Can the Organic Growth of Private Banks Last Long?

Ethiopian private commercial banks, which had humble beginnings in mid-1990s showed tremendous growth over the years through provision of traditional banking products and services. The banks contributed, as well as heavily benefited, from the growth of the Ethiopian economy over the years and the less competitive environment they have been operating in.

Although all the private banks are structured as commercial banks and predominantly use retail deposits to provide their basic functions – channeling funds from savers to borrowers – there is significant but sometimes unrealistic expectation of many entrepreneurs to meet all their long–term financing needs from the commercial banks.

Our commercial bank’s nominal financial capital shown on their balance sheet may meet the capital requirement set by the National Bank of Ethiopia (NBE). However, compared to the capital of banks operating in neighboring countries which have almost equal gross domestic product (GDP) with that of Ethiopia, the individual and aggregate capitals of our local banks are not enough to satisfy the growth needs of the economy, and other critical investments that must be made now rather than later to sustain the sector’s growth and enhance its competitiveness over a longer-term.

Recently, the regulator raised the minimum capital of setting up a bank to 500 million Br and set a due date for earlier established banks to satisfy the requirement. Although many of the private banks have already surpassed the minimum capital requirement before the due date and some of the banks are currently raising their capital many times above the set threshold, it is not enough to organically grow the capital base of the banks with their current handful shareholders.

In the interests of the growing economy and  long-term stability and growth  of the sector, the capital of the banks need to be increased, preferably  voluntarily, if not through regulatory intervention. And there are concrete reasons driving this need.

The Ethiopian economy is growing at impressive rates and is projected to grow with a significant demand for financing the future key growth sector of the economy – the industry.  If the private sector has a role to play in industrial development of this nation, which the Ethiopian government’s Growth & Transformation Plan (GTP) has a critical objective to lay a foundation, our banks need to build a strong balance sheet and capability to sustain growth of the sector and benefit from it.

This requires a capital base more than what is required for the predominant trade finance. In the absence of investment banks, stock exchange market,and other private long-term financing mechanism in the economy, the commercial banks, to some extent, are also expected to shoulder the responsibilities of long-term financing for private sector growth in the sector. Hence, our banks need to revisit their balance sheet funding sources beyond maintaining the regulatory minimum.

The growth rates of the banks must also match the growth rates of their customer base. Some of prominent customers of the banks may flee to banks that have a higher capital base because some of the commercial banks may not satisfy the growing financing requirements of the borrowers, due to a single borrower limit set by the regulator.

Hence, the capital growth should consider not only new customers but also existing customers with growing demands. Losing an established customer which a bank has developed a nin-depth knowledge over the years can significantly affect the bottom line.

Many of the banks are investing in core banking system which is critical to manage front office operations. In addition to core banking, however, modern banking requires significant investments and continuous upgrading in Enterprise Resources Planning (ERP), Customers Relationship Management (CRM) and Analytics systems.

But almost all our banks are lagging on such investments. Consequently, the banks cannot effectively use their big data and convert to critical and meaningful internal information to drive their business.

In addition to heavy investment in technology, the private banks need investment in human capital. The current manpower of the banks which may be appropriate for the current products and services may not be so when additional products and services or channels of delivering existing products and services change.

As competition intensifies, and the way of doing business changes, the skill of employees will have paramount importance in managing risks which banks are always exposed as a cost of doing business.

Although the skilled manpower requirements of the banks may be less than that of the sophisticated investment banking business, they need to develop and engage in specialised long-term training of their current generalist employees to compete effectively before the market is free to foreign players. In this regard, the banking sector wasted the last two decades windows of opportunity.

But it is not too late to set a long-term human capital development program, at least jointly, and may be using the Ethiopian Bankers Association as a key platform to drive the agenda.

Apart from their shareholders funds, all the private banks do not have access to long-term and wholesale funding that are common in many countries. Currently, almost all private banks primarily rely on retail deposits to grow their business. Until wholesale funding and other longer-term financing sources are introduced into the system,the banks only alternative is to rely on the most expensive sources of funding which is equity capital.

Banks manage many types of risks on a day to day basis, particularly credit risk, liquidity risk and operational risk. Although they can factor in expected losses in their lending rates, it is difficult to anticipate and manage abnormal losses that might be resulted from macro-economic and business cycle factors beyond the sectors control.

Unanticipated losses can make undercapitalised banks insolvent. The only mitigating mechanism to absorb unanticipated losses is the Bank’s strong equity capital.

The Basel Committee on Banking Supervision issues capital and liquidity standards on different times for adoption by member countries regulators. The recently issued Standard, Basel-III has also emphasized reliance on bank capital, particularly equity capital, as a key safety net for insolvency. Hence, a strong capital base is a key assurance of a bank’s stability in the long-term.

The key question is, what needs to be done to increase the banks’ capital?

Even if the optimal capital structure theory of corporate finance may not be fully applicable to determine commercial banks capital structure, because of regulation and the power of banks to make money, I have a strong opinion that the key issues highlighted above necessitates a higher capital base.

For instance, the top eight listed banks in Kenya for the last financial year 2012 have a capital base of over 2.7 billion dollars. But our banks total shareholders equity for the same year was less than one billion dollars. Kenya’s GDP is almost the same as that of Ethiopia. However, Kenya Commercial Bank alone has a capital base greater than our nine top commercial banks (including the Commercial Bank of Ethiopia (CBE) and the Construction & Business Bank (CBB)) combined paid-up capital (not considering temporary retained earnings). 

Equity Bank of Kenya which entered into the banking business in early 1990s, when our private banks were also under establishment, has a capital of about 500 million dollars, which is greater than our largest commercial bank – the CBE.

Let alone increasing a strong capital base over the years, our banks did not even bother about capital maintenance. They have been dashing out dividends year-on-year.

As any finance expert might know, inflation in the economy significantly erodes operating capability of any company including the banks. However, from the trend in the private commercial banks high dividend payout ratio, one can assume that the concept of capital maintenance is absent from the bank’s internal financial policy even when inflation was running at double digit.

This was partly blurred by the significant growth in retail deposits over the years. In over a decade, as retail deposit have been extensively used to finance the growth, the private commercial banks, inadvertently engaged in unhealthy competition of dividend payout ratio, and set unnecessary expectations of their shareholders in every annual meeting.

Unless abetted in good time, the current high dividend payout will become a key challenge to senior management of the banks in the years to come and might also lead to “creative accounting”.  It is high time to halt shareholders expectation through a well-articulated dividend policy.

The current dividend payout ratio of the banks, which on is average over 30pc, cannot be sustainable in the long-term unless significant investments are made now on key growth drivers such as strong equity capital, cost effective deposit mobilization, technology, human capital, new products and services and advanced risk management systems.

Building a strong capital base requires more than organic growth.  In addition to retained earnings, earlier established private banks have significant attractiveness to reach new shareholders to raise additional fresh capital. However, the banks leadership must overcome the current “major” shareholders resistance to limit the capital growth of the banks to existing shareholders pocket.

On the other hand, it is good to have own buildings for head office and branches. In my opinion, this will be very expensive and unnecessary at least with the current capital base of our banks. Unless the banks have excess liquidity with no alternative investment, expanding branch networks through own buildings is not an efficient way of using long-term capital that has a more productive use elsewhere.

The other bold move our local commercial banks must consider is consolidation through merger, with other local commercial banks and possibly foreign banks, when this is allowed. At present, it will be a good economics if our private commercial banks consolidate and leverage from each other established branch networks to compete effectively, at least with the Commercial Bank of Ethiopia (CBE), in the short-run and with our neighboring countries banks in the long-run. This requires far-sighted leadership not marred by trivial local issues that might be regrettable in hindsight when the banks would be unable to compete individually in the marketplace.

In conclusion, organic growth has a limit to build strong banks. If voluntary consolidation is not forthcoming within the coming few years, a regulatory intervention may be the ultimate instrument to enhance the sector’s competitiveness and stability. Other countries in Africa have done it and created world class local banks.


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