Revisiting the Ethiopian Bank Corporate Governance System: A Glimpse of the Operation of Private Banks.

• Author: Ayele, Asnakech Getnet

Abbreviations CBE Commercial Bank of Ethiopia CEO Chief Executive Officer Com C The Commercial Code of Ethiopia EFFORT Endowment Fund For the Rehabilitation of Tigray EPRDF Ethiopian Peoples Revolutionary Democratic Front NBE National Bank of Ethiopia OECD Organization for Economic Development and Cooperation TPLF Tigray Peoples Liberation Front Introduction

Bank corporate governance is characterized by a complex framework as it encompasses a wide range of stakeholders including not only shareholders but also depositors, creditors, suppliers, employees, and regulatory bodies. (1) The unique features of banks necessitate strict government regulation through bank supervisors and a range of banking laws and regulations. (2) The interface between these elements determines how well the performance of a bank conforms to the best interest of shareholders, while complying with regulatory standards. (3) Hence, for shareholders and regulators the bank corporate governance framework is critical for the bank's success and its daily operations. (4)

Good corporate governance fosters efficient monitoring of corporate assets, effective risk management and greater transparency of banking activities helps to achieve and maintain public trust and confidence in the banking system. (5) In contrast, poor corporate governance may contribute to bank failures which could, in turn, trigger a bank run or liquidity crisis. (6) In addition, it is associated with "crony capitalism" that transmits shocks leading to bankruptcy and contagion resulting in adverse impacts on the financial system of a country. (7)

Though there is no single model of good corporate governance and no one size fits all model, there are some principles that have been developed by the OECD, the Basel committee on banking supervision, the UK Cadbury report of 1992, and others. (8)

These principles cover the following areas: rights of shareholders; equitable treatment of shareholders; the role of stakeholders; disclosure and transparency; and responsibilities of the board. (9) Moreover, the World Bank has proposed guidelines for good corporate governance in the financial sector seeing the sector as an engine for robust economic growth, and for effective transmission of monetary policy. (10)

This article attempts to deal with the basic features of bank corporate governance in Ethiopia that contribute to its poor performance and indicate the legal and policy changes which need to be made to tackle these problems. It also examines the operation of some selected private banks in light of various aspects of corporate governance. However, the article neither claim to provide a perfect solution for all bank corporate governance problems in Ethiopia nor does it expose the vast corporate malpractices which are alleged to exist in the banking industry for this can hardly be achieved in the current crude state of corporate disclosure. (11)

This work starts by defining corporate governance, and then it discusses the special nature of bank corporate governance and agency problem in banks. The second section examines the Ethiopian aspect of corporate governance and critically analyzes its main features by pinpointing the mix of politics and business, absence of share market, inadequate shareholder protection laws, and the ineffective court system. The Ethiopian bank regulatory environment is also discussed under this section. The third section questions the link between corporate governance and bank performance in five Ethiopian private banks. For this purpose it considers some aspects of corporate governance. The conclusion underlines the implications of the issues discussed and suggests possible recommendations.

1. Defining Corporate Governance

   Corporate governance has been defined in different ways by different authors. (12) Shleifer and Vishny define corporate governance as the ways in which suppliers of finance to corporations make sure of getting a return on their investment. (13) Gillan and Starks take a broad perspective on corporate governance and define it as the system of laws, rules, and factors that control operations in a company. (14) The Organization for Economic Cooperation and Development (OECD) offer a more comprehensive definition of corporate governance as a set of relationships between management of a corporation, its board, its shareholders and other stakeholders, while also providing the structure through which corporate objectives are set, and the means of attaining those objectives and monitoring performance are determined. (15)

   From these definitions, it may be stated that corporate governance frameworks establish systems of accountability and responsibility between the company and its major constituencies by defining the nature of the relationship. (16) In this article the definition provided by Shleifer and Vishny is chosen since it is in harmony with the unique nature of banks that requires adopting a broader view of corporate governance which encapsulates both shareholders and depositors. (17)

   1.1 The Special Nature of Bank Corporate Governance

   Because of the opaque nature of banks and heavy government regulation, corporate governance works differently in the banking sector. (18) Banks are generally more opaque than nonfinancial firms, and evidence suggests that informational asymmetries are larger in banks than in other sectors. (19) The true value of a bank's loan portfolio is not readily observable and can be hidden for long periods. (20) Moreover, banks can change the risky nature of their assets more quickly; they can hide problems by extending loans to clients that cannot service previous debt obligations. (21) Because of this, bond analysts disagree more over the bonds issued by banks than over those of nonfinancial firms. (22)

   The multifaceted and sensitive role which banks play in the economic system normally draws government's attention through heavy regulation. (23) Banks perform as liquidity guarantors, sources of non-market finance, information brokers between lenders and borrowers, and payment system operators. (24) All these features of banks coupled with the opacity of bank assets and activities forces governments to impose an elaborate array of regulations on banks. (25)

   The strict regulation of banks, more often than not, imposes a natural hindrance to corporate governance mechanisms. (26) This is the case when regulation imposes restrictions on concentration of ownership, entry, takeover, bank activities, or when it designs deposit insurance. All have the possibility of reducing the effectiveness of mechanisms designed to control management by shareholders. (27) Limitation on concentrated ownership reduces the control of managers by large share holders as the latter have the impetus to acquire information and monitor managers by electing their representatives to the board of directors. (28) Likewise, restrictions on hostile takeovers reduce the ability of outside bidders to make a credible takeover threat and improve the governance system in a bank. (29)

   The most extreme form of government regulation of banks is ownership of banks. (30) Government ownership of banks presents a problem for corporate governance since it creates a situation of conflict of interest between the state both in acting as an owner and a regulatory authority. (31) The managing of the bank is also handed to bureaucrats who are unlikely to maximize firm value, but rather cater to the interests of specific groups. (32)

   The unique nature of the banking firm requires the legal protection of depositors equally as that of shareholders. (33) For this reason, the government provides explicit deposit insurance and the implicit guarantee of bailing out of large banks to avoid bank runs and hence maintain financial system stability. (34) Deposit insurance might encourage economic agents to deposit their wealth with a bank, as a substantial part of the moral hazard cost is borne by the government. (35) Unfortunately, such public safety-nets engender moral hazard problem in banks as it may encourage banks opportunistically to engage in more risky ventures. (36) To ameliorate moral hazard costs, the government can use economic regulations such as asset restrictions, interest rate ceilings, and reserve requirements. (37)

   1.2 Agency Problem in Banks

   Although the modern corporation has the status of an artificial person under commercial law, it is generally owned by physical persons, directed by a dozen or so individuals who are supposedly acting on the owners' behalf, and run by a deep hierarchy of managers. (38) The vast and complex network of obligations between owners, directors, managers and employees who think on behalf of the organization and also on behalf of themselves can succinctly be described as agency problem. (39)

   Agency problems arise because there is a divergence of interest between shareholders and managers and due to information asymmetry between them. (40) Managers use their full control rights to pursue projects that benefit them rather than investors. (41) Opportunistic managerial behaviours are manifested in shirking, empire building, and expense preference or, in the extreme outright expropriation. (42) Experience has shown that managers may misappropriate corporate assets whenever they get an opportunity to do so. (43) For example, in the "Enron" era the root cause was the transfer of wealth from the corporation and its shareholders into the bank accounts and stock portfolios of senior executives. (44)

   Agency problems in banks not only occurs in the conflict of interests between managers and owners, but also in broader conflict areas, such as shareholders through managers versus bondholders or depositors, major shareholders versus minor ones, and management versus supervisory bodies. (45) Such agency problems underpin the major features of regulatory structures, such as, capital requirements, deposit insurance, etc., and problems of...