The term “liquidity” describes the ease with which securities and assets can be converted into cash. In the financial sector, It is a common indicator of a bank’s ability to meet its short-term financial obligations, such as customer withdrawals.
A liquidity crunch in the banking system may be a sign of structural problems within the market. Furthermore, the more banks are liquid, the faster they can meet financial obligations and withstand risks.
To maintain the integrity of financial systems, central banks across the world have adopted prudential liquidity requirements. Similarly, in Ethiopia’s case, the National Bank of Ethiopia (NBE) has put in place requirements to have banks remain liquid. Loan-to-deposit ratio and reserve requirements are also used as indirect indicators.
Loan to deposit ratio compares a bank’s outstanding loans to its total deposit. If the ratio is too high, the bank may not have enough liquid cash to cover cash demands from its depositors.
Reserve requirements are funds that banks must hold in reserve as a percentage of their total deposits, either in cash or as deposits at the central bank. Reserve requirements play a variety of roles. It is mainly used as a monetary control tool to manage the money supply and its expansion. By increasing reserve requirements, central banks can lower the liquidity of banks, thereby limiting credit creation. On the other hand, in case of a liquidity crunch, the ratio can be lowered to allow banks to be more liquid. For example, in August 2021, the National Bank of Ethiopia doubled reserve requirements to 10% for banks to meet progressively within three months in an attempt to rein in what it perceived to be excessive credit creation in the banking sector. Later after a few months, the requirement was again reduced to its original ratio of 7%.
The Case of Silicon Valley Bank
· Deposit at other banks (Local & foreign), Deposit at the NBE, Reserve at the NBE, Cash on hand, Bonds and securities, Settlement account.
Short term liability
· Customer deposits
The NBE requires the ratio not to be less than 15%.
In addition, Increased loan-to-deposit ratio ( (total outstanding loan + bonds & securities) / total deposit) also negatively affects liquidity. The NBE requires loan to deposit ratio to remain below 90%.
Causes of liquidity crisis in Ethiopia
Seasonal demand for cash
The banking industry has not always had liquidity problems. Contrarily, in the 1980s, excess liquidity pervaded the banking sector, which consisted entirely of government banks. The imbalance between deposit levels and requests for credit was largely to blame. Even in recent years, banks have been hit by occasional excessive liquidity. Liquidity crises became commonplace in the subsequent decades as the economy adapted to new realities and private banks proliferated, increasing the demand for credit by the private and public sectors.
At present, a seasonal liquidity crisis is expected and is considered customary in the banking sector. These incidents typically recur between October to February, when three major events take place that will drain bank deposits. These include harvest season when large sums of funds are disbursed to farmers, traders and exporters. The other is tax season when corporations have to pay taxes to the government, which keeps its deposits at the Commercial Bank of Ethiopia (CBE). And the last one is when banks pay dividends to their shareholders.
Since these patterns are predictable, banks typically prepare for them by borrowing from one another (Interbank market) and also the central bank, requesting reserve requirements to be lowered and adopting conservative loan disbursement strategies.
Nonetheless, the industry can be thrown off by unprecedented external factors like political instability, other banks’ financial position, and inflation that lead to bank runs and excessive credit creation, prompting the governing body to be strict on matters of liquidity.
Although a bank run could occur for a variety of reasons, it generally refers to a situation in which large deposits are withdrawn from a specific bank.
In Ethiopia, a bank run typically impacts multiple banks simultaneously as a result of a decision made by the state giant CBE.
A bank’s business decisions or status can have a ripple or contagion effect throughout the banking system. This is especially true in a monopolistic market like Ethiopia. CBE’s powerful position as a result of its ownership structure and subsequent government favoritism forces banks to follow its lead. For example, if the CBE changed loan interest rates, the effects would be felt throughout the banking industry. Similarly, various activities of CBE, such as a massive letter of credit approval, have been observed to impact the liquidity of banks.
For instance, In January 2016, CBE approved a letter of credit request worth two billion dollars. In these incidents, importers are required to deposit a certain percentage in birr to the bank. Within the next few weeks, a bank run occurred where individuals withdrew huge sums of money from other banks to pour into the CBE.
In a similar situation in 2022, the CBE approved one billion dollar worth letter of credit. The bank reportedly required importers to deposit 100% of the approved amount, which affected the liquidity position of other banks.
Instability and inflation
Inflation and instability have a wide range of effects on economic activities in general as well as the financial sector.
For the past two years, Ethiopia has been experiencing prolonged inflation. According to the Ethiopian Statistical Services, the annual inflation rate was 33.9% in January 2023 and has remained above 30% for more than a year.
Inflationary pressures can lead to lower deposits as users need more cash for transaction purposes or their savings are depleted or shift their savings to real assets. On the other hand, despite massive cash hoarding and a need for cash, the excessive monetary expansion has allowed banks to continue to increase their deposits. According to a report on the first quarter of the current fiscal year from the NBE, the broad money supply has surged by close to 30%.
On the other hand, the presence of high inflation accelerates the need for credit in value and volume. In addition, high inflationary pressure combined with macroeconomic challenges (such as shortage of foreign currency) could impact the repayment ability of borrowers (due to low business activity, lessened demand, and inability to access input), leading to a high loan default rate which affects the liquidity of banks.
Instability across the country has also led to the disruption of operations. In the Tigray region, where war was raging for two years, banking operations were fully shut down. Some banks that have a significant presence in the region, such as Wegagen, Lion, and CBE, have been impeded in their ability to mobilize deposits or collect loan repayments, resulting in a substantial surge of non-performing loans.
The current state of the banking sector
In early March, The National Bank of Ethiopia convened bank executives to address the liquidity crisis looming in the sector and caution against activities that would further degrade banks’ liquidity position.
Private banks in Ethiopia are now facing severe liquidity and credit management challenges. The NBE stated that poor cash management is the root cause of the liquidity problem, which has led most banks to rely on short-term loans from the central bank via a standing facility window. However, this facility is meant to be used as a last resort to address short-term liquidity issues and is not a viable solution. In order to discourage banks from overusing this facility, in August 2021, the NBE increased the borrowing interest rate from 13% to 16%. Despite this measure, borrowing from the facility has increased by 85% annually, reaching an outstanding balance of 15 billion birr.
The report from the central bank assesses the potential source of these liquidity issues. In regard to deposit mobilization, the NBE established that it had seen positive growth in this area.
The report shows that although private banks’ liquid asset ratio meets prudential requirements, the share of high-quality liquid assets (cash on hand) has significantly declined over time, reaching low levels of 12.3% and 13.4% in January 2022 and January 2023, respectively.
Additionally, private banks’ new loan disbursement showed a huge annual increment of 223.9% during the first seven months of the current fiscal year. Last year’s low-level disbursement may have been due to the three-month window of loan suspension and high reserve requirements.
As a result of this significant rise in credit disbursement, private banks’ loan-to-deposit ratio is also increasing and, in fact, reached a historical high of 94.1% during the first seven months of the fiscal year. This ratio is higher than the banking industry’s ratio of 90.6%, although it has declined from 96.2% in January 2018.
According to the latest data, there has been a substantial increase in deposit mobilization by commercial banks in Ethiopia. The overall deposit mobilization has increased by 34.0% annually as of January 2023. In particular, the private banks have seen an even more significant surge in deposits, with a growth rate of 52.9% over the same period.
Moreover, during the first seven months of this year, private banks’ loan collection has shown an impressive annual growth rate of 80.2%. This is in contrast to the overall banking system, which registered a 39.8% annual growth which the NBE assesses is due to “poor performance from the CBE”.
Another contributor to banks’ liquidity position in Ethiopia is the circulation of cash outside the banking system. Between 2019-2022 the share of currency outside the banking system and currency held by banks was about 44.7% and 12%, respectively. In January, the figure remained almost the same for currency outside the banking system, while the amount at banks slightly declined to 9.3%. This small discrepancy, according to the report, does not contribute to the liquidity crisis exhibited now.
Would a bank ever fail in Ethiopia?
In Ethiopia, the banking industry is subject to strict regulations and supervision by the NBE. Given the critical role that banks play in the economy, it is vital to prevent failure and protect creditors from potential losses. As such, there is an implicit interest on the part of the NBE to maintain the stability of the financial sector.
It has been demonstrated time and time again that whenever banks in Ethiopia experience difficulties, the NBE typically intervenes to rescue the entire industry from potential downfall. This has been the case in several instances, some of which are listed below, highlighting the NBE’s crucial role as a lifeguard for the banking sector.
In December 2019, a liquidity problem caused by poor liquidity management of banks arose. NBE stepped in and disbursed 14.5 billion birr loans demanding in return a detailed description and documentation of the loans extended.
In March 2020, NBE injected 15 billion birr into private banks to allow them to provide debt relief and loans to businesses as well as to sustain the economy that was suffering from the effects of the pandemic.
In February 2023, when banks operating in the Tigray region commenced operation, the NBE pumped five billion birr to banks to alleviate liquidity issues.
The NBE also provides assistance to banks by alleviating their immediate commitments in the event of liquidity problems. In 2016, CBE approved massive LCs, resulting in severe liquidity issues for private banks. In response, the NBE not only relieved the private banks of their immediate obligation but also allowed for a delayed payment for the purchase of the bond of the Development Bank of Ethiopia. Furthermore, the NBE also postponed the monthly payment for loans that private banks had taken out from the central bank several years ago.
The central bank has been steadfast in its support to banks and the financial sector, which has led experts to conclude that bank failure in Ethiopia is unlikely to occur.
Nevertheless, the government has taken proactive measures to ensure the safety of depositors’ money by enacting a regulation to establish a depositors’ insurance fund in 2021.
The council ministers approved the establishment of the Fund as a separate entity with the mandate to oversee, manage, and implement deposit insurance provisions for all financial institutions in the event of a financial crisis. The objective of this scheme is to enhance the stability and security of the country’s financial sector by safeguarding customers and creating a deposit insurance fund that can reimburse depositors in case of bank failure.
Two years after the regulation, the NBE has just announced the Fund has been established and Merga Wakweya, director of microfinance supervision at the NBE was appointed as chief executive officer.
Find details about the Fund below.