & Savings Institution S.C (OCSI)

1997 25 70 5 100

Omo Micro-finance Institution S.C 1997 80 19.5 0.5 100 Specialized Financial & Promotional Institution S.C

1997 - 80 20 100

Gasha Micro-Financing S.C 1998 - 61.9 38.1 100 Wisdom Micro-Financing Institution S.C

1998 - - 100 100

Sidama Micro-Financing Institutions S.C

1994 - 70 30 100

Asser Micro-Financing S.C 1998 - 97 3 100 Africa Village Financial Services S.C

1998 - - 100 100

Buussa Gonofa Micro-finance S.C 1999 - 19.6 80.4 100 Mekket Micro-finance Institution S.C

1999 - - 100 100

PEACE Micro-finance Institution S.C

2000 - 16 84 100

Addis Credit and Savings Institution S.C

2000 96.7 3.3 - 100

Meklit Micro-finance Institution S.C

2000 - 91 9 100

Eshet Micro-finance Institution S.C 2000 - 20 80 100 Source: National Bank of Ethiopia (NBE), 2000, Addis Ababa


6

2. The Financial System and Micro-Finance in Ethiopia

2.1 The financial system and its transition

The formal financial sector in Ethiopia has gone through periods of upheaval and transition since

the military government nationalized private commercial banks, specialized financial institutions

and insurance companies on January 1, 1975. The private banks like the Addis Ababa Bank,

Banko di Roma, and Banko di Napoli were merged into one bank, Addis Bank. On July 1, 1980,

Addis Bank was incorporated into the Commercial Bank of Ethiopia. The Savings and Mortgage

Corporation and Ethiopian Savings and Home Ownership Public Association were also merged

into a new Housing and Saving Bank. The Agriculture and Industrial Development Bank

continued as the government’s principal agent for extending medium and long-term credit for

agricultural and industrial enterprises until it was later reorganized in 1995. The revolution also

led to the nationalization of thirteen insurance companies, which were merged to form the

Ethiopian Insurance Corporation. During the same period, land resources were also nationalized

and all land rental, selling and mortgage markets were outlawed. Land still remains under state

ownership but short-term contracts are legalized. During the socialist era of the military regime,

the Ethiopian economy was highly controlled and regulated by the central planning organ of the

government. The Office of the National Committee for Central Planning (ONCCP) outlined

development strategies and plans for all the major economic sectors and even exercised strong

power in fixing the prices of manufactured consumer goods, agricultural products, inputs, and the

foreign exchange rate. Credit schemes were primarily targeted towards producers’ cooperatives

and state farms, both of which were strongly supported by the regime because of ideological

reasons. The participation of the private sector in the economy was highly controlled and minimal.

The majority of the rural poor, smallholder farmers and micro-enterprises had no formal financial

institutions which can provide specialized credit services unless they are organized into producers’

cooperatives.

During the era of central planning, the CBE mainly provided credit facilities to the central

government and public enterprises (see Table 2.1). The share of lending to the private sector has

failed from close to 30% in 1980/81 to close to 5% at the end of the 1980s. The growing

government deficit and poorly performing public enterprises forced the government to increase


7

borrowing from the domestic financial system in the late 1980s until this unsustainable practice

led to an almost catastrophic breakdown of the national economy by the time the regime collapsed

in the early 1990s.

Table 2.1. Allocation of CBE credit by ownership (%age share, 1980/81-1991/92)

1980

-81

1982

-83

1984

-85

1986

-87

1989

-90

1990

-91

1991

-92

Central government 20.9 47. 61.7 57.6 59 86.1 86.3 Other sectors 79.1 52.1 38.3 42.4 41 13.9 13.7 - Public enterprises 49.9 31.4 23 26 28.7 9 10.2

- Cooperatives 0.3 0.2 0.1 1.2 0.7 0.1 0.2

- Private sector 28.9 20.5 15.3 15.2 11.6 4.8 4.3

As will be seen later, the financial sector went through a substantial restructuring soon following

the change in government and development policy in the early 1990s. The worsening macro-

economic problems, the debt burden and the heavy reliance on the non-performing public sector in

the 1970s and 1980s led to widespread recognition of the need for economic policy reform. The

change in the government in May 1991 facilitated acceptance and adoption of adjustment and

reform policies, which were already conceived by the defunct regime. As a result, the World Bank

and IMF led Structural Adjustment Programme (SAP) and economic liberalization started in

earnest around 1994 soon after the country emerged from the devastating wars. Gradually, the

outdated command and control approach was by and large replaced by increasing reliance on the

market mechanism, which grew through an overt policy of privatisation and liberalisation of the

economy as well as restructuring of the public sector. One major outcome of this shift in policy is

the provision to allow participation of the private sector in the banking and insurance business, an

area strictly reserved for the public sector since the outbreak of the revolution in 1974. With the

opening of the financial sector for private investors, few new private banks namely, Awash

International Bank, Dashen Bank, Bank of Abyssinia, Wegagen Bank, United Bank, and Nib

Bank, and eight insurance companies namely, Nyala Insurance, Nile Insurance, Africa Insurance,

National Insurance, Awash Insurance, United Insurance, Lion Insurance, and Global Insurance

were established. This shift was made possible by two proclamations provided in 1994: the


8

Monetary and Banking Proclamation (Proclamation No.83/1994) and the Licensing and

Supervision of Banks and Insurance Companies (Proclamation No.84/1994). The former

proclamation provided increased autonomy and authority to the National Bank of Ethiopia (NBE)

to supervise the banking and insurance system in the country. The latter provided for participation

of the private sector in the banking and insurance business. Following liberalization of entry into

the banking and insurance sector, a separate supervision department was set up in early 1996

under the NBE to regulate and supervise the performance of all the banking and insurance

companies in the country. When the micro-finance institutions begun to emerge and function as

share companies, the supervision department of the NBE was also given the authority and mandate

to regulate and supervise the activities of micro-finance companies (see below).

Table 2.2. Distribution and share of banking business in Ethiopia, 2000 Bank Number of

Branches Share

Commercial Bank of Ethiopia (CBE) 170 55.02

Development Bank of Ethiopia (DBE) 32 10.36

Construction and Business Bank of Ethiopia (CBBE)

20 6.47

Awash International Bank (AIB) 22 7.12

Dashen Bank (DB) 20 6.47

Wegagen Bank (WB) 19 6.15

Bank of Abyssinia (BOA) 12 3.88

United Bank (UB) 7 2.27

Nib Bank (NB) 7 2.27

Source: National Bank of Ethiopia

As of 1995, the Housing and Saving Bank and the Agricultural and Industrial Development Bank

were restructured further and renamed Construction and Business Bank of Ethiopia (CBBE) and

Development Bank of Ethiopia (DBE), respectively. The distribution of banking and insurance

services in Ethiopia is mainly concentrated around major cities and urban business centres. The

government owned Commercial Bank of Ethiopia (CBE) with 170 branches is the largest banking

institution in the country. Available data indicate that, as of December 2000, there were 309 bank

branches throughout the country. The respective share of the banks in the total number of branches


9

across the country is shown in Table 2.2. Before the 1992 reform, on average the CBE alone

comprised more than 90% of the total deposits (while DBE’s share was 1.3%) and 71% of the

total loans advanced (DBE’s share being 16%). Despite the proliferation of private banks in the

post-reform period, their relative share in deposit mobilization and lending generally remained

very small, but grew from 6.3% in 1996/97 to 17.3% in 1997/98 (Geda, 2000).

In relation to the insurance sector, the government owned Ethiopian Insurance Corporation is the

largest insurance company in the country. The eight insurance companies in the private sector

have also started to expand in the country but most of the branches, like that of the banks, are still

concentrated around the major commercial centres, mainly Addis Ababa, Mekele, Dire Dawa,

Harar, Bahir Dar, Awassa, Nazareth and Jima. See Annex III for the regional distribution of the

banks and insurance companies in Ethiopia.

With regard to the provision of credit, the general trend since 1991/92, as opposed to the previous

years, has been a steady growth in lending to the private sector. The domestic credit disbursement

by commercial banks showed a growth in the share of lending to the private sector from 10.3% in

1991/92 to 62.7% in 1997/98. The sectoral distribution of formal lending from banks indicates a

very low share (less than 4% in any one year) for the agricultural sector (see Table 2.3). Lending

to the individual agents and micro-enterprises in the industrial sector has also been very limited.

The limited lending to the agricultural sector and micro-enterprises is contrary to the expressed

development policy of the country, which emphasizes the need to revitalize the agricultural sector

in order to transform and modernize the economy: agricultural development led industrialization

(ADLI). Capital and liquidity constraints are often raised as serious handicaps to the development

and revitalization of the agricultural and rural sector in the country. The limited lending to the

agricultural sector, which constitutes the back of the Ethiopian economy and provides means of

livelihood for over 80% of the population, is a reflection of the underdevelopment of the formal

financial system in the country. The poor infrastructure and lack of commercialisation of

production activities contribute to the weak development of the banking sector. The inadequacy of

the formal banking system to serve the majority of the smallholder farmers and micro-enterprises

in the rural and urban areas necessitates the establishment and promotion of the micro-financing

sector which caters to such needs even in remote locations.


10

Table 2.3. Sectoral breakdown of outstanding claims of commercial banks (% shares)

Sector

1993 1994 1995 1996 1997 1998

Agriculture 1.7 2.4 3 2.7 3.7 3.5

Manufacturing

- Small-scale1

21.9

0.5

15.6

0.4

8.2

0.4

7.3

0.5

8.1

1.1

8.0

1.5

Export 16.5 17.9 13.2 12 10.1 9.6

Imports 21.6 15.5 14.9 13.8 16.8 18.1

Construction 8.3 7.2 16.7 14.4 14.7 13.2

Domestic trade and services

24.8 35 39.1 38.3 39 36.5

Personal 0.7 0.4 0.2 0.2 0.2 0.2

Source: National Bank of Ethiopia 1 The small-scale industries part in the total loans to the manufacturing sector. The balance belongs to the large-scale industries.

2.2 The structure of the micro-financial system in Ethiopia

2.2.1 Saving and credit associations (SCA)

The (SCA) movement in Ethiopia started in the mid-1960s. The SCA were granted legal status by

the cooperative societies proclamation Act. No.241/66 issued in 1966. This proclamation

envisaged gradually converting the SCAs into credit union banks. However, new arrangements

were provided by the Cooperative Societies Proclamation (No.138/78), which annulled these

provisions. A special organ, mandated for registering and promoting SCAs, called the Savings and

Credit Cooperatives Development Office (SACCDO) was formed under the auspices of the

National Bank of Ethiopia. Under the support of SACCDO, SCAs were formed with a minimum

of 20 members having common occupation, residence or profession. As of 1996, a total of 578

SCAs with a membership of 129,216 persons were formed nation wide and mobilised up to 124

million Birr in savings, which is very small considering the enormous demand for credit in a

country of about 60 million during the period.3 Apart from providing credit facilities to members

3 However, most of the SCAs (53%) and SCA members (72%) were concentrated in Addis Ababa, showing very skewed distribution and urban bias in the formation of credit and savings associations (Degefe and Nega, 2000).


11

of the association, SCAs are expected to improve members’ knowledge about the importance of

banking services, financial management, entrepreneurial skills, and promote thrift and hence

serving as instruments of savings mobilization in the country. They were also expected to serve as

a link between the formal and informal financial sector.

In order to revitalise and reorganize the cooperatives, the Cooperative Societies Proclamation (No.

147/1998) was issued in 1998. Following this provision, the Savings and Credit Cooperatives

Societies (SCCS) are being reorganized under the auspices of the regional governments at various

levels starting from the grassroots level. Under the new arrangement, SACCDO has been

dissolved and the regional governments have taken over the responsibility of promoting and

supporting the formation of SCCS. All co-operative societies organised under the previous

proclamations are to be reorganized under the provisions of this new proclamation. At this stage,

no information is available regarding the size of the membership, the number of SCAs and the

amount of savings mobilized in the regions and across the country.

2.2.2 Micro-finance institutions

As indicated earlier, much of the micro-finance activity in rural Ethiopia is related to the provision

of input credit by the formal banks. Until 1994, the DBE was the only supplier of agricultural

input loan to small farmers. In 1997, the DBE terminated the provision of agricultural input loan

to rural households and started specializing in long and medium term credit. The CBE started

involving in the provision of input credit in 1994. Currently, CBE is not directly involved in the

provision of loan to small farmers. The CBE provides input loans to importers and wholesale

traders and regional governments. Before 1996, these banks were providing input credit mainly for

chemical fertilizer and improved seeds through the intermediaries namely Service Cooperatives,

Peasant Associations and farmers groups. The development and extension agents of the Ministry

of Agriculture working at grass-root levels assist the clients in processing their credit and

application of inputs. According to Adugna and Demeke (1999), owing to high defaults, which

seriously affected the liquidity position of banks, a new arrangement of input credit delivery and

collection has been introduced in 1996/97 (particularly for the new extension program) in the

regions. Under the new arrangement banks provide input credit to formers only after the regional

governments guarantee the loans. The CBE is not therefore involved in the collecting the loans


12

from the small farmers. In stead, the regional governments pay the CBE and recover all loans

directly from the farmers.

Although the DBE and the CBE have been providing micro-credit for agricultural inputs and tools

for rural households, credit schemes targeted for micro-enterprises and the rural and urban poor

were generally non-existent until recently when the NGOs initiated this program as part of their

humanitarian interventions in some parts of the country. The United Nations Development

Program (UNDP) recently sponsored a study on the performance of the credit and savings

schemes in the country (Degefe and Nega, 2000). The major findings of the study indicate that

most of the micro-credit programs implemented Grameen Bank type credit programs, which

employed a group lending approach to reduce problems related to moral hazard and adverse

selection in screening potential borrowers and repayment of loans. The group lending model

substitutes peer pressure and monitoring for asset collaterals to enforce repayment of loan. This

approach has been acclaimed throughout the world as a suitable and workable model for extending

credit services to otherwise resource-poor households, traditionally rationed out from formal credit

programs due to lack of assets that can be mortgaged for their loans. The majority of the NGOs

provided soft loans at very low interest rates in the areas affected by drought and famines. The rate

of interest varied between 3% and 10%. The average loan varied from about 100 Birr by Redd

Barna-Ethiopia to 10,000 per annum by CPAR and Action Aid-Ethiopia. Some of the NGO

sponsored credit programs also required compulsory savings and services were openly targeted

towards empowering women and the community. A study commissioned by the Christian Relief

Development Association (CRDA) on the micro-finance activities of NGOs in Ethiopia indicates

that the volume of loans outstanding from micro-credit programs provided by NGOs as of the end

of June 1998 amounted to Birr 42.5 million while the volume of savings stood at Birr 24.7 million

(GVCI, 1999).4

The effectiveness of micro-credit programs depends on their ability to target the poor, their impact

on poverty, and financial sustainability so as to continue the services without donor support. The

credit programs sponsored by the NGOs had played a significant role in relieving stress and

4 This estimate is based on the response of 59% of 142 NGOs included in the survey. The actual amount of outstanding loans and savings generated by micro finance activities of NGOs is likely to be higher than estimated in this study.


13

temporary shocks on rural communities caused by natural calamities. Since the NGO-based

interventions were motivated more by short-term humanitarian objectives rather than profitability

of their credit schemes, the majority of the programs lacked a clear vision and standard to ensure

sustainability of the programs. The NGOs did not follow sound banking and business practices

partly due to lack of professional staff capable of providing business and marketing services and

partly due to their non-profit oriented humanitarian motives. Most were happy to recover the

principal outstanding to maintain a revolving fund.

2.2.3 Emergence of formal micro-financing

The initiative to provide credit services to the rural and urban poor and micro-enterprises started

in the late 1980s when emphasis started to shift from agricultural producers’ cooperatives and

large scale parastatals to private small-scale enterprises. An urban-based pilot micro-financing

scheme started in 1990 through an agreement reached between the government and the

International Development Association (IDA). The scheme aimed employment generation and

improving the income of the urban poor in selected towns considered market and service centres

for the agricultural hinterland. Because of the unfavourable political environment that prevailed in

the country during the beginning of the 1990s, the pilot credit scheme started operation in 16

towns in 1994. The credit delivery model targeted women and the urban poor and employed a

Grameen type group lending methodology. The regional Trade and Industry Bureaus had the

responsibility of screening, organizing and licensing micro-enterprise operators into cooperatives.

The credit was then delivered to clients through the Development Bank of Ethiopia (DBE). The

scheme expanded its outreach and managed to cover about 60 towns across the country (Bediye,

1998; Degefe and Nega, 2000). The pilot micro-enterprise scheme was generally regarded as

successful although more integration between the licensing and lending institutions was needed.

The need for streamlining the pilot credit and micro-credit schemes initiated by various NGOs and

donor agencies in rural and urban areas started to become more visible in the mid-1990s.

Integration of the credit schemes initiated by local NGOs like the Relief Society of Tigray (REST)

and Organization for Rehabilitation and Development in Amhara (ORDA) into the formal

financial system contributed to the formulation of a regulatory and supervision framework for

efficient delivery of services to the urban and rural poor and the issuance of a new proclamation

for Licensing and Supervision of Micro-Financing Institutions (Proclamation No.40/1996) in


14

1996. Pursuant to this new provision, all the NGO based credit schemes and all those engaged in

micro-financing activities in cash or in kind have to be reorganized in terms of share companies,

fully owned by Ethiopian nationals and/or organizations as defined under Article 304 of the

Commercial Code of Ethiopia. The proclamation empowers the NBE to license, supervise and

regulate the activities of the MFIs. The legal and regulatory framework provided under

Proclamation No.40/1996 and various directives issued by the NBE are discussed in Chapter 3. As

of January 2001, 18 MFIs have been established and licensed by the NBE and started delivering

micro-finance services to the rural and urban poor.

Table 2.4 Active clients, share of women, rural and urban clients of MFIs in Ethiopia, January 2001.

Micro-finance Institutions Active clients

Women (%)

Rural (%)

Urban (%)

Amhara Credit & Savings institutions S.C 192,571 47 75 25

Dedebit Credit & Saving Institutions S.C 187,550 41 80 20

Oromia Credit & Saving Institution S.C (OCSI) 37,000 12 99 1

Omo Micro-finance Institution S.C 39,342 35 95 5

Specialized Financial & Promotional Institution 3,700 80 1 99

Gasha Micro-financing S.C 3,217 85 0 100

Wisdom Micro-financing Institutions 8,535 30 85 15

Sidama Micro-financing Institution S.C 4,286 60 90 10

Mekket Micro-finance Institution S,C 2,300 85 100 0

PEACE Micro-finance Institution S,C 974 62 100 0

Addis Credit and Savings Institution S.C 7,000 70 - 100

Eshet Micro-finance Institution S.C 516 54 70 30

Wasasa Micro-finance Institution S.C 562 31 69 31

Asser Micro-financing S.C 3,100 - 73 27

Africa Village Financial Service S.C 450 60 - 100

Buussa Gonofa Micro-finance S.C 2758 85 87 13

Meklit Micro-finance Institution S.C 1,001 73 - 100

Benishangul Micro-finance Institution S.C 425 60 100 -

Source: Compiled by authors based on fieldwork


15

As can be seen from Table 2.4, the Amhara Credit and Savings Institutions S.C (ACSI) and

Dedebit Credit and Savings Institutions S.C (DECSI) are the two largest MFIs in the country

having about 190 thousand active clients. Although ACSI has slightly more active clients, its

coverage of the credit-worthy population in its region of operation is much less than that of

DECSI (see Table 2.6). Only a handful of the MFIs, mainly operating in urban areas, have a policy

of deliberately targeting women clients. The Oromia Credit and Savings institution S.C has a

lowest proportion of women among its clientele while Gasha and Mekket had the highest. The

limited share of women in the MFIs may indicate the difficulties women face in finding reliable

partners in forming a solidarity group and developing a suitable business plan for their activities.

The outreach of Mekket, Sidama, PEACE, ACSI and DECSI to women clients in their

predominantly rural credit programs is very commendable. The other MFIs operating in rural

areas may need to learn from the experience and methodology of these MFIs if they want to

improve their services to rural women. All the largest MFIs now focus in the delivery of micro-

finance services to the rural poor as demonstrated by their active clientele residing in rural areas.

Only few entirely specialize in urban areas (Gasha, Addis, Africa Village, and Meklit).

Table 2.5 Potential demand for rural finance by the rural poor in Ethiopia (000 Birr) Region Loan demand for

petty trading1 Loan demand for animal husbandry2

Demand for input loan3

Total demand

Tigray 16,313 26,100 124,758 167,171 Amhara 77,125 123,400 728,062 928,587 Oromia 93,250 149,200 813,140 1,055,590 Southern Region 60,688 97,100 182,548 340,336 Afar 4,438 7,100 2,343 13,881 Harari 375 600 1,110 2,085 Dire Dawa 375 600 972 1,947 Somali 10,688 17,100 7,524 35,312 Gambela 938 1500 2,010 4,448 Benishangul 2625 4,200 17,640 24,465 Total 266,815 416,800 1,880,105 2,573,822 Source: Renee Chua Beroff et al., (2000)

1 The loan demand for petty trade is estimated by multiplying the active poor by the average demand for petty trade i.e., 250 Birr per individual. 2 The loan demand for animal husbandry is estimated by multiplying the active poor by the average demand for animal husbandry i.e., 400 Birr per individual. 3 Computed by multiplying the average input loan required in each region by the potential clients.


16

2.3 The Demand for Credit and Performance of MFIs in Ethiopia

2.3.1 Demand for Micro-Credit

Despite the strong realization of the role of micro-finance for poverty alleviation and stimulating

economic growth, no systematic and empirical study on the demand for micro- credit has yet been

carried out in the country. The limited capacity of the commercial banks and the infancy of the

micro-finance institutions in reaching out to the majority of the poor residing in remote rural

locations implies a large unsatisfied demand for credit especially in the rural areas. Small farmers

require credit for agricultural inputs (fertilizer, seeds, agricultural implements, improved breeds of

animals, feeds, veterinary drugs, bee keeping, etc.) and non-agricultural activities like small

businesses (grain and livestock trade, shop keeping, handicrafts, etc.). The demand for agriculture

related credit is likely to be concentrated around the planting and harvesting seasons, while that of

the off-farm activities is likely to be needed on the religious holidays and when some of the family

labour force is released from farm activities mainly during the dry season.

The preliminary studies carried out on the demand for credit reflect the obvious whereby an

enormous gap between supply and demand for micro-credit. The potential demand for rural

finance is estimated for each region based on the assumption that 50% of the rural households are

below the poverty line and hence are unable to finance their production and short-term investment

requirements from own sources. Of this, 80% of the poor are estimated to have at least one person

who is economically active and able to engage in income generating activities if credit is made

available. The demand for credit is estimated under three categories: agricultural inputs, animal

husbandry and petty trade (see Table 2.5). This analysis excludes demand for handicrafts and

other related micro-production activities. The number of poor demanding credit here assumed to

be 50% of the rural households may also be an under estimation as the majority of the households

may be cash constrained at least for part of the year. The demand of the urban poor and for micro

and small enterprises in urban areas is also not included. With this qualifications, the conservative

potential demand for rural credit in the country amounts to 2.574 billion Birr. Table 2.6 presents

the gap between the supply of micro-finance from the formal sector (MFIs and commercial banks)

and the potential demand for each region. Except for the regional state of Tigray where the DECSI

has been able to reach out widely (84% coverage of poor households), the rest of the regional

states have enormous unmet demand for financial services from the formal sector. The gap


17

between supply of credit from the formal sector and demand is about 100% in some of the regions

where the MFIs have not been established and where the commercial banks have not been able to

reach. On average, the micro-finance industry has satisfied 11% of the national demand, while the

CBE has met 19% of the demand. Jointly, the formal financial sector has satisfied less than one-

third of the potential demand.

Table 2.6 The unmet demand or gap of rural finance (in 000 Birr) by the rural poor, 1999

Region Total demand

Loan disbursed by MFIs

Coverage of MFIs (%)

Coverage of commercial bank (%)

Total formal sector coverage (%)

Unmet Balance (%)

Tigray 167.2 146,000 87 3 91 9 Amhara 928.6 71,260 8 16 24 76 Oromia 1,055.6 25,181 2 23 26 74 Southern Region

340.3 28,702 8 23 32 68

Afar 13.9 Harari 2.1 Dire Dawa 1.9 Somali 35.3 Gambela 4.5 Benishangul 24.5 Total 2,573.8 271,043 11 19 29 71

Source: Renee Chua Beroff et al., (2000)

2.3.2 Performance of MFIs

As stated above, a number of micro-finance institutions have emerged after the issuance of a legal

framework for running such businesses. Some of them were formed and licensed with the support

of the regional governments and local NGOs as shareholders. Others have been licensed with

individual shareholders joining hands with local NGOs and civic organizations. The foreign NGOs

and donors were instrumental in providing loan funds to the micro-finance share companies often

as a grant. The level of development of the MFIs in Ethiopia shows substantial variation from one

to another. Some are under formative stages while others have shown enormous progress in terms

of outreach, size of capital operated and mobilizing savings. The primary objective of the majority

of the MFIs and especially those share-owned by the regional governments remains to be

provision of financial services and poverty reduction. The need to reach out the rural and urban

poor has necessitated non-collateral based lending system whereby peer monitoring and pressure

is used for screening credit-worthy applicants and repayment of loans. The heavy focus on poverty


18

alleviation and welfare improvement through provision of subsidized credit and mobilizing

savings, an intervention policy inherited from the charity-based NGOs, which initiated micro-

credit programs in the country, seems to contradict with economic efficiency and financial

sustainability of the MFIs. The ability to find a workable balance between the goal of welfare

improvement and economic efficiency is likely to have a significant effect on the success of

micro-financing businesses in Ethiopia. However, no detailed investigation has yet been carried

out on the performance of MFIs, especially in relation to their outreach, impact on poverty, and

economic/financial sustainability.

However, some studies indicate that, in their brief period of existence, MFIs in Ethiopia have an

outstanding loan of Birr 273 million, reached out to more than 471, 966 clients with a cumulative

credit delivered amounting Birr 526 million, and have mobilized more than Birr 129 million in

savings (Amha, 2000). Some of the MFIs also involve themselves in the supply of input (fertilizer

and improved seeds) credit to farmers. The rural poor are the major clientele of the MFIs in

Ethiopia, about 44% of which are women. The majority of the MFIs still have an average loan

size less than 1000 Birr, indicating the poverty focus of the programs and the need to ration the

limited funds available for credit to several beneficiaries in remote areas of the country. As of

August 1998, the NBE has lifted the ceiling on interest charged on credit and the board of

directors of each MFI is mandated to set the appropriate rate of interest. The floor on interest on

savings and time deposits is set at 6% per annum. Many of the MFIs still charge an annual rate of

interest ranging 12.5 -25% per annum for the credit they provide to the poor. This rate of interest

is much lower compared with exploitative rates charged by the moneylenders in the informal

market (higher than 60% per annum). The reluctance to increase the rate of interest in the

deregulated financial environment seems to be paradoxical to the high operational costs in

reaching out to the poor in remote locations and in dealing with small loans for several borrowers.

The poverty focus of the micro-credit programs and the concern for the welfare of the borrowers

seem to have discouraged a drastic shift towards higher rates of interest thereby inducing the MFIs

to go slow through careful follow up and experimentation on the effect of increasing the rate of

interest on the demand for micro-credit and the profitability of loans provided to the poor.


19

2.4 Weaknesses of the financial system The recent annual report on the Ethiopian economy published by the Ethiopian Economic

Association (Degefe and Nega, 2000) outlines a number of shortcomings in the financial system.

A partial list of the shortcomings includes:

a) Inadequate supervisory capacity of the supervision department of the NBE, which has the

mandate to regulate and supervise the financial sector (banks, insurance and MFIs). The

supervision department is now organized under two units: the banking and micro-finance

unit and the insurance unit. The limited internal capacity of the department means that

much of the effort is spent in regulating and supervising the banking and insurance sectors.

The micro-finance sector has so far received limited attention, but efforts are now being

made to set up a separate unit dealing with micro-finance issues (personal communication,

head of the Supervision Department, NBE).

b) Poor repayment performance, particularly those owed by government owned banks. Legal

provisions are now in place in order to increase the capacity of the banks to recover their

loans. A proclamation to provide for property mortgaged or pledged with by banks

(Proclamation No.97/1998) has been issued to ease the legal process required in recovering

poorly performing loans. According to this provision, a creditor bank which has a claim on

property mortgaged or pledged with it, may sell the property by auction to recover its

loans.

c) Poor record keeping and financial management systems: Many of the banks and insurance

companies are striving hard to upgrade their data management facilities, but significant

improvements in efficiency can be attained by introducing appropriate technologies for

data management. The problem is more severe in relation to the micro-finance companies

operating in remote rural locations.

d) Shortage of technical skills: Apart from limited use of computerized facilities, shortage of

skilled human resources is a major handicap for the newly opened private banking,

insurance and micro-finance companies. Lack a specialized training program catering to

the needs of the financial sector is major handicap in finding skilled human capital. The

problem is more severe in the area of micro-finance where there is very limited experience

and knowledge.

e) Lack of competition: Except in the major commercial centres like in Addis Ababa, there is

lack a serious lack of a competitive environment for financial businesses across the


20

country. There is a tendency that only a single banking, insurance or micro-finance

company is operational in much of the country. The situation is even worse for the newly

emerging micro-finance institutions, which by and large followed a regional rather than

national focus in their areas of operation. Promotion of a more competitive environment

would be useful for improving efficiency and provision of quality and reliable services to

the populace.


21

3. Regulations and Supervision in Ethiopia

3.1 The rationale to regulate the micro-finance industry in Ethiopia International donors, NGOs, and the government in Ethiopia have supported the expansion of

credit services to the rural poor in the 1970s, 1980s and 1990s. The delivery of rural credit in

Ethiopia through conventional banks such as AIDB, renamed DBE in 1995, and CBE focused on

input loans delivered through the service cooperatives. Until 1994, AIDB was the only supplier of

agricultural input loan to small farmers. Since then, AIDB terminated the provision of agricultural

input loan to rural households and started specializing in long and medium term credit. Table 3.1

indicates that the performance of AIDB in the delivery of rural finance was a failure. It had the

highest repayment rate of 68% in 1988 and the lowest, 11% in 1993.

Table 3.1 Repayment rate, outstanding and arrears of rural credit of agricultural and industrial

development bank (1985-93)

Loan Portfolio (000 Birr) Year Repayment

Rate (%) Outstanding

(000 Birr)

Arrears

(000 Birr)

Arrears as % of

outstanding loans

1985/86 36 85,000 11,000 13

1987 55 81,000 29,000 36

1988 68 98,000 41,000 42

1989 63 114,800 46,300 40

1990 31 126,000 67,300 53

1991 47 123,263 120,762 98

1992 15 151,558 121,116 80

1993 11 198,711 176,900 89

Source: Tilahun (1995)

The arrears of AIDB have been progressively increasing which incurred significant amount of

losses. This has destroyed the credit culture in the country where farmers/borrowers have

developed wrong attitude and expectation of debt rescheduling or write-off. The heavy arrears

increased the transaction cost of AIDB (cost of loan administration, supervision and follow-ups).

The major reasons for the poor loan recovery performance include: (a) crop failure, (b)


22

unwillingness of borrowers to repay the loans viewing loans as grants or as political patronage, (c)

very weak system of credit delivery and collection mechanisms of the bank, (d) absence of

physical and social collateral, and (e) the loans were not tied with savings.

Micro-credit activities in rural and urban Ethiopia were also initiated by NGOs (local and

international). According to Pischke et al. (1996), there were 30 NGOs in Ethiopia who were

delivering micro-credit services, most of whom concentrated on urban areas. Although the NGOs

had contributed in testing innovative methodologies, and products, they had problem of mixing the

humanitarian objectives of the NGOs with the financial objectives of the micro-credit programs,

which lessened their effectiveness as business entities.

Each of the credit programs of these NGOs had their own philosophy and approach and challenges

in the delivery of micro-credit. The study of ACDI/CEE (1995) identified a long list of the major

shortcomings of the micro-credit schemes of NGOs in Ethiopia. These included:

• Real effective interest rates and fees did not cover the true cost of capital and program

operations, the inflation rate, a realistic loan loss reserve, and at least a modest return on

assets;

• Sound lending and collection policies and procedures were not developed or were

inconsistently or inadequately applied;

• Sufficient systems were not in place to verify borrower integrity and business skills;

• Lending was based upon NGO staff perceptions of borrower needs, rather than on sound

credit analysis;

• Loan terms did not reflect borrower repayment capacity, i.e; production sales cycles and

cash flow;

• Loans were provided without serious expectation of repayment and a realistic system for

collecting delinquent loans;


23

• Loan decisions were made based on inaccurate market or source of supply information;

• Risk in loan portfolio was insufficiently diversified by location, type of business activity,

number of borrowers, or aging of loans;

• Loan security or collateral was either not required, or if required, not exercised upon

default;

• Loan size was inappropriate for the borrower’s income producing opportunity; and

• In some cases, loans were granted to personal friends and relatives of loan officers or

influential community leaders. As a result staff will be reluctant to press for collection.

A study sponsored by USAID in 1995 clearly revealed that financial schemes of NGOs and

institutions that do not follow sound, sustainable financial principles and facilitate real community

economic growth might cause more harm than good (ACDI/CEE, 1995) because it encourages

financially responsible behaviour. Thus, any lending scheme must be designed to be self-

sustaining.

The study of ACDI/CEE (1995) recommended that the government should develop national

standards for NGO credit schemes or programs. Another study by Pischke et al. (1996) also

recommended that NGOs offering credit and other financial services should be subject to national

standards, and that adoption of appropriate standards could improve their performance.

In general, the micro-credit initiatives in pre 1996 (before the issuance of the micro-finance law)

in Ethiopia had the following limitations: -

a) The entire orientation of the micro-credit initiatives or activities in Ethiopia was

geared towards a project concept. NGOs and government projects involved in

micro-credit programs were not interested in establishing sustainable institutions,

which deliver diversified financial services to the poor.


24

b) Subsidized micro-credit programs in Ethiopia, with low lending interest rates,

created a problem in building sustainable institutions. The real interest rates in

these micro-credit programs were negative (the actual interest rates deflated by the

annual rate of inflation were negative). As a result, the loans were considered as

gifts instead of loans, which should be paid regularly. The micro-credit schemes or

programs were not able to cover the transaction costs of the lending agencies. As a

result, the lending agencies required a permanent subsidy to be sustainable.

c) The very high default, as indicated earlier (Table 3.1), was mainly the result of

borrowers seeing the lending organizations as donor funded or government funded

projects, which were providing financial services for a fixed period of time for

humanitarian reasons.

d) The employees of the lending NGOs and projects were not seriously concerned and

committed on loan recovery, but instead focused on keeping funds flowing.

e) The micro-credit programs of NGOs and projects concentrated entirely on the

provision of loan or credit. Saving was forgotten in the delivery of financial

services to the poor. The policy makers, development experts, researchers from

academics believed that poor people are too poor to save. This is contrary to the

latest empirical evidence from micro-credit programs that link access to credit with

compulsory and optional savings. Access to credit is likely to have raised the

ability of the poor to save. In other cases, the poor are compelled to save to

maintain access to scarce operating capital.

f) Saving was not considered to be a viable as a source of loan capital. Donors were

considered as the only source of loan funds, which actually encouraged

dependency. The lending institutions were not sustainable because they relied on

external funding for loan funds. The low interest rates on loans also discouraged

the beneficiaries from starting savings. As a result, the micro-credit programs in

Ethiopia failed to promote a culture of thriftiness and saving.


25

g) In general, AIDB, NGOs and cooperatives which delivered financial services to the

urban and rural poor before the issuance of regulatory law in 1996 were not in

reality financial intermediaries, but rather tools of distributing donor or government

funds to a target population in order to increase production and incomes.

Given the above problems of default in AIDB, NGOs and the collapse of the service cooperatives,

it was time for the policy makers and individuals involved in development activities to rethink and

redesign new strategies for delivering financial services to the poor through sustainable

institutions. This required a redefinition and reorientation of the mission, vision and objectives of

the lending institutions that usually provided only micro-credit services. The most important

change of direction was building a sustainable financial service delivery system followed by

mobilizing savings, charging reasonable interest rate on loans sufficient to cover operational costs,

apply strict financial discipline through strict recovery discipline, developing proper lending

methodologies, reducing transaction costs and increasing outreach. The experiences of some

sustainable micro-finance institutions in Asia, Latin America, and Africa were useful in directing

the changes in the delivery of financial services to the poor in Ethiopia

Based on the development of the micro-finance industry at national and global level, Ethiopia took

the direction of building more sustainable micro-finance institutions in order to deliver financial

services to the poor. This required promoting financial institutions operating on sound commercial

principles that can attract private capital investment and private savings in order to increase

outreach and expand funding on a sustainable basis.

The need to promote more sustainable micro-finance institutions in Ethiopia necessitated a

regulatory framework. Therefore, prudential regulation and supervision of the micro-finance

institutions was a critical issue to the development of the micro-finance industry. This need has

brought the activities of the MFIs under Ethiopia’s monetary and financial policy framework.

Although regulation contributes to the stable and efficient performance of the micro-finance

institutions, regulation and supervision also entail significant costs.


26

There is consensus among practitioners that enabling regulation and supervision of MFIs is a

means of promoting and guiding the development of MFIs (MBP, 1999a). Here, regulation and

supervision refers to the body of laws and practices that define the rules of the game for the safe

entry, operation, and exit of actors in the financial system, thus ensuring the safety, soundness, and

effectiveness of the financial market on behalf of the public.

According to Chaves and Gonzalez-Vega (1993), regulation of MFIs refers to government

regulation, which should serve three basic goals. The first one, macroeconomic in nature, is to

ensure the solvency and financial soundness of all intermediaries, in order to protect the stability

of the country’s payments system. The second objective is to provide consumer protection against

undue risks of losses that may arise from failure, fraud, or opportunist behaviour of the suppliers

of financial services. The third goal of financial regulation is to promote the efficient performance

of institutions and markets and the proper working of competitive market forces.

The theoretical foundation for regulation in general is the new institutional economics, which is

centred on the theory of asymmetric and imperfect information in relevant input and output

markets. Supervision of MFIs consists of the examination and monitoring mechanisms through

which the authorities verify compliance with regulation and determine the actual risks faced by an

intermediary.

Currently, there is an increasing recognition of the importance of the micro-finance industry as a

component of the overall financial system its role in serving a huge portion of the Ethiopian

population. There is a growing acceptance of the role and effectiveness of micro-finance in

poverty alleviation. With the increase in the number of micro-finance institutions and MFIs taking

voluntary deposits from the poor, the issue of regulating and supervising the micro-finance

industry becomes even more important. The main motives of regulating the micro-finance industry

in Ethiopia include:

• Promoting the micro-finance industry to alleviate rural poverty,

• Protecting the safety of the depositors,

• Raising barriers to NGOs which mix charity and delivery of financial services,

• Introducing strong financial discipline in the delivery of financial services to the poor,


27

Ensuring the safety of clients and building healthy institutions for the development of the financial

sector appears to require micro-finance regulation and supervision compatible with the objective

conditions of Ethiopia. The specific characteristics of micro-finance institutions imply that micro-

financing businesses face a higher risk portfolio than conventional banks. These characteristics

include provision of financial services to the poor with numerous repeated loans, lack of collateral,

high transaction and operating cost per loan or deposit, and covariate risk among homogenous

group of borrowers. The high-risk profiles of MFIs will increase the importance of regulation and

supervision in the industry.

In the micro-finance industry in Ethiopia, the NBE has been given the legal power to supervise

MFIs, grant and revoke licenses and maintain confidence in the safety of deposits by setting

appropriate requirements and ensuring that institutions are sound, with enough capital and

earnings to cover operational costs and risks, and maintain enough liquidity to meet client

withdrawal demands.

3.2 Main Features of the Regulatory Framework in Ethiopia There are different government policies, laws and directives that affect the development of micro-

finance industry in Ethiopia. These mainly include Proclamation No. 83/1994, Proclamation No.

84/1994, Proclamation No. 40/1996 and the 12 directives issued by the NBE as per the provision

of Proclamation No. 40/1996.

Proclamation No. 83/1994, the Monetary and Banking Proclamation, directed that the NBE of

Ethiopia has the authority to license, supervise and regulate banks, insurance companies and other

financial institutions. The other financial institutions in the proclamation include, postal savings,

saving and credit cooperatives and other similar institutions engaged in any type of banking

business.

Proclamation No.84/1994, the Licensing and Supervision of Banking Business Proclamation,

provides that only incorporated institutions may conduct banking business, and only if they are

licensed by the NBE. As stated earlier, the proclamation allowed, for the first time, the

establishment of private financial institutions, thus breaking the state monopoly in the banking and


28

insurance business. To date, six private banks and eight private insurance companies have been

established. The proclamation precludes foreign nationals from conducting banking business in

Ethiopia, and prohibits anyone from owning more than 20% of the share of the banking

companies. Obviously, foreign banks could have increased the inflow capital to the country and

brought expertise, improved management, and new technologies in banking practices that would

improve the efficiency of services and increase competition. However, currently given the limited

experience and infancy of the newly established private banks, the foreign banks may deny them

the opportunity to succeed in the market under free competition. This suggests the need to allow

some time before permitting foreign banks to invest in Ethiopia to provide sufficient time for the

younger local private banks to build their capacity to compete in a competitive market economy.

Moreover, the Supervision Department of the NBE should be given time to build its capacity in

supervising foreign banks.

Since Proclamation No. 83/1994 and Proclamation No. 84/1994 did not address the delivery of

sustainable financial services to the poor, issuing a separate law for micro-finance institutions was

deemed necessary. Proclamation 40/1996, the Licensing and Supervision of Micro-financing

Institutions Proclamation, was therefore issued to provide for the licensing and supervision of the

business of micro-financing businesses in Ethiopia. The proclamation empowered the NBE to

license, supervise and regulate the delivery of financial services to the rural and urban poor

through micro-finance institutions. The proclamation defines a micro-financing business as “an

activity of extending credit, in cash or in kind, to peasant farmers or urban small entrepreneurs”.

The proclamation sets out the ground rules for carrying out the business of micro-finance in the

country. For this reason, it is hereafter referred to as the ‘micro-finance law’ of Ethiopia. It is a

landmark in establishing a proper legislative and regulatory framework for the micro-finance

industry in the country. It is expected to improve access to credit to the rural and urban poor, raise

saver confidence, and help towards better integration and the orderly functioning of the financial

delivery system in Ethiopia. It must be noted that producing and implementing the regulatory

framework is not a panacea for the major constraints in the delivery of financial services to the

poor. However, it is one of the important elements and a precondition to create well-managed and

permanent financial institutions in Ethiopia. The regulatory framework assists MFIs in Ethiopia to

strengthen their organization and operate as prudent and effective financial intermediaries.


29

In what follows, we shall outline and discuss the major features of the Proclamation 40/1996 (fully

reproduced in Annex IV) and the 12 directives of the NBE, which are serving as the regulatory

framework of the micro-finance industry in Ethiopia.

3.2.1 Entry into the micro-finance industry

Directive No. MFI/01/96 states that MFI applying for a license shall have a minimum paid up

capital of Birr 200 thousand.5 Due to the deliberate interest of the government to improve entry

into the micro-finance industry, the minimum capital requirement is relatively low. Since MFIs in

many African counties such as Kenya, Uganda, Tanzania, etc are not legally permitted to mobilise

savings, they are required a higher minimum paid-up capital. Those applying for license from the

NBE are also required to submit memorandum and articles of association of the company, a

business plan, and the curriculum vitae of board of directors (BOD) and the chief executive officer

(CEO).

3.2.2 Ownership

Proclamation No.84/1994 instructs that financial institutions (including MFIs) formed as

companies should be fully owned by Ethiopian nationals. As stated earlier, Ethiopian law requires

that licensed micro-finance institutions should be established as share companies. As defined

under Article 304 of the commercial code, the capital of a share company should be fully owned

by Ethiopian nationals and/or organizations wholly owned by Ethiopian nationals and registered

under the laws and have its head office in Ethiopia. The commercial code of Ethiopia indicates

that a share company is a company whose capital is fixed in advance and divided into shares and

whose liabilities are limited to the assets of the company. The members shall be liable only to the

extent of their share holding. Only members of a company may manage the company. A company

shall have not less than three or more than twelve directors who shall form a board of directors. In

this regard, the micro-finance law has the intention of creating business like shareholders and

board of directors who control, guide monitor the activities of the micro-financing business as a

private company.

5 For simplicity, all currency units are given in Ethiopian Birr. The official exchange rate in January 2001 is about 8.3 Birr for 1 USD.


30

Although the Proclamation clearly indicates that the shareholders are investors who buy shares

from their own resources, the reality in the micro-finance industry in Ethiopia tells us that the

shareholders in the MFIs are nominal shareholders who are not investing their own capital. The

shareholders in the Ethiopian MFIs are individuals, regional governments and local NGOs, which

include humanitarian and civic organisations (see Table 1.1). This indicates the absence of private

capital in the industry and dominance of shareholders who may not have strong economic

incentives to strive for excellence and serious interest for the success of the micro-financing

business. Moreover, the MFIs deliver loans much higher than their paid-up capital and savings

mobilized because of the continuous flow of grants from donors. Some of the MFIs like ACSI and

DECSI have also started inter-MFI lending at the prevailing deposit rate of interest in the

conventional banks.

3.2.3 Corporate management

Directive No. MFI/03/96 of the NBE has clearly indicated the criteria for selection of officers and

directors of MFIs. The directive requires that the CEO of MFI should have at least a first degree in

a relevant field of social science and a minimum of three years experience in a senior post in a

financial institution and should be older than 30 years. Board members of MFIs should at least

have completed secondary school and preferably have some managerial experience and should be

older than 25 years. The problem here is that the nominal shareholders might not have the right

mix of professionals to serve in the BOD. Given the current objective condition in Ethiopia and

serious shortage of trained manpower in the areas of business administration and financial

management, it may be difficult to require more than the qualification stated on the directives.

Lowering the educational requirements and lack of skilled managers and board members can,

however, have serious implications for the success of the micro-financing business.

3.2.4 Operational modality

Under an article on ‘special responsibility’ the 1996 micro-finance law asks MFIs to reach out to

the rural poor in the delivery of credit services in a manner in which group guarantee will

substitute for property collateral. The article, however, fails short of decreeing group lending as

the only means of providing credit to the poor. The lending institution is given only a special

responsibility to find ways and means to avoid property collaterals. There is a general

understanding among the practitioners that this article prohibits individual lending and other


31

lending approaches. As would be discussed later, lack of a legal mechanism for MFIs to recover

loans using mortgaged property and absence of an appropriate institution authorized to register

such property pledged or mortgaged by the borrower to guarantee the loan is a serious problem de

facto prohibiting individual lending with collateral requirements by MFIs. This legal provision

now exists for the conventional banks (Proclamation No.97/1998).

Directive No. MFI/05/1996 states that loans extended to any one borrower by a licensed MFI shall

not at any time exceed Birr 5,000 and should be paid back during a single loan period of not more

than 12 months. However, the lending institution may reschedule loans based on repayment

performance and the nature of the enterprise for which the loan is provided.

3.2.5 Delivery of financial services

The micro-finance law specifies that MFIs could be involved in the delivery of micro-credit,

accept savings as well as demand and time deposits and engage in other activities customarily

undertaken by micro-finance institutions. The proclamation defines deposits as any regular or

irregular savings, which may be withdrawn partially or totally at anytime by the account holder.

All MFIs in Ethiopia provide loan and saving products to clients. Some MFIs such as ACSI and

DECSI have even started delivering other financial products such as money transfer services and

pension funds to pensioners in some localities. Very few MFIs offer non-financial services (SFPI

and Meklit) where the cost is covered from donor grants. Moreover, MFIs have to make 100%

provisions for loans overdue for more than one year and 50% provisions for loans in arrears for

more than six months.

3.2.6 Interest rate

The interest rates of MFIs were revised four times by the directives of the NBE. Initially, the NBE

issued Directive No. MFI/09/96, which determined the lending and saving interest rates of MFIs.

According to this directive, the maximum lending interest rate of MFIs should not be higher than

2% above the maximum lending interest rate charged on loans extended by formal banks. The

maximum lending interest rate was, therefore, set at 12.5% per annum. The minimum interest rate

on savings and time deposits shall not be less than 1% below the minimum interest rate paid on

such deposits by formal banks. Thus, the minimum savings interest rate for MFIs was set at 7%

per annum. In May 1998, the NBE increased the ceiling of the lending interest rate of MFIs to


32

15.5 % per annum (Directive No. MFI/10/98). However, both directives did not state whether the

lending interest rate of MFIs would be a flat rate or increasing rate. In June 1998, the NBE entirely

removed the ceiling on the lending interest rate of MFIs. Directive No. MFI/11/98 decreed that the

board of directors of each MFI could set their own lending interest rate. The minimum interest rate

on savings and time deposits remained at 7% per annum. Directive No. MFI/12/98 was later

introduced to reduce the minimum interest rate on savings and time deposits from 7% to 6% per

annum. MFIs today are free to set their own lending interest rates. Table 3.2 shows the rate of

interest charged by the MFIs in Ethiopia.

Despite the lifting of the ceiling rate of interest on loans, the majority of the MFIs have chosen to

maintain a lower rate of interest. This may reflect the concern of the BOD of these MFIs about the

effect of high rate of interest on the profitability of investments by the poor. Regarding the rate of

interest on savings and deposits, the majority of the MFIs offer the floor interest rate of 6%

although some even offer a rate of interest close to that of the conventional banks. We shall

discuss the details about the rationale and implications of these interest rates for financial

sustainability of the MFIs in the following chapter.

3.2.7 Reporting

Reporting is one of the tools to supervise MFIs in Ethiopia. MFIs are required to submit quarterly

reports of income statement, balance sheets, reports on loan, savings and provisioning to the NBE

(Directive No. MFI/07/96). However, the relatively larger MFIs have not reported regularly

because of their vast geographical coverage (e.g. the entire districts of Tigray (DECSI) and

Amhara (ACSI) and 42 districts of Oromia (OCSI)), and the weak management information

system (MIS) they use. As a result, complete and timely reporting was difficult for some of the

MFIs. Building a networked MIS and using appropriate software will improve timely reporting

problems. The regular on-site supervision is expected to verify the reports submitted by the MFIs.

However, given the limited capacity of the Supervision Department of the NBE, it has only made

five on-site supervisions so far by sending the inspection team to perform the evaluation.


33

Table 3.2 Active clients, average loan size, rate of interest on loans and saving/deposits for MFIs in Ethiopia, January 2001. Micro-finance Institutions

Active clients

Average loan (Birr)

Interest on credit (%) per annum)

Interest on Deposits and savings1

Amhara Credit & Savings Institution S.C 192,571 900 12.5 6

Dedebit Credit & Saving Institution S.C 187,550 600 12.5 6

Oromia Credit & Saving Institution S.C 37,000 1,000 12.5 8

Omo Micro-finance Institution S.C 39,342 600 12.5 6

Specialized Financial & Promotional

Institution S.C

3700

1,000

16

7

Gasha Micro-financing S.C 3,217 800 13 6

Wisdom Micro-financing Institution S.C 8,535 755 14.5 6

Sidama Micro-financing Institution S.C 4,286 1,800 15 6

Mekket Micro-finance Institution S,C 2,300 400 25 6

PEACE Micro-finance Institution S,C 974 682 12.5 6

Addis Credit and Savings Institution S.C 7,000 1,300 12.5 7

Eshet Micro-finance Institution S.C 516 500 24 6

Wasasa Micro-finance Institution S.C 562 498 24 6

Asser Micro-financing S.C 3,100 750 16 7

Africa Village Financial Service S.C 450 1500 16 -

Buussa Gonofa Micro-finance S.C 2758 - 24 8

Meklit Micro-finance Institution S.C 1,001 700 16 6

Benishangul Micro-finance Institution S.C 425 - 12.5 6

Source: Compiled by the authors based on the field Survey

3.2.8 External audit

The micro-finance law states that an independent auditor acceptable to the bank prior to the

payment of dividends to shareholders shall audit the accounts of MFIs annually. Some MFIs have

started auditing their accounts by external auditors. However, the external audits were rarely

undertaken annually. This partly reflects the high costs of external auditors and the weakness of

the regulatory agency to enforce the laws. The NBE should insist on annual external audit, which

could serve as one of the tools of supervision and add significant value to MFIs with complicated


34

financial structures. Unless they are forced by law to carry out external auditing, the majority of

the MFIs may see the external audit as drain on their hard earned resources.

3.2.9 Branching out and outreach

The directive of the NBE (Directive No. MFI/07/1996) indicates that MFIs can open branches

without prior approval of the NBE. Micro-finance institutions are only required to inform the NBE

in writing about the opening of a new branch not later than 15 days after the commencement of

operation. The report should specify the full address of the branch, the date of commencement and

provide an overview of the economic conditions in the area of operation. The later is intended to

provide information to assess the risk portfolio that MFIs face in their areas of operation.

However, MFIs can only close a branch after obtaining approval from the NBE. The application

for closure of a branch office should be submitted to the NBE at least three months prior to

conducting the intended closure of the branch office.

3.2.10 Taxable status

There is no clear government directive on tax exemption for the micro-finance industry.

Proclamation 40/1996 states that the Ministry of Finance is empowered to determine the period,

manner and conditions of exemption of micro-finance institutions on income tax.

3.2.11 Re-registration

As per the micro-finance law, the MFIs in Ethiopia should re-register when the savings mobilized

reach the Birr 1 million mark. Some of the micro-finance institutions such as DECSI and ACSI

have already mobilized Birr 90 million and Birr 52 million in saving, respectively, and yet have

not been required to re-register as per the legal requirements. This has to do with the capacity of

the Supervision Department of the NBE to enforce the regulatory framework.

3.2.12 Supervision

During the era of central planning, there was no need and no department to supervise the financial

sector as all the banks and insurance businesses were owned and controlled by the government.

The NBE was only responsible for enforcing administrative control. With the emergence of

private banks and insurance companies after liberalization of these markets for private investors,


35

the need for prudential supervision became more apparent. To this effect, the Supervision

Department of the NBE was established in 1994 to supervise banks and insurance companies. The

micro-finance supervision also falls under the unit responsible for supervision of the banks. The

other unit is charged with inspection and supervision of the insurance sector.

The supervision of MFIs in Ethiopia involves both off-site and on-site supervision. In the off-site

supervision, MFIs are requested to report regularly to the Supervision Department of the NBE.

Introducing computerized MIS could facilitate the off-site supervision. Supervision on the spot

(on-site) supervision is also very important to verify the qualitative and quantitative information

provided by the financial institutions in their reports. The on-site supervision also helps to gain

insight about the economic conditions in the area of operation and data collection method and the

professionalism of management and staff of the MFIs.

The methods and processes used to supervise MFIs and conventional banks by the supervision

department of the NBE are very similar. However reserve requirement, liquidity ratio, capital

adequacy ratio and collateral assessment, which are used in supervising the conventional banks,

are not used as tools of supervising the MFIs in Ethiopia. The issue here is that since the risk

portfolios of the conventional banks and MFIs are different, the micro-finance industry should

have appropriate tools, which are based on the understanding of the risk features that characterize

the micro-finance industry. Moreover, although there seems to be clear criteria to control entry in

the industry, there is no clear exit policy from the industry. The main problems in the supervision

of MFIs include delays in reporting, absence of sound loan loss provision, write-off policies and

limited capacity of the NBE.

3.3 Comparing the Ethiopian Legal Framework with Other Countries Many of the African countries are in the process of drafting the regulatory framework for the

micro-finance industry. Ethiopia is one of the very few countries with a well-defined regulatory

framework for the micro-finance institutions. According to MBP workshop report (MBP, 1999a),

many African and Central American countries in particular are in the midst of financial sector

reform processes. Like Ethiopia, Brazil, Gambia, Morocco, West African countries, Nepal, and

Peru are examples of countries that already have passed specialized laws for the creation of


36

regulated micro-finance institutions. Countries revising draft micro-finance laws, among others,

include Uganda, Tanzania, Kenya, Zambia, El Salvador, Honduras, and Nicaragua (MBP, 1999a).

In this section an attempt is made to compare the major elements of the regulatory framework of

Ethiopia with the experiences of West African countries. The West African countries are one of

the very few countries with relatively well-defined regulatory framework. It should be also noted

that there are no micro-finance laws, which could be referred as best practices in the world. Some

comparison of the Ethiopian regulatory framework is made with the experiences of other countries

such as Tanzania, Zambia, Morocco, Nepal, Bolivia, Brazil, Honduras and Peru (see Annex V for

the details).

During the 1980s, the banking crisis in the West Africa Economic and Monetary Union (UEMOA)

led to the virtual disappearance of banks from the rural and urban areas (Berenbach and Churchill

1997). A wide range of informal financial institutions emerged to fill the gap and deliver the

financial services to the poor. As these financial institutions grew, the Central Bank of the West

Africa States (BCEAO) started designing an appropriate regulatory framework.

In June 1992, the Central Bank of West African States6 (BCEAO) started launching a program in

order to establish and implement a regulatory framework for the delivery of financial services to

the poor. The Central Bank received significant amount of support from donors, particularly from

the Canadian International Development Agency (CIDA) to draft, train, discuss, implement and

follow-up the regulatory frameworks. The law was adopted in December 1993 and ratified later by

the eight member countries (Anne-Marie and Gallade 1997).

Initially, BCEAO was mainly designing a regulatory framework for mutual institutions (credit and

saving cooperatives). Later on, as a result of consultations with micro-finance institutions and

donors, the coverage of the law was modified to include other types of institutions, which deliver

financial services to the poor. These included village banking, solidarity and individual lending

models. In this law, each MFI should adopt the credit union structure within a two years period or

it must receive special permission to operate from the Ministry of Finance of the respective

6 Eight member countries include: Benin, Burkina Faso, Ivory Coast, Mali, Niger, Senegal, Togo and Guinea Bissau


37

country. The law classifies all micro-finance institutions in West African countries into the

following three categories (Anne-Marie and Gallade 1997).

Category I: This group contains what are called mutualist institutions (proper saving and credit co-

operatives). The law states that mutualist institutions should adhere to the mutualist principles and

structures including: (i) membership must be voluntary and not limited; (ii) the governance

structure must be democratic and based on one vote per member; (iii) votes by proxy are not

authorized except under exceptional circumstances; (iv) dividends on shares are limited; (v) the

creation of a general reserve is obligatory and can not be shared among members; and (vi) priority

should be given to actions aimed at the economic and social education of members.

Category II: This group contains the saving and credit associations, institutions designed as

cooperatives or mutuals, but do not fully adhere to the principles outlined in Category I. They are

not governed by the law, and have no legal status. These institutions must legalize their operations

by seeking recognition from the Ministry of Finance under the condition set forth by the decree of

application.

Category III: This includes all other institutions (including MFIs). All other institutions that

conduct saving and/or credit activities must either register under the banking law or obtain

approval to operate through a special convention “Convention Cadre” from the Ministry of

Finance.

The law establishes a distinction between pure and mutual system and other types of structures. It

defines the principles and structures of the mutualist institutions that must be adopted by any

institution seeking recognition and approval from the Ministry of Finance. Institutions that are not

structured along these lines are given the choice either to modify their operation by-laws and be

regulated as a credit union or to operate without any legal protection and obtain a license from the

Ministry of Finance otherwise they face sanctions that can include prison sentence. After the law

was drafted, series of training, round table meetings and workshops were organized by BCEAO to

discuss the law (Anne-Marie and Gallade 1997). Table 3.3 compares the basic elements of the

legal framework of West African countries and Ethiopia. The regulatory framework of the West

African countries emphasized the first category (proper saving and credit co-operatives). The non-


38

mutualist institutions (category II and III) including MFIs are not fully covered by the laws. The

MFIs are boxed into a legal framework, which has the main objective of promoting the saving and

credit co-operatives. This resulted in confusion on the legal status of category II and III. The law is

also rigid for the mutualist institutions. The law does not promote the delivery of financial services

through MFIs. For example, since the law requires the MFIs to comply with the usury law, which

puts ceiling on lending interest rates, it restricts the MFIs from setting reasonable interest rates to

cover their costs. The law requires huge resources and capacity of the supervision authority, which

is very difficult in many of the African countries.


39

Table 3.3. The basic elements of the regulatory framework of West African countries and Ethiopia

Regulation and Supervision in West Africa Regulation and Supervision in Ethiopia

1. Objectives

To regulate the activity of credit and saving unions, MFIs, village banks

To regulate only MFIs. Cooperatives such as saving and credit cooperatives are not included in the law

2. Date of MFI law Adopted in December 1993 and ratified by the eight West African countries (with the exception of Benin) in May, 1997

In 1996

3. Implementing Institution The Central Bank of West African States (BCEAO), however, it is the individual country’s Ministry of Finance with a special unit called CAS/SMEC which has the mandate to supervise

Supervisory Department, National Bank of Ethiopia, is legally empowered to supervise the micro-finance industry

4. Initiatives Donors such as CIDA and offered USD 3.75 million to implement and follow up the regulatory framework

Initiated by the Ethiopian government

5. Participation of stakeholders The stakeholders were trained and discussed the law in a series of round table meetings, seminars, and workshops

Limited training and discussions on the regulatory framework

6. Classification of MFIs The law classifies the micro-finance institution into three categories, namely: (a) mutualist institution (b) saving and credit cooperatives (c) other institutions.

The regulatory framework does not have any classification or categories (with the exception of re-registration requirement for MFIs which mobilize savings of more than Birr 1 million)

7. Allowed function Credit and Saving

Credit, saving, money transfer, and other micro-finance activities

8. Other options There is escape valve for credit union to operate without any legal protection by obtaining licenses from the Ministry of Finance

Saving and credit cooperatives are not supervised by the NBE and not governed by the micro-finance law. License given by the regional cooperative bureaus.

9. Taxes Exempted from all forms of taxes

There is no clear policy decision on taxes. The law only indicates that this will be determined by the Ministry of Finance

10. Control Expected annual external audit

Expected annual external audit

11. Minimum capital requirement No minimum capital requirement to mobilize savings

A minimum capital requirement of about USD 24,000 (Birr 200 thousand) to get the license


40

Table 3.3. The basic elements of the regulatory framework… (cont.)

Regulation and Supervision in West Africa Regulation and Supervision in Ethiopia

12. Prudential ratios a) Mutualist (proper saving and credit co-operatives) - Limits equity investment to 5% of the institutions loan

portfolio - Outstanding credit portfolio to twice the amount of

members savings excluding resources available from donors

- Allocated 15% of net surplus at the end of each fiscal year to a general reserve fund - Loan to one individual must not exceed 20% of the value

of member depositors - Loans to one member can not exceed 10% of the value members deposits - Liquidity where short term assets must equal 80% of short term liabilities at all times

The activities of saving and credit cooperatives are not regulated by the micro-finance law

b) b) Non-mutualist - The convention cadre does not give clear legal status for

the non mutualists - The convention cadre does not provide any protection to

savers

-The MFIs do have clear legal status and the savers are protected by the law -Submit annual reports

c) Other institutions (MFIs) - No prudential ratios - Regularly send annual reports - They are subject to the law on usury

13. Interest rate The three categories are subject to the law of usury where it sets the ceiling on interest rate as twice the discount rate.

- No limit on the lending interest rate - 6% is the lower limit for interest rates on savings

14. Loan ceiling - No loan ceiling

- Loan ceiling of about 5000 Birr (600 USD)

15. Loan term - No specific loan term

- Loan term of one year

16. Methodology Different lending methodologies are used in different countries and within a given country

- Group lending and group collateral

Source: Compiled by the authors for this study


41

4. Regulatory and Supervision Issues for Micro-finance

4.1 Governance In the context of micro-finance, governance is the process through which the board of directors of

MFIs guide the business in fulfilling its corporate mission and protect the assets of the institution

overtime (Campion and Frankiewicz 1999). Any attempt to study the governance of a micro-

financing business has to look into the role of the board members, board composition,

commitment of board members, and issues of ownership, trust and conflict of interests. In the

Ethiopian context, there are strong and committed boards of directors but there are also very weak

ones. The CEOs of MFIs want strong board to provide guidance to their organizations. As a result

some of the MFIs are in the process of restructuring the board in order to give them greater

responsibility. The core problem of governance of MFIs in Ethiopia is that the board members are

not formal owners with no capital investment to lose. The board mix does not meet the quality

required to guide the MFI. In this case, having a technical advisory group could support the board

and management of an MFI.

Since many of the micro-finance in Ethiopia are transformed from NGO credit schemes to MFIs,

the founding or mother NGOs are the real owners of the institutions although the local NGOs and

individuals may have become nominal owners to satisfy the legal requirements. This type of

ownership creates a complicated governance and board structures. So far, there is no private

capital invested in the Ethiopian micro-finance companies. The capital of MFIs is mobilized from

donors, prohibited by law from becoming shareholders and sit in the management of the micro-

financing company. Hence, the foreign NGOs are considered as donors supporting the MFI

without having a direct influence in its day-to-day activities. As will be discussed later, this has

created a problem in corporate governance and discouraged the wider participation of foreign

NGOs and donors in providing credit services to the poor.

4.1.1 Ownership

Owners are expected to provide appropriate leadership and guidance to the operations of MFIs. In

conventional commercial banks, private investors own and finance the banks from their private

pockets. The owners of the bank, through the board of directors, are interested to improve

efficiency and earn profits after covering all costs. To get this financial return, the board will


42

seriously watch the performance of the bank, minimize risk, and follow the safety of the bank. On

the other hand, the supervision cares about capital adequacy ratio, not just to provide a cushion in

time of problems, but also to insure that the owners continue to have enough incentives to watch

management of MFIs closely.

It is this incentive structure of the private investors that results in self-initiated effort for

excellence and enforcement of strict self-discipline and supervision regarding the financial health

of a private firm. The regional government and local NGOs are the major owner of the MFIs in

Ethiopia. Due to the low expected returns to investments (primarily due to high operating costs

and high risk portfolio), micro-financing businesses in Ethiopia have yet to become attractive for

private investors. The board members now represent government offices, local humanitarian and

civic organizations, and private individuals (mainly nominal owners). Although one may expect

representatives of public offices and civic organizations may have the interest to improve the

operation of micro-financing businesses, it is unlikely that individuals as nominal shareholders

will have the necessary incentive to strive for excellence and success of the company. In the latter

case, the individual nominal owners do not have much to gain or to loose from the operation of the

concerned MFI. However, individuals with altruistic motives or strong commitment for improving

the welfare of the public or those having strong association with the mother donor NGO could

demonstrate strong interest to improve the governance and operation of the company. It should be

noted here that one should not own the company to be an interested and efficient manager. What is

really needed is a system of proper incentives rewarding success and penalizing failures.

The individual shareholders registered by the NBE are not real shareholders; this is not a secret for

the NBE. Given the high operational costs, high risk profile and low returns to investments in

areas where markets are poorly developed, micro-financing businesses will requires initially

strong donor support and subsidies to attain profitability. Although the intention of the NBE is to

create the framework where the industry will be profitable in the long-run and private individuals

will put their resources and create a competitive market, this has not yet been realized. The proper

strategy in this situation is to transfer the ownership of MFIs from individuals to legally

accountable institutions with good standing until economic viability is attained and, selling shares

to private investors when the industry starts to become profitable.


43

4.1.2 Board of directors

In four of the MFIs in the industry, the CEOs of the MFIs are also the managers of the founding

NGOs. In some cases, the manager of the mother NGO is at the same time board chairperson and

general manager of the MFI. Wearing two hats in the industry will mix up the charity objectives of

the NGOs and the financial and economic objectives of the MFIs. This really confuses the MFI for

the NGO and adds significant complexity to the governance of MFIs.

The board of MFIs should have the following five major responsibilities (Chu 1999):

a) Legal obligation: The board ensures that the micro-finance institution fulfils its legal

obligations and protects it from unnecessary liability and legal action;

b) Fiduciary: The board serves as the steward of the micro-finance institution, it ensures that

the MFI has adequate resources to implement the agreed upon plans, and it guarantees the

long-term viability of the business.

c) Strategic direction: the board ensures that the mission of the MFI is well defined, reviewed

periodically and respected overtime. The board also ensures effective planning and works

to enhance the image of the MFI.

d) Oversight: The board provides directions to management and oversees that management

carries out the business plan; the board appoints and oversees the performance of the

managing director; the board monitors operations and business performance of the MFI

and its performance in relation to other MFIs; and the board responds to internal and

external risks and protects the MFI in times of crisis.

e) Self-assessment and renewal: the board should regularly assess its own performance and

use this assessment to effect change.

Accordingly, the BODs of MFIs in Ethiopia are expected to be determined, vision-driven, task-

oriented, possessive (strong sense of ownership), assuming full accountability, with clear

understanding of the micro-finance industry, and have the ability to provide policies for direction

and develop systems for effective internal control. They are also expected to play a major role in

business planning, fund raising, monitoring the performance of the MFIs and understand their

responsibility and accountability.


44

4.1.3 Suggested interventions to improve the effectiveness of the board of MFIs

• Establish an advisory committee to provide technical support to the board and

management. These could involve professionals and nominees of the donors.

• Restructure the board and involve clients to gain feedback.

• Establish a clear distinction between the founding NGO and the MFI. Avoid conditions

where the mangers of NGOs or the BODs of MFIs are also the executive managers of the

MFIs.

• Provide the necessary training to board members especially when the members have

limited educational background and managerial experience in micro-finance.

• Proper legal mechanisms of accountability to one’s action and enforcement where board

members and managers are found to be involved in corruption and other illegal activities.

These should include strict rules including prison terms for violators.

• Establish a transparent system of checks and balances between the BODs, CEO and the

other management of the MFI.

• Improve the internal control and establish a suitable management information system.

• Contract annual external audit of MFIs.

• Provide a system of incentives to motivate and increase the efficiency of board members.

• Put specific restrictions on sharing of dividends of the MFI to protect the public from

abuse and corruption.

• Conduct detailed studies on improving governance and efficiency of the management of

MFIs.

4.2 Supervision A set of directives and regulations without effective supervision and enforcement will not help

achieve the desired goals and social objective. Thus, there must be a regular supervision of the

micro-finance sector. This should be aimed at reducing the probability of failure in the industry

and assuring depositors and stakeholders about the level of legal protection against losses and

bankruptcy of the business. Currently, the Supervision Department of the NBE has a very limited

staff (about 25) to supervise banks, insurances and MFIs. The NBE is attempting to regulate an

industry that it cannot supervise. Owing to the limited share of the micro-finance sector in the

national economy, micro-finance issues are now at the bottom of the priority list of the NBE. In


45

the last four years, they have conducted on-site supervision for only five MFIs. The off-site

surveillance system through continuous reporting is also very weak, as many of the MFIs have not

been reporting as required by law. Moreover, the supervision designed for the risk profiles of

commercial banks is used as a tool of supervision for MFIs.

As per the micro-finance law, the NBE is responsible for the promotion, development and

supervision of MFIs. Enforcing the regulations has a profound effect on the efficiency of the

industry. In Ethiopia, implementing the regulatory framework requires building the capacity of the

regulatory institution to effectively discharge its responsibilities. At present, the NBE does not

have the institutional capacity to properly supervise the financial system. Increasing the staff and

technical skill in supervising micro-finance activities improves the effectiveness of the

Supervision Department. Regulating MFIs is not just a matter of making adjustments to the

supervising tools or methodologies of conventional banks. It requires a different approach and

method, which assists in identifying the weaknesses of MFIs. The supervision of the MFIs should

be conducted by well-trained experts who are familiar with the operation and management of the

micro-finance sector and the special type of risk affecting micro-finance businesses in the country.

As conditions vary from region to region, more specialized skills consistent with conditions in the

areas of operation of the MFIs may also be needed in the future, especially as the coverage of

micro-finance expands across the country.

Suggested interventions

- Establish and strengthen the micro-finance unit under the Supervision Department of the

NBE.

- Train the staff of NBE to effectively monitor and supervise the industry.

- Introduce some prudential ratios such as reserve requirement, liquidity ratio, capital

adequacy ratio, etc. for the industry.

- Enforce periodic reporting by the MFIs

- Find ways to carry out on-site supervision for all MFIs at some intervals.

- Build the capacity of MFIs in-terms of establishing effective internal control.

- Assist the Research Department of the NBE to develop a system for monitoring and

evaluation of the MFIs as per the regulatory framework.


46

In addition to regulation and supervision by the NBE, prudent oversight and supervision can be

undertaken through the following methods.

• An effective and efficient BODs which can establish a realistic business plan, set up

financial and risk management policies and hold the management accountable for

implementing those policies effectively. Attempts should be made to create the incentives

for MFIs to develop strong risk management policies and internal control.

• Effective internal controls and an internal audit function to confirm that hose policies are

followed and procedures are effective. High quality external auditors who are

knowledgeable and competent in micro-finance as an objective check on internal systems

to protect against fraud and mismanagement.

Moreover, the Association of Ethiopian Micro-finance Institutions (AEMFI) can support self-

regulation by assisting MFIs in producing financial report of higher standard, in performance

analysis and in sharing and disseminating financial and market information on a regular basis.

4.2.1 The costs of regulation and enforcing compliance

As stated earlier, since the issuance of the regulatory framework in 1996, the NBE had carried on-

site supervision on only five MFIs. Since it has not effectively or regularly supervised the

industry, it would be difficult to estimate the cost of supervision and enforcement of the regulatory

framework. However, the cost of supervision and enforcement of compliance could be an

enormous burden to the Bank, especially considering high transaction costs and the need to inspect

a multitude of micro-financing businesses across the country. Let us take the experience of the

Central Bank of Philippines to as an example to demonstrate the high cost of regulating the micro-

finance industry.

As of September 1997, about 824 rural banks in Philippines were serving half a million clients.

These banks had only about 2% of the banking system’s assets and deposits, but they made up

83% of the institutions, the central bank had to supervise. Supervising the rural banks has severely

stretched the resources of the Central Bank’s supervision department, taking up as much as one-

half of its total staff and budgetary resources. The report of 1996 estimated that 200 inspectors

were assigned to the rural banks. Even this level of resources was viewed as inadequate. Each


47

field visit consumes up to three person-weeks or more. At one point, the supervision department

found that this burden, combined with its budget limitations, was severely endangering its ability

to function (CGAP, 2000)

4.3 Operational modalities 4.3.1 Loan term

During our fieldwork, many of the practitioners indicated that the one-year loan term has affected

their activities. This is a serious problem for MFIs, which provide agricultural loans like for

purchase of oxen for traction, dairy cattle and so forth. Many have indicated that the one-year loan

term restricts the activities of clients in urban and rural areas. The micro and small enterprises

require loan products usually for more than one year. Although it might tie-up the limited

resources of the MFI, it is seems more appropriate to solve the funding problems instead of

restricting the loan term to one year. It is important to add that the loan term of one year is not a

hard and fast requirement. Depending on performance and the nature of the enterprise, the law

indicates that the crediting institution can reschedule the repayment period.

4.3.2 Loan ceiling

The loan ceiling of Birr 5000 clearly directs MFIs towards the poor as their main target and serves

as a self-selection tool for reaching out to the most capital-constrained active clients. Currently,

the average loan size of the majority of the MFIs in Ethiopia is way below the loan ceiling of Birr

5000 (see Table 3.2). As we found during our fieldwork, some of the MFIs, therefore, do not

consider the loan ceiling as a major hindrance to their micro-credit programs at this time.

However, some of the MFIs already reported that it is becoming a culprit to their activities,

especially for their long-standing clientele. From our discussions with practitioners and

stakeholders, we have found the following limitations related to the current loan ceiling.

• Some of the productive activities that the poor farmers could be involved, such as buying

water pump for irrigation, grain mills, investment in tree crops, and so forth require a

capital of more than Birr 5000. MFIs should be ready to provide loans to such important

investments that would have effects on the medium and long-term welfare of the rural

poor.


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• When clients take repeated loans and finish several cycles, they require larger loans, which

can be used for expanding existing businesses or start new and more profitable investments

with larger capital requirements. It will be unwise for the MFI, which strives to attain

financial sustainability, to deny loans to some of its hard working clients with proven skills

in managing their business and demonstrated ability to repay their loans. The BODs of

some of the MFIs are considering graduating some of their clients who demand loans more

than the allowable ceiling.

• It limits access to the micro and small enterprises that need more than Birr 5,000. In

Ethiopia, a loan of less than Birr 100 thousand is not attractive for the conventional banks.

The largest commercial bank in the country, CBE, often prefers to lend loans in large

volumes (in hundreds of millions) and does not find micro-loans attractive. The

commercial banks have no incentive to deliver small loans to the rural and urban areas due

to high branching expenses, higher transaction costs, low volume of activity per branch,

and low rates of return on loans. The CBE now specialises in very large loans while it

considers smaller loans to be in the sphere of private banks. Unfortunately, the latter’s

outreach is still limited to Addis Ababa and few towns across the country. There is a

significant gap or mismatch between what the commercial banks actually offer (a

minimum of 30,000 Birr) and the maximum loan ceiling (Birr 5000) for MFIs. If MFIs

cannot be allowed to gradually move upwards and fill this vacuum, there is a need for

establishing specialized banks catering micro-enterprise credit. The objective of this

financial institution will be to provide entrepreneurs in urban and rural areas engaged in

micro and small enterprises with access to investment capital.

Table 4.1 Active clients and the rate of loan recovery for MFIs in Ethiopia, January 2001.

Micro-finance Institutions Active clients Loan recovery rate (%)

Amhara Credit & Savings institutions S.C 192,571 98.6

Dedebit Credit & Saving Institutions S.C 187,550 97

Oromia Credit & Saving Institution S.C 37,000 98

Omo Micro-finance Institution S.C 39,342 97

Specialized Financial & Promotional Institution S.C 3,700 97

Gasha Micro-financing S.C 3,217 86

Wisdom Micro-financing Institutions 8,535 98


49

Sidama Micro-financing Institution S.C 4,286 90

Mekket Micro-finance Institution S,C 2,300 99

PEACE Micro-finance Institution S,C 974 100

Addis Credit and Savings Institution S.C 7,000 95

Eshet Micro-finance Institution S.C 516 100

Wasasa Micro-finance Institution S.C 562 100

Asser Micro-financing S.C 3,100 85

Africa Village Financial Service S.C 450 70

Buussa Gonofa Micro-finance S.C 2758 99.6

Meklit Micro-finance Institution S.C 1,001 99.39

Benishangul Micro-finance Institution S.C 425 100

Source: Compiled by the authors based on fieldwork

4.3.3 Group lending

In the absence of accessible collateral and weak legal system to settle claims of MFIs, the group

guarantee system is a reliable method to ensure repayment. In Ethiopia the group lending

methodology, which is being practiced as the only model by all the MFIs, has proved to be

effective both in terms of reaching the poor and good repayment performance (see Table 4.1).

However, certain socio-economic factors such as population density of the target area (when

population density is very low, forming a solidarity group becomes more difficult and increases

transaction costs) and the size of the loan (individuals may be unwilling to guarantee the larger

loans taken by others) and the nature of the enterprise should be considered to provide a more

differentiated and targeted lending system. In other countries like in West Africa, individual

lending systems and saving products tend to be customized to client needs and repayment

capacity, and hence are more demand driven than the traditional group lending approach (MBP,

1999b). A ‘one size fits all’ approach being practiced in Ethiopia needs to be revised to provide

demand and market driven services to the users. There is a need to carryout a detailed study to find

out more flexible and client-oriented lending approaches suitable to varying socio-economic and

biophysical conditions in the country.


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4.4 The role of donors and foreign NGOs It is clear that NGOs and donors are behind the development of the micro-finance industry in

Ethiopia since the early stages before the issuance of the 1996 micro-finance law. In the post-1996

period many of the foreign NGOs, which were involved in the provision of micro-credit have

either curtailed or minimized their support. The legal requirement to establish a share company

consistent with profit-maximizing objectives to deliver financial services and a ban on foreigners

from owning such companies (businesses) in Ethiopia is the major reason for the reduction in

donor participation in the micro-finance industry. In the pre-1996 period, there were numerous

NGOs in Ethiopia, which offered credit and savings services in rural and urban areas. However,

on June 18, 1998 the NBE issued a Public Notice (No. 2/1998), which ended the involvement of

all unlicensed institutions (except the credit and savings cooperatives) from delivering micro-

finance services.7 The regulatory framework has, therefore, significantly reduced the role of NGOs

in the delivery of financial services. In the process of their involvement in rural development

programs, NGOs also assist in transfer and adaptation of new technologies and methods useful for

sustainable development. The regulatory framework has, therefore, hindered the development of

innovative approaches and methodologies by the NGOs in the delivery of financial services to the

poor.

Attempts should be made to encourage NGOs to increase their involvement and support for the

delivery of financial services in various ways. It is important to create an environment where

funds could flow to the industry from foreign NGOs and donors. Given the scale of the poverty

and destitution in the country, this can only be expected to have a positive effect towards poverty

alleviation and reduction in the Ethiopia. However, such interventions should not conflict with the

integrity of the financial system and national interest of the savers, borrowers and the public. Such

interventions should be designed in ways that would foster self-sufficiency and sustainability

rather than perpetuate dependence on foreign support.

As a result of the proclamations and directives of the NBE, some of the local NGOs, which are

allowed to be legal shareowners of the new companies, have established MFIs to deliver financial

services to the poor. Some of the foreign NGOs, which are not allowed to own shares in the MFIs,

7 Despite the laws and directives of the NBE, there are still some civic organizations and NGOs, which deliver financial services at small scale in the country.


51

either sponsored individuals or local NGOs in an effort to continue their support to the poor. A

few other NGOs are using the saving and credit cooperatives as the last option to deliver financial

services directly to the poor. In the face of the new legal framework, a number of donor NGOs

have decided to give up their intervention on micro-credit activities and preferred to wait and see

until the legal and policy environment permits their increased participation.

From our consultations with the NGOs and donors, it has become clear that they would like to

increase their involvement in the provision of financial services in the country provided that

improvements in the regulatory framework would allow such participation. This may in turn

contribute towards improving the unclear and potentially unproductive governance structure of

MFIs. Our suggestions for improving the participation of the donors and foreign NGOs include:

• Involve donors and foreign NGOs in the board of directors (without being shareholders or

owners),

• Involve donors and foreign NGOs in the technical advisory committee of the BODs of MFIs,

• Increase the participation of donors in the capacity building of MFIs,

• Encourage NGOs to provide advisory services to clients to develop their businesses (i.e.,

business development services)

• Encourage donors to provide seed money for MFIs,

• Encourage donors to provide loan funds that can be delivered by MFIs at low rates of interest

in marginal areas which are vulnerable to drought and famine,

• Encourage donors and foreign NGOs towards promoting and supporting saving and credit

cooperatives,

• Encourage donors and NGOs to support conducting surveys and research such as impact

studies,

• Support research and innovation by MFIs to experiment different products and innovations.

This can be done in collaboration with AEMFI, academic departments and research institutes.


52

4.5 Internal control and sound information management system Internal control is very important for MFIs. Some of the MFIs in Ethiopia do not have internal

audit departments. Some are on the process of establishing this unit. The micro-finance law

requires MFIs to carryout external audit on their business annually. However, very few (about four

MFIs) have undertaken external audit once in their life span let alone on an annual basis. The

MFIs should get the necessary support to build their system of internal control. The NBE should

enforce the regulation, which requires an annual external audit.

The board must ensure that the management of the MFI has established an effective internal

control system. In some cases the boards have established an audit or finance committee to control

the daily operating procedures of the micro-financing business. Internal audit is part of the self-

regulation and control, which needs to be institutionalised in the operating system of MFIs in

order to disclose irregularities, to minimize risk and prevent losses, to introduce timely correction

measures, and regularly monitor internal working procedures. The internal auditor seeks to

identify new or previously uncontrolled risks or inefficiencies, which requires new control

activities (Campion and Frankiewicz, 1999). Internal audit involves: (a) procedural audit which

reviews whether staff members are properly implementing procedures and operation manuals of

the MFIs (b) Portfolio quality verification to examine the portfolio data at various levels; and (c)

client sampling which is again verifying the information using a sample of clients.

An external audit provides the board detailed information and opinion on the adequacy of the

internal control system. This mainly include financial statement audit. Although external audit as

per the proclamation should be undertaken annually, it could be a heavy burden on the meagre

resources of the MFIs. Larger MFIs such as DECSI and ACSI will require significant resources to

audit their institutions using external auditors. The smaller MFIs, which are in the process of

establishing themselves, may also find it very costly to undertake external audit on an annual

basis. External audit is, however, especially important for institutions which have mobilized large

savings from the public.


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4.6 Interest Rate Initially, there were legal limits to the lending and saving interest rates of MFIs. The ceiling on the

lending interest rate was 12.5%. This rate was set far too low to implement sustainable micro-

finance activities in Ethiopia. However, the NBE issued the directive on August 1998 to remove

ceiling on the lending interest rate and left the interest rate unregulated or free. Currently, although

the boards determine the lending interest rate, the MFIs in Ethiopia have relatively lower rates of

interest compared to other countries in Africa, Latin America and Asia. As a result, many of the

MFIs are not operationally or financially sustainable. The lending interest rate varies between

12.5% and 25% per annum (see Table 3.2). Although many have expected the MFIs to move

quickly towards higher interest rates for their loan products, many of them preferred to move

slowly by carefully examining the ability of the borrowers to pay back their loans. This is

consistent with the welfare orientation of the micro-finance business in the country. Besides,

unlike MFIs in the rest of the world, the lending interest rate used by many of the MFIs in

Ethiopia is a declining rate.

There is consensus among practitioners that the interest rates of MFIs are very low. Some have

been exercising revision and plan to raise interest rates gradually. As per the law, the floor for

the interest rate on saving and time deposits for the MFIs is 6%. When operational costs are too

high like in areas of low population density and poor market access, the floor on the savings

interest rate could affect the long run sustainability of the MFIs and delivery of services in these

areas. The NBE should move towards gradual deregulation and lifting of both the credit and

savings interest rates. More research needs to be done to investigate the effect of deregulating the

savings rate of interest on the delivery of micro-finance to the poor.

Actually, in the Ethiopian context, since the MFIs focus entirely on the provision of financial

services to the rural poor, they face covariant risks, seasonal fluctuations in the demand for

financial services and high transaction costs. The long distance, low settlement density, poor

infrastructure and the weak legal system increase the cost of providing financial services to the

rural poor. This may indicate towards increasing the interest rate of MFIs in Ethiopia. Some of the

empirical evidence from the field also indicates that capital constrained individuals in areas with

good market access have higher shadow values for credit and are willing to pay higher rates of

interest than what MFIs charge now. This also suggests a need to differentiate rates of interest on


54

loans according to the profitability of investments. Again a one-size-fits-all and a fixed rate of

interest for all locations across the regions is likely to be sub-optimal. MFIs should consider

differentiated rates of interest as dictated by the performance of the investment and the enterprise

to which loans are provided.

4.7 Monitoring and evaluation of the regulatory framework Regular monitoring and evaluation of the micro-finance law is also an important tool to address

the issues and concerns raised in the industry. The entry point for policy analysis in the financial

sector in general and micro-finance industry in particular is the review of the existing policies with

the view to understanding shortcomings and to assess the necessary adjustments and the extent of

overhauling required. The analysis should involve both quantitative and qualitative approaches.

The impact monitoring aspect involves measuring the qualitative and quantitative changes brought

about as a result of the implementation of the regulatory framework of the micro-finance industry.

This should be compared against the objectives and targets set for the industry. The NBE with full

participation of the stakeholders should undertake such impact evaluation or policy monitoring

activities more regularly. This involve, among others, evaluating the impact of new procedures on

MFIs and the delivery of financial services to the poor, problems encountered, measures taken,

and recommendations for improvement. The AEMFI in collaboration with the NBE could

facilitate the design of a holistic, transparent, and participatory impact assessment, policy

implementation, monitoring and evaluation procedure in the micro-finance industry.

4.8 Supervising the saving and credit cooperatives The saving and credit cooperatives in Ethiopia are concentrated in urban areas. Registered saving

and credit cooperatives hardly exist in rural areas. Since the capacity of MFIs is limited, saving

and credit cooperatives should play a significant role in the delivery of financial services to the

poor. Such cooperatives provide alternatives for saving and access to loans for the rural poor.

Thus, taking funds from the public would be the prerequisite for supervision by the NBE.

Although the mandate of supervising activities of saving and credit cooperatives has been

transferred from the NBE to the regional cooperative bureaus, there is no clear indication in the

co-operative law about the supervision of saving and credit cooperatives. There is a need to


55

oversee and inspect the saving and credit cooperatives through a federal cooperative office (which

is not yet established) or the NBE. There must be harmonization of financial standards to be

implemented for MFIs and saving and credit cooperatives. There should be common financial

statement formats, prudential ratio, and reporting requirements for MFIs and saving and credit

cooperatives. Guidelines from the NBE or federal co-operatives office may assist in standardizing

the performance and accounting system of saving and credit cooperatives.

4.9 Other issues 4.9.1 Absence of deposit insurance

Although the risk portfolio of MFIs is higher than conventional banks, there is no deposit

insurance in the industry. However if MFIs introduce deposit insurance, it will have the objective

of reimbursing depositors in the event of failure of the MFIs. This insurance could be used to

provide emergency liquidity to the MFIs in times of need. It can also serve in providing capital to

MFIs in case of insolvency and corrective measures.

4.9.2 Low capital requirement (equity capital requirement)

Equity capital is the amount that would be lost by the owners of the MFIs (shareholders) in the

event of bankruptcy. The larger the equity capital, the more cautious the behaviour of the MFI

would be, and would have a higher incentive to improve its efficiency (less likely to be involved

in moral hazard). In this case, the owners have stake in the solvency of the MFI and hence in the

safety of deposits (Chaves and Gonzalez-Vega 1994). The Birr 200 thousand equity requirement

of MFI in Ethiopia is very low to protect the depositors from bankruptcy and moral hazard.

Actually, bigger MFIs like DECSI have mobilized 90 million Birr. This indicates that the poor can

save and they are bankable. At the same time serious attention should be given to protect poor

people’s deposits to encourage further savings and prevent the failure of the micro-finance system

in the area. On the other hand, such low capital requirement is a deliberate action by the

government to ease entry into the micro-finance industry. This was true in Indonesia and

Philippines where the availability of a special legal character with low capital requirements

brought large number of private rural banks (CGAP, 2000).


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4.9.3 The danger of bankruptcy

If some of the MFIs in Ethiopia fail, it will have an effect on the trust and confidence of depositors

(the incentives of clients to save declines) and may reduce the incentive to repay loans. It also

erodes the trust and confidence of the public, government and NGOs on the entire micro-finance

industry. We believe that the failure of one or two MFIs will be a problem in the industry. If such

a situation happens in the industry, the NBE has to revoke the license of the MFI and allow it to

exit the industry after the MFI replaces equity losses without damaging the depositors’ interest.

Otherwise, keeping such inefficient institution in the industry will affect the entire financial and

policy environment. It could cause a panic to the industry.

4.9.4 Establishing a wholesale window

The fieldwork has indicated that despite the high demand for micro-credit, most of the MFIs in

Ethiopia are suffering from lack of loan capital to deliver financial services to the poor. All of the

MFIs surveyed have indicated that they were unable to fulfil the demands of even 50% of the

credit worthy applicants. One of the interventions to provide access to loan fund is to establish a

wholesale lending window under the NBE to support the development of the MFIs.

4.9.5 Tiered approach to regulate the industry

One of the issues raised in supervising MFIs is to treat the MFIs differently depending on their

level of development or tiered approach. However this does not mean favouring some MFIs and

neglecting others, regulation should focus on the compliance of the MFIs to standard rules. The

objective of the regulatory framework in Ethiopia is to create equal opportunities for MFIs.

Although the re-registration could be a starting point to differentiate the MFIs, there has not been

any re-registration yet.

4.9.6 Accessing funds from external sources

If made available, donor funds with zero cost of capital could be used to increase geographical

expansion and loan volume of MFIs significantly. Attempts should be made to improve access to

donor funding, soft loan from donors, and internal and external capital markets. This can

contribute towards easing the serious problem of shortage of loanable capital in the industry.

However, except in areas where returns to investments are very low, donors should, however,


57

discourage MFIs from extending highly subsidised loans and donations that may further reduce

their effort to get involved in the difficult task of mobilising savings for the rural poor.

4.9.7 Exemption from taxes

There has not been any decision by the Ministry of Finance on the taxable status of MFIs. The

MFIs in Ethiopia have not paid any type of tax. Since MFIs are not profitable, they are not

seriously concerned with the profit tax. However, recently, some of the MFIs have been requested

to pay income tax on interest income (on savings). The MFIs brought the issue to the Board of

Association of Micro-finance Institutions (AEMFI) for discussion. The board members decided

that AEMFI should discuss this issue with the Ministry of Finance and the NBE on behalf of the

industry.


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5. Conclusion and Recommendations In poor countries like Ethiopia where the livelihood of the majority of the population predominantly

relies on smallholder agriculture with supplements from other income generating activities, an

efficient and reliable delivery of financial services will play a vital role for poverty alleviation,

improved food security and economic growth. In Ethiopia, about 60% of the population does not earn

an income sufficient to meet basic needs. The poor are highly cash constrained not only for

production and investment activities but also for smoothing consumption overtime. Imperfections in

credit markets are often associated with inefficient use of other household resources including land,

traction power and family labor. The seasonality of agricultural activities also means that family

labor will be unemployed or underemployed for large part of the year. Availability of financial

services will therefore allow employment of otherwise unproductive labor, efficient use of other

family resources (like land) and generation of supplementary income, which will be very vital for

poverty alleviation and improving household welfare. Improving access to financial services is

especially very useful to the active poor who lack other productive resources other than their own

labor and entrepreneurial skills. Women in urban areas, townships and rural areas often fall to this

category of people. When financial services are made available, the active poor are able to invest in

various kinds of income generating activities that would allow quick repayment of loans. If small

enterprises also obtain medium-term credit from micro-finance services, it may also encourage

sustainable investments (like tree planting, soils and water conservation) that would both raise the

welfare of the poor and improve environmental quality.

Micro-finance institutions also help in integrating the informal economy into the modern sector,

encourage thriftiness and savings among the poor, and create opportunities for increased investment.

The performance of government sponsored micro-credit programs in developing countries has

historically been very poor due to high operating costs and high risk of default. The success of the

delivery of financial services generally depends on the ability to counter the effects of high

transaction costs and imperfect information in dealing with a multitude of poor borrowers in remote

locations. Widespread adoption of Grameen-type models of group lending and peer-monitoring has

minimized information problems of adverse selection and moral hazard and permitted disbursement

of credit to the poor without collateral requirements. This has been demonstrated in several countries

where micro-finance activities have been expanding in urban and rural areas. Recognizing the vital


59

role of micro-finance services in the process of economic growth and development, Ethiopia has

recently initiated and supported the development of micro-finance institutions that provide financial

services to the poor and mobilize investments. The shift from the highly centralized planned

economy to a market-based liberalized economy since the early 1990s has facilitated the participation

of the private investors in the financial sector including micro-financing, banking and insurance. In

this regard, a key regulatory and legislative framework for licensing and supervision of micro-finance

businesses, which provides for establishment of micro-finance institutions (MFIs) as share companies

fully owned by Ethiopian nationals and/or organizations, was issues in 1996. The NBE, which is

authorized to license and supervise MFIs, has issued a number of directives and public notices to

implement the provisions of the 1996 proclamation. While a number of MFIs have been established

pursuant to this legal provision, a number of micro-finance services, which were hitherto initiated and

supported by donors and NGOs, have been forced to terminate their activities unless they conform to

the statutory requirements. This study has examined the strength and weaknesses of the legislative

and regulatory framework for the development of micro-finance activities with special emphasis on

the possible role of donors in micro-financing in the country. Below we present a summary of the

major findings and recommendations of the study.

5.1 Enabling policy environment Ethiopia has generally made progress towards creating the enabling legal and policy environment for

establishment of sustainable micro-finance institutions. The 1996 proclamation for licensing and

supervision of MFIs and the directives issued by the NBE were very instrumental in providing a legal

and regulatory framework for operation of micro-finance businesses in the country. There seems to

be increasing understanding and realization among the policy makers on the positive role micro-

finance plays in the process of development. The NBE has entirely deregulated the lending rates of

interest for micro-finance institutions and it is up to the board of directors (BOD) of each MFI to set

an optimal rate of interest. There are, however, some weaknesses and rigidities in the legislative and

regulatory framework that need to be addressed (see below).

5.2 Licensing and entry The process of licensing a micro-finance business is generally simple. The legal requirements for

establishing a share company include a minimum capital requirement of 200 thousand Birr, a


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memorandum and articles of association of the MFI, evidence of possession of an office, a work plan

for the first year of operation, and curriculum vitae of the proposed chief executive officer (CEO) and

BOD of the MFI. The CEO is required to have a minimum of a first degree in a relevant social

science field and some experience in financial management. The members of the BOD are mainly

required to have certificate of completion of secondary school. The NBE seemed to have issued the

license to set up the MFI in a relatively short period of time once these conditions are met and a

processing fee is duly paid. The MFIs are required to commence operation within 12 months thereof

in the area where they have been licensed, and can freely open branches within this area, although

prior permission from the NBE is required to operate outside of the area the license has been issued.

5.3 Competitiveness In a market economy, increased competition in the micro-financing business will be very healthy for

improving efficiency in the delivery of services and creation of more sustainable and reliable

financial institutions. The four largest MFIs in the country, established with a regional focus under

the shareholding of the regional governments, now operate in their respective regions. This kind of

arrangement is not very conducive and enabling for increasing efficiency through market-based

competition in the delivery of services. In an environment where the capacity for supervision and

enforcement of the regulatory system is weak, increased competition will also be good for improving

internal control, governance and accountability to the public. There is a strong need to encourage and

support the emergence of other micro-financing businesses in areas which are now under the domain

of location-specific MFIs. This will generally improve social efficiency through its effect on

outreach, impact and sustainability of financial institutions.

5.4 Corporate governance The licensing of MFIs in the form of share companies has created ownership and governance

problems especially for those established through donor-sponsored individuals as shareholders. When

foreign donors and NGOs were outlawed from owning and operating micro-finance activities, some

of them continued their operation under the new legal environment by sponsoring Ethiopians as

shareholders and setting up micro-financing businesses. As per legal provisions, the shareholders

have the legal right to appoint the CEO and BOD of the micro-financing business. Many of the

individual shareholders sponsored by foreign donors have agreed not to claim any proceeds from


61

transfer of their shares or dividends (if any). This implies that the nominal equity holders have no real

stake in the micro-financing business. Under this type of governance and ownership structure, the

individual shareholders lack strong incentive and interest for excellence to improve the operation and

economic viability of their company. The shareholders may also be tempted to renounce their

promise not to claim their shares in case the business becomes successful. This type of loose

governance structure can lead to weak internal control, conflict of interest and severely compromise

minimum prudential requirements needed for solvency of the company and mobilizing savings from

the public. More research is needed to investigate the ways and mechanisms for improving the

governance and management of micro-finance businesses.

5.5 Loan ceiling and repayment period Currently, the NBE restricts single borrower loan limit to Birr 5000, which is to be repaid during a

single loan period of 12 months. The creditor may however, reschedule loans considering the nature

of the enterprise (the loan period of one year is not a strict requirement). The rationale behind these

restrictions is to mainly to reduce the risk faced by the MFIs when they lend out large sums and to

increase their outreach in providing micro-loans to the poor. However, our findings indicate that a

ceiling on lending at Birr 5000 has started to become a hindrance to some of the MFIs that receive

loan requests in higher amounts from repeat borrowers. These borrowers have already accumulated

some assets and want to expand their micro business or enterprise by increasing the volume of loans.

In view of sustainability of micro-finance, it will be unwise for the creditors to abandon these kinds

of reliable and successful clients who have demonstrated their entrepreneurial skills and ability to

repay loans. The ceiling on loans and the pressure to repay in a single year encourages borrowers to

focus on micro-economic activities that bring immediate returns and discourages investments that

have longer gestation period and higher capital requirements such as agricultural and environmental

conservation activities (e.g., tree planting, livestock production, soil and water conservation, small-

scale irrigation, small-scale manufacturing, etc.). Unfortunately, there is no financial institution in the

country providing loans to such medium-term win-win investments that will bring external benefits

to the society in terms of improvements in the welfare of the poor and the environment. The loan

ceiling and repayment period should therefore be either lifted entirely or increased significantly.

More research is needed to determine the need and level of a higher ceiling on loans and the

modalities for linking the ceiling and loan period with the ability of the MFI to take risk. One

mechanism to do this is to allow only a given %age of outstanding loans to be over Birr 5000 (while


62

the average loan size is still below Birr 5000) so that the MFIs can provide services to those who

require larger capital without also compromising the outreach to the poor. The %age of outstanding

loans over the threshold may also be linked to the operational and financial self-sufficiency of the

micro-financing business.

5.6 Group lending vs. individual liability In an attempt to maximize the benefits to the poor, the legal framework prevents individual liability

in loans and requires use of a group-lending model, which does not necessitate asset collaterals. The

peer pressure and social sanctions are expected to serve as a social collateral. However, heavy

reliance on the group-lending approach seems to have discouraged experimentation on other

modalities that may be useful to those who cannot form groups (e.g., minorities) or want to take

individual liabilities for their loans. As individuals gain experience and skills and the level of their

business expands, they manage to accumulate some wealth, which may also qualify them for higher

loans individually. As the portfolio of repeat borrowers expands and their ability to withstand higher

risks improves, they resent being tied up in a group and prefer to take individual loans. The current

arrangement simply locks everyone under the group liability system and fails to provide an exit for

relatively better-off and successful entrepreneurs to innovate and explore new methods of doing

things and implement individual strategies. The group liability system means that the more successful

clients have to bear the risk of default of the less skillful and less efficient members of the group.

This has in some cases prompted all members to default when one or more members of the group are

unable to pay their loans. Therefore, although the group-lending and peer-monitoring model

functions well at early stages where information problems create serious impediments in screening

quality clients, its usefulness declines as clients mature, accumulate skills and wealth, and hence

preferring to try out their own strategies without the retarding influences of the group liability system.

Therefore, in order to reduce the dependence on the group-lending system as the only mechanism for

disbursement of micro-loans, more successful clients with their own collaterals should be allowed to

take up loans without making the whole group liable for their actions.

5.7 Re-registration The micro-financing law of 1996 requires that all micro-financing businesses should apply for re-

registration once their mobilized savings exceed the Birr 1 million mark. The intention is to have


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differentiated standards in the regulation and supervision of the MFIs consistent with the level of

risk associated in the business. Although a number of MFIs have already mobilized deposits far

higher than the legal threshold, none have indeed been required to re-register. This is related to the

weak supervision and enforcement capacity of the NBE as well as the low savings threshold set

for enforcing re-registration. There is little justification in re-registering MFIs that just pass the

lower threshold level unless the same procedure can be repeated when the amount of savings

grows much beyond this lower level. Calling for re-registration at every point as the level of

savings increases does not seem to be a feasible and efficient regulatory tool. Rather a system

should be designed whereby a more strict and stringent compliance would be required as the size

of savings mobilized by the MFI increases without asking for re-registration.

5.8 Supervision The micro-finance law of 1996 and the banking related proclamations of 1994 authorize the NBE to

license, supervise and regulate the activities of micro-financing businesses in the country. The

regulatory function is hence entrusted to the Supervision Department of the NBE, which has two

divisions, one dealing with the formal banks and MFIs, and another dealing with the insurance sector.

The NBE has issued a number of directives setting out the ‘rules of the game’ that must be complied

with in starting and operating micro-financing businesses. There is widespread agreement among the

regulators and the practitioner companies themselves about the importance of adhering to certain

operational principles and statutory codes of conduct for the success of micro-financing business in

the country. The higher risk under which the MFIs operate (related to lack of asset collaterals,

covariate risk in lending out to a relatively homogenous group of poor clients, dependence on donor

funding, high transaction costs, weak corporate governance, etc.) strengthens the need for closer

follow up and supervision of the activities of micro-financial companies. Unfortunately, the

Supervision Department of the NBE currently lacks the institutional capacity to carry out its

mandates more effectively. Apart from issuing few directives, the Bank has given little attention so

far to the micro-finance sector. Lack of capacity within the Bank has also curtailed other related

activities it should have undertaken to support, promote and strengthen the micro-finance sector in

the country. However, there is increasing realization of the need for strengthening the overall

capacity in the micro-finance sector within the Bank. To that effect, the Bank is now in the process of

setting up a separate and specialized unit or division dealing directly with the micro-finance


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activities. We commend this effort being taken by the Bank and encourage them to quickly build and

strengthen their capacity to supervise and regulate the sector.

5.9 Enforcement It is of little use to set up rules and regulations that cannot be enforced. Following the promulgation

of the micro-financing law in 1996, the NBE has issued several directives and public notices, which it

has not been able to follow more closely regarding their enforcement and compliance. The need for

re-registration (see above), quarterly reporting, notifying the Bank while opening a new branch,

annual external audit, are some examples of rules and regulations which have not been strictly

complied with by the operators in the sector. The risk of not enforcing the laws and weak supervision

could be very high as some of the MFIs have already mobilized large sums of money in deposits

before their performance is carefully evaluated and before confirming that internal checks and

balances have been put together for good governance. Therefore, the Bank should quickly strengthen

its capacity, establish a sound system of regulation and supervision, and develop ways and means for

enforcing compliance to existing laws, standards and procedures. The micro-financing law of 1996

does not state that the NBE has the power to revoke licenses of MFIs or impose penalties for non-

compliance or failing to meet minimum operational prudence. There is a need to clarify and explicitly

state the authority of the Bank in enforcing the micro-finance laws and set up a clear system of

penalties for non-compliance to the applicable laws and regulations.

5.10 The role of donors and foreign NGOs Prior to the issuance of the 1996 proclamation, much of the micro-loan services to the poor were

provided by various NGOs supported by foreign donors. This proclamation has essentially ended the

direct involvement of foreign donors in the provision of micro-finance services. All micro-financing

businesses in the country (except credit and savings cooperatives) are required to be formed as a

share company wholly owned by Ethiopian nationals or organizations. The majority of foreign NGOs

and donors have terminated their credit services following this proclamation and the public notice

(No.2/1998) issued by the NBE that made all such undertakings illegal unless the activity is

reorganized according to the provisions of the law and owned by Ethiopian organizations or

nationals. Given this new legal framework, the donors have either stopped their involvement in

micro-finance activities or downsized their support in which case they had continued to provide


65

minimal credit services to the poor by sponsoring individuals or local NGOs to establish micro-

financing businesses as per the requirements of the law. A number of donors and foreign NGOs

resent to function like profit-oriented businesses as their main objective was provision of credit to the

needy at low cost. The new set up and governance structure denies the donors any direct control and

influence on the operation of the micro-financing business, which is directly run by the legal

shareholders (Ethiopian nationals and organizations). Although the level of resource flows to the poor

directly from the credit programs of the donors (foreign NGOs) has fallen, the overall impact on

outreach and poverty alleviation is not yet clear. Some of this gap may have been filled by the MFIs

which have a wider coverage in certain parts of the country (e.g., DESCI in Tigray). Where the MFIs

have not yet managed increase their coverage, the decrease in resource flows may have affected

income generation and employment opportunities for the poor. As per the law, MFIs operating in the

country cannot receive any assistance or soft loans from foreign sources without prior approval from

the Ministry of Finance. This is another hurdle for increasing the participation of donors and foreign

NGOs in micro-finance services. The big question then is what can be done to increase the

participation of donors and NGOs in the delivery of micro-finance in the country?

��Involving donors in corporate management: The issue of ownership of micro-finance

operations by foreign donors and NGOs does not seem to be negotiable under the current

policy environment. In view of the central role micro-finance plays for poverty alleviation and

the higher operational costs that make private investments in the sector unattractive, there

seems to be a strong argument to attract resources, allowing increased participation of donors

in the provision of such services, and expanding outreach to the poor. Another argument for

allowing the foreign donors and NGOs to take a more proactive role is to encourage

innovation and exploration into the most efficient ways of delivering financial services to the

poor. One way to encourage donors is to allow representation in the board of directors of the

MFI. More work needs to be done in this direction to identify the possible avenues and

modalities for increasing the participation of the donors.

��Credit and savings cooperatives: Another avenue for the foreign donors and NGOs is

channeling their support through savings and credit cooperatives, which are entitled to

provide micro-finance services without compliance to the 1996 micro-finance law. The

cooperative societies proclamation (No.147/1998) provides for the establishment of different

types of cooperatives, one of which is the savings and credit cooperatives. To this effect,


66

offices mandated with the promotion of cooperatives have been set up under the regional

governments. However, organizing the beneficiaries and establishing effective credit and

savings cooperatives in rural areas of the country is likely to be a challenging task. Because of

the negative stigma of the past, extensive training and extension is likely to be needed to

persuade the populace about the benefits of organizing different types of cooperatives. Donors

and NGOs interested in providing micro-finance services to the poor may help in the process

of organizing such institutions at the grassroots level, and assist them directly (both

financially and otherwise) to attain self-sufficiency and operational sustainability. The

government should also allow donors and NGOs to effectively participate in this process.

��Capacity building: From our investigation, a number of MFIs and stakeholders indicated an

increasing role for donors in the area of strengthening the capacity of the borrowers through

training, provision of information on marketing and business opportunities, provision of new

technologies, and so forth. This kind of work needs to be done in close collaboration with the

MFIs and will be mutually beneficial to borrowers and the creditors.

5.11 Taxation and foreign aid The 1996 micro-finance law, Ministry of Finance is empowered to determine the period, manner and

conditions for exempting MFIs from paying income tax. Given the social external benefits associated

with the promotion and expansion of such services in the country, it is laudable that such provisions

were included to give a tax relief for emerging MFIs. Our survey has shown that none of the MFIs

have so far paid any income tax, but some have been already asked to do so. At the time this study

was carried out, the Ministry of Finance has yet to undertake a comprehensive study to determine the

modalities by which MFIs would qualify for tax relief. Some initiatives through the NBE are

however underway to bring this process into completion. The Ministry was also empowered to

receive and approve requests regarding grants and other confessional loans that MFIs may obtain

from external sources. Although the justification for this seems to be related to lowering the debt

burden of the country, this step is likely to create bureaucratic hurdles for attracting external

resources to the micro-finance sector in the country especially given the limited capacity and other

related duties requiring the attention of the Ministry. This also means that the MFIs should deal with

two regulatory agencies, the Bank and the Ministry thereby complicating the process of supervision

and compliance. Therefore, this requirement should be waived at least for the case of grants received


67

from abroad. All supervision and regulatory requirements should also be transferred to the NBE,

which is now in the process of building its capacity. It is high time that the tax exemption and

bureaucratic steps in attracting foreign resources should be resolved soon.


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6. References ACDI/CEE 1995. Ethiopia: rural finance and micro-enterprise needs assessment, Washington D.C and Addis Ababa. Adugna, Techane and Demeke Mulat (1999) Institutional reform and sustainable input supply and distribution in Ethiopia. A paper presented in the Fourth Annual Conference of the Agricultural Economics Society of Ethiopia, November 1999, Addis Ababa. Amha, Wolday. (2000) Review of micro-finance industry in Ethiopia: Regulatory framework and performance. Occasional Paper No. 2 Association of Ethiopian Micro-finance Institution (AEMFI), Addis Ababa Anne-Marie C. and Gallade G. (1997) Regulation and supervision case studies: West Africa. In Micro-finance Network, Regulation and Supervision of Micro-finance Institutions: Case studies: Occasional Paper No.2 Bediye, Mengistu (1998) Micro-enterprise project loan administration (Amharic version). Paper Presented at a National Workshop on Micro-enterprise Project organized by the Urban Development Support Services, June 9-11, 1998. Addis Aababa. Berenbach S. and Churchill C. (1997) Regulation and supervision of micro-finance institutions: Experience from Latin America, Asia and Africa. The Micro-finance Network. Occasional Paper No. 1 Campion A. and Frankiewicz C. (1999) Guidelines for the effective governance of micro-finance institution. The Micro-finance Network. Occasional Paper No.3 CGAP (2000) The rush to regulate: Legal frameworks for micro-finance: Occasional paper No.4. Washington Chaves R. and Gonzalez-Vega C. (1994) Should principles of regulation and prudential supervision be different for micro-enterprise finance organisations? In Maria Otero and Elisabeth Rhyne (eds), The New World of Micro-enterprise Finance. Connecticut Chu M. (1999) Mandate of the board. In Campion A and Frankiewicz C, Guidelines for the effective governance of micro-finance institutions. Occasional paper No.3. The Micro-finance Network Washington. Degefe, Befekadu and Nega, Berhanu (Eds.) (2000) Annual report on the Ethiopian Economy. Vol. 1, 1999/2000. The Ethiopian Economic Association. Addis Ababa. Geda, Alemayehu (2000) Macro-economic performance in post-reform Ethiopia. Paper presented at the Symposium for Reviewing Ethiopia’s Socio-economic Performance 1991-1999, April 26-29, Addis Ababa.


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Green Bell Consultancy Service (2000) Review of the micro-finance industry in Ethiopia: A study submitted to the Association of Ethiopian Micro-finance Institution (AEMFI), Addis Ababa. GVCI (1999) Micro-finance activities of NGOs in Ethiopia. Comprehensive Survey Report prepared and submitted to the Christian Relief and Development Association (CRDA). Global Vision Consultants International (GVCI), Addis Ababa, Ethiopia. Transitional Government of Ethiopia (1994) Agricultural Cooperative Societies Proclamation. Proclamation No. 85/1994, Negarit Gazeta, Addis Ababa.

Transitional Government of Ethiopia (1994), Monetary and banking Proclamation No. 83/1994, Negarit Gazeta, Addis Ababa. Transitional Government of Ethiopia (1994) Licensing and supervision of banking business proclamation. Proclamation No. 84/1994, Negarit Gazeta, Addis Ababa. Government of Ethiopia (1996) Licensing and supervision of micro-financing institutions. Proclamation No. 40/1996, Federal Negarit Gazeta, Addis Ababa. Government of Ethiopia (1998) Property mortgaged or pledged with bank proclamation. Proclamation No. 97/1998, Federal Negarit Gazeta, Addis Ababa. Government of Ethiopia (1998) Cooperative Societies Proclamation. Proclamation No. 147/1998, Federal Negarit Gazeta, Addis Ababa. Imperial Government of Ethiopia (1960) Commercial code of the empire of Ethiopia. Proclamation No. 166/1960, Negarit Gazeta, Addis Ababa.

MBP (1999a) Consultation on regulation and supervision of micro-finance: A workshop report Washington MBP (1999b) Commercialisation of micro-finance: A framework for Latin America, Washington NBE (1996) Minimum paid up capital and information required from applicants. Directive No. MFI/01/96. Addis Ababa NBE (1996) Contribution in kind, Directive No. MFI/02/96, Addis Ababa

NBE (1996) Criteria for selection of officers and directors. Directive No. MFI/03/96, Addis Ababa NBE (1996) Conditions to be met prior to commencement of operations Directive No. MFI/04/96, Addis Ababa NBE (1996) Loan policy, limit period and provisions. Directive No. MFI/05/96. Addis Ababa NBE (1996) Investment in equities of allied activities. Directive No. MFI/06/96, Addis Ababa


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NBE (1996) Branches. Directive No. MFI/07/96, Addis Ababa NBE (1996) Interest rates, Directive No. MFI/09/96 Addis Ababa

NBE (1998) Amendments of interest rates, Directive No. MFI/11/98, Addis Ababa NBE (1998) Amendments of interest rates, Directive No. MFI/12/98 Addis Ababa Pischke J.D, Ayana Itana. Edward L.N and Nemera Mesfin (1996) Ethiopia: rural credit. centre for economic growth. Credit Financial Sector Development Project II (FSDP II) Renee C., Wolday Amha, Mengesha Tesfaye., Sefere Yohanes and Tesgera Kurende (2000) Enhancing rural financial intermediation. A study sponsored by IFAD and the World Bank. Tilahun, Bekele (1995) Rural credit in Ethiopia. In: Aredo Degene and Demeke Mulat (1995) Ethiopian Agriculture: Problems of transformation. Proceedings of the fourth annual conference on the Ethiopian economy. Addis Ababa, Ethiopia.


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7. Annexes Annex I: A List of Stakeholders Consulted During the Fieldwork in Ethiopia

1. Atakilti Kiros CEO, Dedebit Credit and Savings Institution S.C (DECSI) 2. Dawit Kebede

Program Manager, Norwegian Church Aid (NCA) 3. Ejigayehu Tefera

Program Coordinator, Norwegian Church Aid (NCA) 4. Gemechu Dubiso

CEO, Oromia Credit and Savings Institution SC.(OCSI) 5. Hailu Legesse

Vice President, Credit and Risk Management Commercial Bank of Ethiopia (CBE)

6. Itana Ayana CEO, ITAB Consult, and Chairman, BOD, Mekket Micro-finance Institution, SC

7. Lakew Lemma Manager, Supervision Department National Bank of Ethiopia (NBE)

8. Tadesse Kassa CEO, Amara Credit and Savings Institution SC (ACSI), and Chairman, Board of Directors of AEMFI

9. Tihut Yirgu DCG Coordinator, CARE Ethiopia

10. Tsegaye Anebo CEO, Sidama Micro-financing Institution S.C

11. Tsehay Tsegaye CEO, Specialized Financial & Promotional Institution (SFPI)

12. Worku Tsega CEO, Wisdom Micoro-Financing Institution, SC

13. Wondimagegnehu Gizaw, Asser Micro-financing Institution SC

14. Head, Legal Services Department Ministry of Finance


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Annex II: The questionnaire used in the survey. Questionnaire for Research on Legislative and Regulatory Constraints on the

Performance of Micro-Finance Institutions in Ethiopia A) Basic Information Name Active Clients Number of Branches Year of Establishment Region Town Head office location Branches (if any) 1.

2.

3.

B) Demand for Credit and Diversification Who are the major clients in your operation? Rank 1 as most important or give percentages. Period (month, year)

Rural areas (share in total__________) Urban area (share in total__________)

Small farmers

Landless peasants

Female headed hhs

Others (state)

Type of activities to which you have provided loans. Rank or state in percentages. Period Rural areas Urban areas Fertilizer

credit Oxen credit

Small business

Others (state)


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C) Sources of Funds Were you able to provide credit for all credit-worthy applicants? ______________ If NO, state the rough percentage of credit-worthy applicants that received loans__________. What was the reason for rationing credit (not providing for all credit-worthy applicants)? Rank source of funds by importance (If possible, for each source, state it’s share in the total annual disbursements). Period NGO Commercial

Banks Regional Government

Other (state)

Would you be interested to receive loans from NGOs and other partners? ___________ What would be the maximum rate of interest you would be willing to pay if you had to borrow from such sources?____________________

State the criteria (method) you use in selecting the applicants that would receive credit. (Poor, women headed, rural, agricultural, business, etc) Criterion Rank Remark


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D) Lending mechanism

What are the problems with the group lending? ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ What improvement do you suggest? ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ If a group lending (the Grameen Bank model) scheme is practiced,

a) What is the size of the group?___________ b) How is the group formed (by neighbourhood, friendship, relatives, by the MFI, etc.)

_____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

c) What do you do when some members (e.g., one) of the group default? Do you suspend

loans to all group members? _______________________________________________________________________________ ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ What is the recent loan recovery rate in your MFI? ______________________________________ What should be done to decrease the rate of default or increase the rate of loan recovery? _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ _______________________________________________________________________________ _______________________________________________________________________________


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Do you think allowing collaterals would be more useful in improving the repayment rate? _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ Would you prefer other models that may allow individual lending, accountability and access to collaterals than the group lending approach?________________ Give examples that you suggest may work better in your case. _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ E) Interest Rates The rate of interest on credit and savings since establishment, and preferred rates of interest that would enable financial sustainability of your MFI. From period (month and year)

Interest Rate (%) State a reasonable rate of interest (r) that you would (have) prefer(red) for financial sustainability of your MFI

Credit Savings and Deposit

Credit (the smallest r you can offer)

Savings and deposits (highest r you can offer)

Future

Next 2 years

F) Regulation and Supervision How long did it take for you to get the license from the NBE after you have fulfilled all the requirements?_________________________________________________________________________________________________________________________________________________________________________________________________________________________________ Were you able to get the licence in the area and region that you wanted to operate? ______. If NO state possible reason why you were not allowed to operate in the area of your choice. _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________


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Did you face problems in fulfilling the requirements for getting a license from the NBE?______ If YES, state the major problems that you faced. _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ State other problems that you faced in starting and running your MFI? _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ Would you like to open other branches? ______________. If NO, why are you not interested? _____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ Have you been asked to pay axes?___________________________________________________ Have you paid? _________________ If No, why not ____________________________________ Is the Birr 5000 per period limit on loans and the repayment period of one year an important constraint on your operation?______________ What is the average loan size for your MFI ? ___________________________________________ What are the problems with the loan ceiling and one year loan term? ___________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________ Do you think a loan ceiling (limit) is needed?___________. If yes, could you suggest a more reasonable loan limit and repayment period? Maximum allowable loan per year__________ Max allowable repayment period___________ What should be the role of NGOs in the micro-finance industry? ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________


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Have you ever received any technical assistance or advice from NBE?_____________ Period Type of advice provided Training Information

on Profitable portfolios

Regulatory rules and framework

Rates of inflation

Advice on site selection or branching

Other (state)

G. Additional issues for discussions

What are the major challenges of the micro-finance industry? ____________________________________________________________________________ ________________________________________________________________________________________________________________________________________________________

Is regulation and supervision necessary for proper functioning of MFIs in Ethiopia? ____________________________________________________________________________ ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________ If yes, please explain the kind of regulation you would prefer to have? ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________ What should be the role of the regulatory agency (NBE)? ____________________________________________________________________________________________________________________________________________________________________________________________________________________________________

What are the major problems in the regulatory and supervision process? ____________________________________________________________________________

________________________________________________________________________________________________________________________________________________________

What should be revised in the regulatory framework and how ?

____________________________________________________________________________________________________________________________________________________________________________________________________________________________________


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Please provide your comments on the following issues :- (use back page for comments)

a) the capital requirement of 200,000 Birr b) governance in general and board of MFIs c) ownership d) limiting ownership of MFIs to Ethiopians only e) reporting f) support of NBE g) support from the government h) safety of depositors resources i) supervision of MFIs

What support do you need from NGOs?

________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________


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Annex III: Distribution of Commercial Banks and Insurance Companies in Ethiopia A. The Ethiopian Insurance Corporation (EIC) and its Branches. No. Name of Company Location (city) 1 Ethiopian Insurance Corporation Addis Ababa 2 EIC: Southern Main Branch Addis Ababa 3 Nazareth Branch Nazreth 4 Awassa Branch Awassa 5 Assela Branch Assela 6 Robe Branch Robe 7 Arbaminich Branch Arbaminch 8 Ziway Branch Ziway 9 EIC: North Eastern Branch Addis Ababa 10 Combolcha Branch Combolcha 11 Mekele Branch Mekele 12 Dessie Branch Dessie 13 EIC : Western Main Branch Addis Ababa 14 Nekemt Branch Nekemt 15 Jimma Branch Jimma 16 Gimbie Branch Gimbie 17 EIC: Eastern Main Branch Addis Ababa 18 Dire Dawa Dire Dawa 19 Harar Harar 20 Asebe Teferi Asebe Teferi 21 Jijiga Jijiga 22 EIC: North Western Branch Addis Ababa 23 Gonder Gonder 24 Bahir Dar Bahir Dar 25 Arada Branch Addis Ababa 26 EIC: Djibouti Djibouti 27 EIC: Life Main Branch Addis Ababa Source: National Bank of Ethiopia (NBE)


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B. Private insurances and their distribution No. Name of Company Location (city) 1 National Insurance Company Addis Ababa Addis Ketema Branch Addis Ababa Megenaga Branch Addis Ababa Jimma Branch Jimma Awassa Branch Awassa Dire Dawa Branch Dire Dawa Nazareth Branch Nazareth 2 Awash Insurance Company Addis Ababa Addis Ketema Branch Addis Ababa Merkato Branch Addis Ababa 22 Mazoria Branch Addis Ababa Gofa Mazoria Branch Addis Ababa Nefas Silk Branch Addis Ababa Nazareth Branch Nazareth Dilla Branch Dilla Dire Dawa Branch Dire Dawa Gimbe Branch Gimbe Jimma Branch Jimma Nekempte Branch Nekempte 3 The United Insurance Company Addis Ababa Kirkos Branch Addis Ababa Beklobet Branch Addis Ababa Addis Ketema Branch Addis Ababa Arada Branch Addis Ababa Misrak Branch Addis Ababa Mesalemia Branch Addis Ababa Adama Branch Nazareth Awassa Branch Awassa Bahir Dar Branch Bahir Dar Dire Dawa Branch Dire Dawa Mekele Branch Mekele 4 Africa Insurance Company Addis Ababa Joseph Branch Addis Ababa Arada Branch Addis Ababa Nazareth Branch Nazareth Mekele Branch Mekele Bahir Dar Branch Bahir Dar Awassa Branch Awassa Combolcha Branch Combolcha Source: National Bank of Ethiopia (NBE)


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B. Private insurances and their distribution (cont…) No. Name of Company Location (city) 5 Nile Insurance Company Addis Ababa Theodros Branch Addis Ababa Kirkso Branch Addis Ababa Addis Ketema Branch Addis Ababa Beklobet Branch Addis Ababa Gerji Branch Addis Ababa Kaliti Branch Addis Ababa Gondar Branch Gondar Kombolcha Branch Kombolcha Bahir Dar Branch Bahir Dar Jimma Branch Jimma Awassa Branch Awassa Dire Dawa Branch Dire Dawa Nazareth Branch Nazareth Mekele Branch Mekele 6 Nyala Insurance Company Addis Ababa Kerra Ketema Branch Addis Ababa Golla Branch Addis Ababa Eastern Branch Addis Ababa Bole Branch Addis Ababa Nazareth Branch Nazareth Dessie Branch Dessie Dire Dawa Branch Dire Dawa Mekele Branch Mekele Jimma Branch Jimma Bahir Dar Branch Bahir Dar Awassa Branch Awassa 7 Global Insurance Company Addis Ababa Lideta Branch Addis Ababa Arada Branch Addis Ababa Dire Dawa Branch Dire Dawa Harar Branch Harar 8 Lion Insurance Company Addis Ababa Merkato Branch Addis Ababa Ghotera Branch Addis Ababa Source: National Bank of Ethiopia (NBE)


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C. Banking Sector Branches by Region as of 30 November 2000

Region

Gambella Bensh. Harari Afar Somali Dire Dawa Tigray SNNP Amhara A.A Oromia Total

Share (%)

State Owned CBE 1 2 1 3 4 2 12 19 33 35 58 170 55.02DBE - - 1- - 1 2 7 5 1 15 32 10.36CBB - - - - - 1 1 2 4 5 7 20 6.47Sub Total 1 2 2 3 4 4 15 28 42 41 80 222 71.84Private Sector AIB - - - - 1 1- 1 2 10 7 22 7.12DB - - 1- - 1 1 2 4 9 2 20 6.47BOA - - - - - - 1 1 2 6 2 12 3.88WB - - - - 1 1 2 2 4 6 3 19 6.15UB - - - - - - - - - 6 1 7 2.27NIB - - - - - - - - 1 6- 7 2.27Sub Total - - 1- 2 3 4 6 12 43 15 87 28.16Grand Total 1 2 3 3 6 7 19 34 54 84 95 309 100Share (%) 0.32 0.65 0.97 1.94 0.97 2.27 6.15 11 17.48 27.18 30.74 100 Source: National Bank of Ethiopia (NBE)


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Annex IV. Proclamation no. 40/1996

A PROCLAMATION TO PROVIDE FOR THE LICENSING AND

SUPERVISION OF THE BUSINESS OF MICRO-FINANCING

INSTITUTIONS

WHEREAS, it needs to provide for a legal regime that brings the activities of Micro-financing

Institutions within Ethiopia's monetary and financial policies;

WHEREAS, the monetary and banking laws in force do not provide for micro-financing

institutions catering for the credit needs of peasant farmers and others engaged in small-scale

production and service activities;

WHEREAS, it has become necessary to legislate on the licensing and supervision of the business

of micro financing institutions;

NOW, THEREFORE, in accordance with Article 55 (1) of the Constitution of the Federal

Democratic Republic of Ethiopia, it is hereby proclaimed as follows.

PART ONE

General

1. Short Title

This Proclamation may be cited as the " Licensing and Supervision of Micro-financing Institutions

Proclamation No. 40/1996".

2. Definitions

In this Proclamation, unless the context otherwise requires:

1) " Bank " means the National Bank of Ethiopia ;


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2) "Company " means a share company, as defined under Article 304 of the Commercial

Code, the capital thereof owned fully by Ethiopian nationals and/or organizations

wholly owned by Ethiopian Nationals and registered under the laws of, and having its

head office in Ethiopia.

3) "Micro-financing business " means an activity of extending credit, in cash or kind, to

peasant farmers or urban small entrepreneurs, the loan size of which shall be fixed by

the Bank;

4) " Micro-financing institution " means a company licensed under this Proclamation to

engage in micro-financing business in rural and urban areas;

5) "Members" means the shareholders of a micro-financing institution or signatories to any

type of membership arrangement created by such institutions ;

6) "Group guarantee" means a guarantee mechanism whereby a group of borrowers

undertake to be liable jointly or severally to defaulted loan of any one of them ;

7) "Savings" means non-withdrawable mandatory or regular savings of members of

micro-financing institutions;

8) "Deposits" means any regular or irregular savings which may be withdrawn partially or

totally at any time by the account holder;

9) "Directors" means members of the board of a micro-financing institution.

3. Purpose and Duty

1) The purpose of micro-financing is granting credit, in cash or in kind, the maximum

amount of which shall be determined by the bank.


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2) Subject to conditions set under this Proclamation, a micro-financing institution may carry

out some or all of the following activities.

a) accepting savings as well as demand and time deposits;

b) drawing and accepting drafts payable within Ethiopia

c) borrowing money for its business purposes against the security of its assets or otherwise;

d) purchasing such income generating financial instruments as treasury bills;

e) acquiring, maintaining and transferring of any movable and immovable property

including premises for carrying out its business;

f) providing counseling service to its clients;

g) encouraging income-generating projects for urban and rural micro operators ;

h) rendering managerial, marketing, technical and administrative advice to borrowers and

assisting them to obtain services in those fields ;

i) managing funds for micro financing business ; and

j) engaging in other activities customarily undertaken by micro-financing institutions.

PART TWO

Licensing of Micro-financing Institutions

4. Conditions Required to Engage in Micro-Financing Business

1) To carry out micro-financing business, the following conditions shall be fulfilled :


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a) obtain a license from the bank ;

a) be formed as a company

c) deposit with a bank the minimum initial capital required by the Bank ; and

a) that the directors and other officers meet requirements set by the Bank

2) The Council of Ministers may, upon recommendation by the Bank, exempt an

applicant from the requirements of any of the provisions of sub-Article (1) of this Article

in order that other innovative financial intermediaries engage in micro-financing business

and for other causes consistent with the objective of this Proclamation.

5) Prescribing Additional Conditions

1) The Bank may issue directives at any time and prescribe additional conditions to be

complied with before a license is issued.

2) Where the Bank intends to change or vary the terms and conditions attached

to a license, it shall notify the concerned micro-financing institutions of such

intentions orty-five (45) days before the date it proposes to carry the same into effect.

6) Application For License

1) An application for license to carry out micro financing business shall contain the

following:

a) the prospective place of operation (indicating that of the head office and branches);

b) the name, occupation, residence and nationality of the founders;

c) form of organization of the undertaking;

d) memorandum of association of the undertaking;

e) proposed name of the undertaking ;

f) biographical data on each of the founder, proposed directors and officers;

g) the proportion of contribution in cash and in kind and the manner of valuation of

contribution in kind;

h) the proposed transactions and operations of the undertaking as well as the manner

for carrying out the same ; and


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i) such other relevant information as the bank may require.

2) an investigation fee, prescribed by the bank, shall be paid at the time of submitting

the application for license.

3) an applicant issued with a license shall commence operations within 12 (twelve)

months from the date thereof.

4) No micro-financing institution shall, without prior consent of the bank, operate

outside the area for which it has been issued with a license.

5) every micro-financing institution shall pay such annual license renewal fee as the

Bank may prescribe.

7) Authorization of Commencement of Operation

Any micro-financing institution may, before commencing operations, be required to meet

certain conditions prescribed in a directive to be issued by the Bank.

8) Recovery of Monies and Securities Received by Unlicensed undertakings

Where any unlicensed person undertakes activities carried out pursuant to this Proclamation,

and holds monies or property obtained through such act, the Bank may apply to the Federal

High Court for orders in respect of the disposition of the same; the High Court shall give

orders for the speedy and efficient return of such monies or property to the depositors or

owners thereof.

9) Revocation of License

The license of a micro-financing institution may be revoked by the Bank for any of the

following reasons:

1) where it fails to commence operations within a period of 12 (twelve) months

following the issuance of license ;

2) where it ceases to carry on its activity;


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3) where it is declared bankrupt or decided that it be liquidated;

4) where it is amalgamated with another micro-financing institution or bank without

prior written authorization of the Bank ; or

5) where it is confirmed that its registration was effected on the basis of false

information.

10) Application for re-registration

1) where the savings mobilized by a micro-financing institution equals Birr 1,000,000

(One Million Birr) it shall apply for re-registration.

2) where application is made under sub-Article (1) of this Article, it may be required that

additional conditions prescribed by directives issued by the Bank be met.

11. Assistance

1) Where it deems it appropriate, the Bank shall extend technical assistance requested by

a micro-financing institution while being organized or in the course of operations.

2) Micro-financing institutions may obtain line of concessional credit of any assistance

from foreign sources for the purpose of on -lending or capitalization.

3) Any credit or assistance to be obtained under sub-Article (2) of this Article shall

require the prior approval of the Ministry of Finance.

PART THREE

Financial Requirements and Limitations

12) Minimum Capital Requirement and Powers and Responsibilities of the Bank

1) The minimum paid-up capital required to obtain license for micro-financing business

shall be determined by directives to be issued by the Bank.

2) The Bank may issue directives governing the following:-

a) limits on the maximum credit extended by micro-financing institutions to


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any individual or group;

b) the loan period and procedures;

c) periodic reporting of the accounting system and the keeping of books of

accounts ;

d) periodic surveys of loan and audits;

e) standards regarding accountability, structure, savings system and financial

performance ;

f) setting of special interest rate applicable to micro-financing institutions;

3) The Bank shall have the responsibility to :

a) encourage banks and other financing institutions to engage in micro-financing

business or to expand their activities in the same ;

b) offer or facilitate training for the personnel of micro-financing institutions ;

c) promote and develop traditional savings institutions such as Iqub in order that the

low-income section of society benefit most from them; and

d) promote investment in micro-financing business, especially in rural Ethiopia, pursuant

to powers vested in it under the law.

13) Consolidation and Merger

Consolidation and merger of micro-financing institutions operating in adjacent areas shall be

encouraged and such incentives as the bank deems appropriate shall be granted to them.

14) Opening of Branches

1) Every micro-financing institution shall notify its opening of a branch office within fifteen

(15) days of the commencement of operation of such a branch.

2) The Bank may set general guidelines on donations of opening and operating branch

offices by micro-financing institutions.


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PART FOUR

General Conditions

15. Extending of Loan Services

Micro-financing institutions may extend loan to members as well as to non-members.

However, such credit schemes as operating under group guarantee shall exert themselves

to bring borrowers into membership of the institutions.

16. Minimum Operational Prudence

The minimum prudential framework of operation in respect of all micro-financing

institutions shall be in the manner and form to be prescribed by the Bank.

17. Prohibitions

Without the prior approval of the Bank, no micro-financing institutions may :-

1) enter into any arrangement or agreement for the sale of disposal, by amalgamation or

otherwise, of its business or effect self restructuring ;

2) transfer or otherwise dispose of the whole or any part of its property, whether inside or

outside Ethiopia, other than in the ordinary course of its business ;

3) effect reduction of its capital; or

4) amend its memorandum of association or alter the name under which it is licensed.

18. Circumstances Requiring Approval for Managerial Responsibility

The following shall not be allowed to manage micro-financing institutions without the

prior written approval of the Bank :

1) persons declared bankrupt or who have made a compromise with their


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creditors, whether in Ethiopia or elsewhere; and

2) Persons convicted of offenses of breach of trust or fraud, whether in Ethiopia

or elsewhere.

19) Tax Exemption

The Ministry of Finance is hereby empowered to determine the period, manner and

condition of exemption of micro-financing institutions from income tax.

20) Special Responsibility

Every micro-financing institution shall devise and execute a policy whereby the low-income

section of society, especially in rural areas, get access to credit and to this end it shall

implement such means of substituting group guarantee for property collateral requirement.

PART FIVE

Miscellaneous Provisions

21) Duty to Cooperate

Where so requested by the Bank, all concerned bodies shall have the duty to cooperate in the

implementation of this Proclamation.

22) Audit

Accounts of micro-financing institutions shall be audited annually by an independent

auditor acceptable to the Bank prior to the payment of dividends to shareholders.

23) Inapplicable Laws

Any law inconsistent with the provisions of this Proclamation shall not apply to matters

provided for under this Proclamation.


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24) Other Applicable Law

With respect to matters not covered under this Proclamation, the Licensing and

Supervision of Banking Business Proclamation No. 84/1994 shall apply, mutatis mutandis.

25) Power to Issue Directives

The Bank may issue directives necessary for the proper implementation of this

Proclamation.

26) Transitory Provisions

1) Undertaking engagement in micro-financing business, prior to the coming into force

of this Proclamation, may continue in their previous form until reorganized in

compliance with the provisions of this Proclamation

2) The conditions and time limit of non-applicability of this Proclamation to such

undertakings shall be determined in directives to be issued by the Bank.

27. Effective Date

This Proclamation shall come into force as of the 5th day of July, 1996.


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Annex V: Comparison of the Ethiopian regulatory framework with other selected countries

Ethiopia Zambia( law) Latest banking reform 1994 1994 Financial Sector Insitutions Eight commercial banks (minimum capital is at $1.10

million); 2 government owned specialized banks Institutions doing micro-finance: Licensed MFIs under the National Bank of Ethiopia & Cooperatives

19 commercial banks (minimum capital is at $825,000); 18 non bank financial institutions (leasing, pension, credit cards, building and cooperative societies, for which minimum capital is about $ 10,300). Institutions doing micro-finance: a company (Credit Management Services), Credit unions and NGOs

Date of MFI Law July 5, 1996 Proclamation No. 40/1996 In parliament Type of Law Establishes MFI license Establishes MFI license Allowed functions Regular savings, time deposits, checks, loans trusts,

business development services (BDS). If savings are above 1 million Birr ($125,000), must register

Small loans only 1 per client : forced and voluntary savings; business development services

NGO, company, credit union Share company. Tax exempt. Can only be owned by Ethiopians

Minimum capital 27,000 $250 for credit only and forced savings $10,000 for loans and member savings $100,000 for loans and public savings

Supervising entity Central Bank-National Bank of Ethiopia Central Bank –Bank of Zambia Collateral Group lending acknowledged Not specified Interest rates 2% month, Government can intervene Not specified Capital adequacy Not specified Not specified Reports Audit Not specified Max. Loan $ 673 Not specified

Source : Micro-enterprise Best Practices (1999). Consultation on Regulation and Supervision of Micro-finance : A workshop report Washington


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Brazil Honduras Peru Latest Banking Reform 1964 1995 1996 Financial Sector Institutions 175 multiple banks: 32 commercial banks: 9

development banks; 22 investment banks, 50 consumer finance companies; 83 leasing companies; 460 securities and brokerage companies and dealers; 22 real estates credit companies and saving and loan associations; 2 saving banks; and 1,167 credit unions Institutions doing micro-finance: State banks; finance companies, credit unions, NGOs, and municipal and state authorities.

23 commercial banks (minimum capital of $ 7 million); 4 savings and loan associations (minimum capital of $ 2 million); 11 finance companies ( minimum capital of $ 1.5 million); 17 security companies and deposit warehouses; 13 stock exchange bureaus; 2 pension funds; 3 state banks; 2 second tier institutions

25 commercial (minimum capital of $ 5.6 million ); 5 finance companies (minimum capital of $ 2.8 million); 16 rural cajas; 12 municipal cajas; 5 leasing companies; 7 EDPYMES. Institutions doing micro-finance: 3 commercial banks, rural and municipals cajas, 7 EDPYMES and some 27 NGOs.

Date of MFI Law August 2, 1999 Resolution No. 002627

In Congress in 1999 December 1995 Small and Micro enterprise Enterprises (EDPYME)

Type of Law MFI license MFI license MFI license Allowed functions Credit only, no consumption loans Loans, savings with

authorization, trust funds, no current accounts

Loans, savings with authorized and minimum capital of $ 1.4 million . No current accounts unless $ 2.8 million capitalization. Foreign exchange

Type of institution Non-profit Non—profit Share company Minimum capital $50,000 Non supervised

entitites:14,0001 supervised entities $700,000

$265,000

Supervising entity Central Bank Central Bank Superintendency of Banks Collateral Not specified Recognize group lending Not specified Interest rates Not specified Free Free Capital adequacy Not specified Not specified 10% Reports Specified norms Semi-annual Regular reports and annual audits Maximum loan size $5,000 Not specified No more than 5% of net equity


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Morocco Nepal Bolivia Latest Banking Reform

1993 1996 1992

Financial sector institutions

15 commercial banks (minimum capital of $10 million); 6 specialized financial institutions (mostly government owned), and three foreign banks Institutions doing micro-finance: Banque Populaire Foundation, created by the government owned bank (Credit Populaire du Maroc); a specialized financial institution (Caisse Nationale de Credit); and numerous licensed NGOs

13 commercial banks (minimum capital of $450,000 to $7 million depending on geographic coverage); 45 finance companies ($35,000 to $870,000); 5 rural development banks (government ownded Grameen replicators); 3 private development banks (minimum capital of $150,000 to $2.3 million depending on regional coverage); 1 postal savings bank, 29 cooperative societies (with limited banking license); 850 savings and credit cooperatives Institutions doing micro-finance:most commercial banks (under government directed lending programs); 5 rural development banks; 1 development bank (Nirdhan); 25 NGOs and most cooperatives

15 commercial banks (minimum capital of $7.7 million); 6 private financial funds; 13 mutual housing societies; 17 credit unions (of which there are some 200 that are unregulated); and 11 non bank financial institutions Institutions doing micro-finance: 3 banks, 4 FFP’s , most of the 200+ credit unions and some 12 NGOs

Date of Law February 5, 1997 Law No. 18-97 relative to microcredit

1998 Financial Intermediaries Societies Act 2055

1995 Private Financial Fund (FFP)

Law Type MFI License MFI license Micro and Small bank license Allowed functions Credit only Credit only Loans, saving, no current accounts

Foreign exchange Type of institutions Non-profit; tax exempt for a 5 year period

only Non-profit; tax exempt Share company

Minimum capital None None Annual registration

$1,000,000

Supervising entity Ministry of Finance; oversight committee; federation of MFIs

Central Bank-Nepal Rastra Bank (assumes liabilities in the event of non-payment)

Superintendnecy of Banks

Collateral Recognizes group lending Recognizes group lending Recognizes group lending Interest rates Free-but government can fix Free but government can intervene Free Capital adequacy Not specified Not specified 10% Reports Annual external audit Annual report Rigorous reporting Max. Loan Size $5,000 $1,000 Not specified

* Bolivian micro-finance regulation goes much beyond the establishment of the FFP license, which is essentially a “ small bank” or finance company license. Regulators have formulated new norms aimed at strengthening the loan classification system. Resolution No. 155/98 of December 29, 1998, recognizes microcredit as an “ activity” not an “ institution “ and establishes provisioning guidelines for 4 different categories of loans; commercial, housing, consumer and microcredit.


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1 A. Synnevåg, G. et Halassy, S. 1998: “Etude des indicateurs de la sécurité alimentaire dans deux sites de la zone d’intervention de l’AEN-Mali: Bambara Maodé et Ndaki (Gourma Malien)”, Groupe de Coordination des Zones Arides et Noragric, Agricultural University of Norway. 1 B. Synnevåg, G. and Halassy, S. 1998: “Food Security Indicators in Two Sites of Norwegian Church Aid’s Intervention Zone in Mali: Bambara Maoudé and N’Daki (Malian Gourma)”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 2 A. Aune, J.B. and Doumbia, M.D. 1998: “Integrated Plant Nutrient Management (IPNM), Case studies of two projects in Mali: CARE Macina programme and PIDEB”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 2 B. Aune, J.B. et Doumbia, M.D. 1998: “Gestion Intégrée de Nutriments Végétaux (GINV), Etude de Cas de deux projets au Mali: Programme de CARE Macina et PIDEB”, Groupe de Coordination des Zones Arides et Noragric, Agricultural University of Norway. 3 A. Berge, G., Larsen, K., Rye, S., Dembele, S.M. and Hassan, M. 1999: “Synthesis report and Four Case Studies on Gender Issues and Development of an Improved Focus on Women in Natural Resource Management and Agricultural Projects”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 3 B. Berge, G., Larsen, K., Rye, S., Dembele, S.M. et Hassan, M. 1999:“Rapport de synthèse et quatre études de cas sur Les Questions de Genre et Développement d’une Approche Améliorée concernant les Femmes et les Projets d’Agriculture et de Gestion des Ressources Naturelles”, Groupe de Coordination des Zones Arides et Noragric, Agricultural University of Norway. 4 A. Sydness, M. et Ba, B. 1999: “Processus de decentralisation, développement institutionnel et reorganisation des ONG financées par la Norvège au Mali”, Groupe de Coordination des Zones Arides at Noragric, Agricultural University of Norway. 4 B. Sydness, M. and Ba, B. 1999: “Decentralisation Process, Institution Development and Phasing out of the Norwegian Involvement in Mali”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 5. Waktola, A. and Michael, D.G. 1999: “Institutional Development and Phasing Out of the Norwegian Involvement, the Case of Awash Conservation and Development Project, Ethiopia”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 6. Waktola, A. 1999: “Exploratory Study of Two Regions in Ethiopia : Identification of Target Areas and partners for Intervention”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 7. Mossige, A. 2000: “Workshop on Gender and Rural Development – Training Manual”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 8. Synnevåg, G. et Halassy, S. 2000: ”Sécurité Sémenciére: Etude de la gestion et de l’approvisionnement en semences dans deux villages du cercle de Ké-Macina au Mali: Kélle et Tangana”, )”, Groupe de Coordination des Zones Arides et Noragric, Agricultural University of Norway.


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9. Abesha, D., Waktola, A, Aune, J.B. 2000: ”Agricutural Extension in the Drylands of Ethiopia”, Drylands Coordination Group and Noragric, Agricultural University of Norway. 10. Sydness, M., Doumbia, S. et Diakité K. 2000: ”Atelier sur la désentralisation au Mali”, Groupe de Coordination des Zones Arides et Noragric, Agricultural University of Norway. 11. N’Dior, P. A. et Traore, N. 2000: ”Etude sur les programmes d’espargne et de credit au Mali”, Groupe de Coordination des Zones Arides et Noragric, Agricultural University of Norway. 12. Lode, K. and G. Kassa. 2001: ”Proceedings from a Workshop on Conflict Resolution Organised by the Drylands Coordination Group (DCG), November 8-10, 2000 Nazareth, Ethiopia”, Drylands Coordination Group and Noragric, Agricultural University of Norway.


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Drylands Coordination Group Addresses in Norway: ADRA Norge, P.O. Box 6897 St. Olavs Plass, 0165 Oslo, Norway Tel: +47 22 94 32 30, Fax: +47 22 20 53 27 e-mail: [email protected] CARE Norge, Universitetsgt. 12, 0164 Oslo, Norway Tel: +47 22 20 39 30, Fax: +47 22 20 39 36 e-mail: [email protected] The Development Fund, Nedregt. 8, 0551 Oslo, Norway Tel: +47 22 35 10 10, Fax: .+47 22 35 20 60 e-mail: [email protected] Norwegian Church Aid, P.O. Box 4544 Torshov, 0404 Oslo, Norway Tel: +47 22 22 22 99, Fax: + 47 22 22 24 20 e-mail: [email protected] Norwegian People’s Aid, P.O. Box 8844 Youngstorget, 0028 Oslo, Norway Tel: + 47 22 03 77 32, Fax: + 47 22 17 70 82 e-mail: [email protected] Strømme Foundation, P.O. Box 414, 4601 Kristiansand, Norway Tel: +47 38 12 75 00, Fax: + 47 38 02 57 10 e-mail: [email protected] Noragric, Centre for International Environment and Development Studies Agricultural University of Norway, P.O. Box 5001, 1432 Ås Tel: +47 64 94 99 50, Fax: +47 64 94 07 60 e-mail: [email protected]

revisiting the regulatory and supervision framework of the

Documents