In my previous two articles I shared my perspectives on what it takes the Ethiopian Capital Market to thrive (The Ecosystem approach) and followed on my second article with a historical grasp on the genesis of capital market and shared one of the potential pitfalls to watch out (risk of market concentration) ( financial institutions in Ethiopian case)-hopefully without dampening the excitement and diminishing the opportunities the Capital Market brings to businesses and both institutional and retail investors !

Capital markets play a crucial role in powering the global economy. They facilitate the flow of funds between investors and borrowers, enabling efficient allocation of capital. Again, there is no perfect mechanism to bring market participant without a calculated risk and well thought regulatory framework.

So, in this article I discuss the importance of Capital Market Regulation and the risk and implications of not having well designed and resourced regulatory body.

The banking sector in Ethiopia is regulated by the National Bank of Ethiopia. Currently most businesses and individual investors access their financing needs through the existing banks. What is changing? Soon there will be other options to access finance (financial intermediation) in Ethiopia- the long-awaited Capital Markets. The advent of the capital market provides a mechanism to obtain finance through a nonbank financial intermediation (e.g., allows companies to issue debt securities and equity, insurers, mutual funds, and exchanges). It worth pointing out the nonbank financial firms represent almost half of the global financial system’s assets. While these have no role in Ethiopia at present the Ethiopian capital markets with enabled ecosystem have the potential to create a robust financial system in conjunction with the banking system.

The Ethiopian Capital market is starting with the Stock Exchange, as well as provides a regulated mechanisms for companies to raise funds through debt and equity instruments, then to follow other options to participate I the capital markets such as the Collective Investment Scheme (CSI) in due course.

The role of a regulator is to ensure risks such as Market conduct, liquidity, credit, operational and systemic risks are mitigated as much as possible.

Market conduct risk happens when individuals trade based on non-public information (insider trading), it undermines market integrity and deliberate actions to distort market prices or create false impressions can harm investors (Market manipulation). Market Conduct risks can be addressed through Surveillance and Enforcement: Regulators monitor trading activities, investigate suspicious behaviour, and enforce rules against insider trading. Similarly, market manipulations can be mitigated by requiring companies to disclose material information ensures transparency and fair access for all investors.

There is an overlap between the financial institutions market conduct regulation and large companies that are listed on a stock exchange and non-listed entities that raise funds either through debt and equity instruments. In many countries there are a number of regulators working in tandem. For example, in Kenya while the Kenyan Capital market Authority have a number of Regulatinions (over 30) that deals with specific areas e.g., The Capital Markets (Real Estate Investment Trust) (Collective Investment Schemes) (Amendment) Regulations, 2023) and Capital Market (Investment-Based Crowdfunding) Regulations 2022) that gives a framework to regulate the capital markets. Other Countries, such as Australia has various statutory bodies funded by governments and industry levies that deals with various aspects of the financial sectors with overlapping responsibilities from market conduct, liquidity and investor and consumer protections. These agencies have legislative powers to impose penalties and use the judiciary to correct any misconduct by institutions and company directors. Each countries have their own context and legal frameworks, which often is dictated by the size and maturity of their financial markets.

Liquidity risk occurs from liquidity mismatch (fund shortage if assets cannot be converted into cash during market stress and sudden withdrawal of funds from an investment vehicle can lead to a liquidity crisis. The way regulators can mitigate liquidity risk is by a established mechanism and assess how financial institutions and markets would perform under adverse conditions (Stress Testing). Further by providing guidance or directives institutions to maintain sufficient liquid assets to meet obligations during stress (Liquidity Requirements).

Credit risk is when a borrower or issuer defaults on its obligations as well as when an issuer suffers a down grade credit rating- This affects the values of debt securities. As part of the capital market ecosystem robust credit rating agency is critical.

A rating agency assesses the creditworthiness of financial entities. For e.g., an agency assigns ratings to their debt instruments. This evaluation helps to indicate the reliability of payment and the risks of default. Moreover, the ratings provided by these agencies shape investment decisions in capital markets. They offer investors a tool to measure the risk of any debt instrument and assess if the returns are worth the risks, that is, helps in creating a correlation between risk and return of an instrument.

Overall, Credit rating agencies contribute to the efficient functioning of the fixed income markets by providing an independent source of information on the credit standing of issuers of debt securities.

Other two equally important risks are operational and systemic risks. Operational risk in capital markets often happens around the integrity and safety of the technology employed and its ability to withstand cyber-attacks . Cybersecurity breaches can disrupt trading platforms, settlement systems, and financial institutions. Similarly technological failures such as glitches can disrupt market operations. Finally, one of an overarching responsibility of a

Capital Markets Regulator is to deal with systemic risk. Systemic Risk is the possibility that an event at the company level could trigger severe instability or even collapse an entire industry or economy. When a company is considered “too big to fail,” it means that its failure could have widespread repercussions. These institutions are either large relative to their respective industries or make up a significant part of the overall economy.

In a capital market context Regulators have two fundamental ways of addressing Systemic Risks: by monitoring interconnectedness and imposing additional requirements on systemically important institutions (Macroprudential policies) and ensuring there is  a resolution framework, that is a plan for orderly resolution of failing institutions prevent contagion. In summary, addressing regulatory risks in capital markets is crucial for maintaining stability, investor confidence, and sustainable economic growth

On my fourth and final article, I will return to discuss my area of interest – investor education and investor protection. I will deep dive and explain whose role is it and how can it be done at the national level. Who has the explicit mandate? What is the role of the capital Authority’s role if any?

Within a fast-evolving financial landscape where access to financial services is made easier while more risks are being transferred to citizens, financial literacy has become a key life skill for individuals as well as micro and small businesses. Financial education can help enhance financial literacy by increasing financial knowledge, skills and attitudes. In turn, this can contribute to individuals’ (including vulnerable and low income) participation in financial, economic and social life as well as to their financial well-being. As a complement to financial inclusion and financial consumer protection, financial education is also important to restore confidence and trust in financial markets.

I will elaborate on this on my next edition!

Mengistu Weldemariam is a Senior consultant in business and finance. Previously lecturer in corporate finance and accounting. Currently works in consumer and investor protection. -Senior Program Manager

In recent years, Ethiopia has seen significant economic reforms aimed at liberalizing its financial sector. Among the major developments is the emergence of a capital market, which promises to reshape the country’s financial landscape and potentially redefine the role of commercial banks. This article explores the implications of this shift, analyzing how the capital market is poised to influence Ethiopia’s economy and the future trajectory of its banking sector.

A capital market is a vital component of any economy, facilitating the buying and selling of financial instruments such as stocks, bonds, and other long-term investments. Unlike traditional banking, which focuses on lending and deposits, capital markets provide avenues for businesses and governments to raise funds directly from investors. This direct access to capital can fuel economic growth by financing infrastructure projects, expanding businesses, and promoting innovation. Historically, commercial banks have played a crucial role in mobilizing savings and providing credit to businesses and individuals. However, this model has limitations, particularly in meeting the long-term financing needs of large-scale projects and promoting broader financial inclusion.

According to the National Bank of Ethiopia’s (NBE) recent financial stability report, more than 96% of the country’s financial sector is dominated by commercial banks. Moreover, only 0.27% out of the 130 million population, have access to loans from banks. This shows that commercial banks haven’t provided inclusive services for the majority of the population. This lack of inclusivity highlights the urgent need for alternative financial mechanisms, such as a well-developed capital market, to broaden access to financial services and support economic growth. By offering diverse financial instruments and funding opportunities, the capital market can play a crucial role in addressing the financing needs of underrepresented segments of the population and promoting broader financial inclusion in Ethiopia. Ethiopia’s move towards establishing a capital market signifies a shift away from its predominantly bank-centered financial system.

The emergence of a capital market poses both challenges and opportunities for Ethiopia’s commercial banks. On one hand, banks may face increased competition for deposits as investors diversify their portfolios into stocks and bonds. This could potentially squeeze banks’ traditional sources of funding, prompting them to innovate in their product offerings and customer service to retain market share. However, the capital market also offers banks new revenue opportunities through underwriting and advisory services related to initial public offerings (IPOs) and corporate bonds. By leveraging their expertise in risk management and financial advisory, banks can play a pivotal role in facilitating the growth of the capital market.

The development of the capital market can enhance the efficiency of resource allocation and risk management within the financial system. As investors seek higher returns through capital market investments, commercial banks may experience a reduction in deposit inflows and loan demand. Nonetheless, this trend can create opportunities for banks to develop innovative products and services tailored to the needs of capital market participants.

Despite these opportunities, commercial banks face significant competitive pressures in an evolving financial landscape. The rise of non-bank financial institutions, such as investment banks and asset management firms, poses a threat to the traditional business models of commercial banks. These institutions are well-positioned to capitalize on the growing demand for capital market services, potentially eroding the market share of commercial banks.

Moreover, the integration of Ethiopia’s financial markets with global capital markets introduces new risks and vulnerabilities for commercial banks. Fluctuations in exchange rates, interest rates, and commodity prices can have profound implications for banks’ profitability and stability. Therefore, commercial banks must adopt robust risk management practices and embrace technological innovations to remain competitive in this dynamic environment.

A robust capital market enhances economic resilience by reducing dependency on bank financing and foreign aid. It allows businesses to access alternative sources of funding, thereby promoting entrepreneurship and job creation. Moreover, a diversified financial ecosystem promotes investor confidence and attracts foreign direct investment (FDI), bolstering Ethiopia’s position as a competitive destination for global capital.

Ethiopia’s ambitious infrastructure projects require substantial long-term financing. A well-functioning capital market can mobilize domestic savings and attract international investors seeking attractive returns. This not only supports the government’s development agenda but also catalyzes private sector growth across key industries.

The successful establishment of a capital market hinges on a robust regulatory framework that ensures transparency, fairness, and investor protection. Ethiopia’s capital market authorities must develop stringent oversight mechanisms to prevent market manipulation, insider trading, and other unethical practices. Effective regulation fosters trust among investors and promotes long-term market stability, which is essential for sustainable economic growth.

Furthermore, efforts to educate the public about investing in capital markets are crucial. Financial literacy programs can empower individuals to make informed investment decisions, thereby democratizing access to wealth-creation opportunities. By promoting inclusivity and broadening investor participation, Ethiopia can nurture a dynamic capital market that benefits all segments of society.

Despite its potential benefits, the establishment of a capital market in Ethiopia faces several challenges. These include limited institutional capacity, inadequate infrastructure, and a nascent legal framework. Addressing these obstacles requires concerted efforts from policymakers, regulators, and market participants to build the necessary infrastructure, strengthen governance structures, and enhance market liquidity.

Moreover, the integration of Ethiopia’s capital market with regional and global financial markets presents opportunities for cross-border investment and diversification. Collaborative initiatives with neighboring countries and international financial institutions can promote knowledge sharing and foster a vibrant economic ecosystem in the Horn of Africa region.

In conclusion, the emergence of a capital market represents a transformative opportunity for Ethiopia, signaling a shift towards a more diversified and resilient financial sector. While commercial banks will continue to play a pivotal role in the economy, the capital market offers new avenues for growth, innovation, and economic empowerment. By fostering a conducive regulatory environment, promoting financial inclusion, and investing in infrastructure, Ethiopia can unleash the full potential of its capital market and propel sustainable economic development for years to come.

Million Gashaw, Million is a Business Advisor at the Ethiopia office of R&D Group, a Dutch-based consulting and offshore outsourcing firm. He is currently pursuing an MSc in Corporate Finance and Investment Management at Addis Ababa University. For inquiries, the writer can be contacted at Millanovic.77@gmail.com Opinions expressed are personal and not endorsed by Capital.