Tuesday, February 27, 2024
CommentaryCaught in a liquidity quagmire

Caught in a liquidity quagmire

Over the past several years, in addition to seasonal liquidity shortages, liquidity problems in the banking industry have become increasingly common. Lately, the severity of these issues has escalated. Despite the National Bank of Ethiopia (NBE) repeatedly denying the existence of a systematic liquidity problem, the shortage of liquid resources in the industry is unmistakable. Customers face significant difficulties when trying to withdraw cash from their bank accounts, and during holiday periods, these challenges become unbearable. Both commercial banks and the NBE share responsibility for this predicament.

While the NBE acknowledges the presence of liquidity problems in a few banks, its response has been to raise the emergency credit interest rate on two occasions in recent years. However, this measure serves more as a means to discipline the banks rather than a genuine solution.

It appears that increased competition and pressure from shareholders have compelled banks to invest heavily in extending credits, often without due regard to their liquidity positions. The growing demand for credit, coupled with attractive short-term investment opportunities in treasury bills, may have encouraged banks to utilize all their resources for income-generating activities. Additionally, a rule requiring banks to purchase bonds equivalent to 20 percent of their gross loan disbursements has significantly depleted their available funds.

It is important to note the impact of telebirr, with over 34 million subscribers, on the liquidity of private banks. Since the custody account of telebirr is held with the Commercial Bank of Ethiopia (CBE), transfers from private bank customers’ accounts to their telebirr accounts result in a leakage of private banks’ reserves held with the NBE. This undermines the liquidity of private banks while significantly boosting the liquid resources of the CBE.

In order to maintain a minimum liquidity level, banks are required to hold at least 15 percent of demand, savings, time deposits, and other liabilities maturing in less than one month. However, the liquidity indicator, which is calculated by dividing reserves with the NBE, cash in hand, and net foreign assets by net deposits, reveals that the industry’s liquidity ratio has been below 15 percent for two-thirds of the months between July 2020 and March 2023. Almost half of the liquid resources are held in reserve accounts within the NBE, and net foreign assets also consume a significant portion of the liquid resources. If we exclude these components from the liquidity requirement, the banks’ liquidity level would decrease by half.

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This indicates that the regulatory liquidity requirement allows banks to operate with a small amount of liquid resources. According to the latest data from the NBE as of March 31, 2023, commercial banks hold cash in their vaults equivalent to 2.3 percent of their deposits, and their excess reserves (total deposits with the NBE minus reserve requirements) amount to 2.9 percent of their deposits. Both of these figures have been declining for years. In fact, the cash-to-total-deposit ratio of some banks is even less than two percent.

The NBE closely monitors the liquidity position of banks on a weekly basis. Banks are also required to submit quarterly reports that disclose their maturing assets and liabilities. Additionally, the NBE’s Liquidity Requirement Directive mandates banks to establish an Asset and Liability Management Committee (ALCO) with the responsibility of managing liquidity. Some banks voluntarily adopt the Basel III approach to liquidity management, using the Liquidity Coverage Ratio (LCR), which indicates the proportion of highly liquid assets to net cash outflows over the next 30 days.

Despite the existence of these mechanisms to maintain liquidity in the banking industry, they are not functioning properly. The inter-bank money market, which was established in the late 1990s, has been barely active. In 2021, the NBE introduced Open Market Operations and Standing Facilities, which include a range of instruments to manage the liquidity of the banking system for conducting monetary policy. However, it appears that these facilities are not currently operational.

It is understandable that the role of cash declines with the improvement in payment technologies. However, cash still holds importance in the Ethiopian economy, especially considering the significant presence of a large informal economic sector. Moreover, commercial banks need to maintain adequate funds with the NBE to facilitate smooth inter-bank transactions.

The negative experiences faced by customers, the data provided by the NBE, and the recent increase in the NBE’s emergency lending rate, as well as a couple of years ago, all indicate that the liquidity problem appears to be systematic. This suggests that both the banks and the NBE are facing issues with their liquidity management, which is causing the problem to persist.

Given that the liquidity of the banking industry is a crucial aspect of financial stability, it should primarily concern the NBE. The NBE should consider increasing the liquidity requirement ratio while taking into account the lending situation and interest rates. It should also review the composition of liquid assets used in the computation of the liquidity ratio.

Additionally, there should be a strong emphasis on promoting the inter-bank money market, actively utilizing Open Market Operations (OMO) and other funding facilities (the substantial holdings of treasury bills and bonds should enable commercial banks to have easy access to NBE funding by using these securities as collateral). The NBE should also demand that banks revamp their liquidity management practices and enhance their capacity for liquidity forecasting.

Similarly, commercial banks have a responsibility to maintain adequate liquid resources to ensure the smooth operation of their activities. The adoption of the Basel II approach for liquidity management is commendable. However, the effectiveness of this forward-looking approach depends on the quality of forecasts. This requires investment in resources and analytical capacity, which the banks should prioritize.

Contributed by Abdulmena Mohammed

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Video from Enat Bank Youtube Channel.

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