Financial Regulation and Development On this date, the NBE issued a directive requiring all commercial banks to hold 27% of new loan disbursements in NBE bills. Unlike many western economies, who used analogous measures to slash public debt, Ethiopia launched this regulation to promote long-term investment (IMF 2013b).

The relevant aspect of studying the so-called “27% rule” is given by the unique nature of this shock: 1) it was unexpected and was announced less than a month before implementation; 2) it caused a large mobilization in banks’ assets, as shown in the next subsection.

From a theoretical point of view, this policy can be mapped as a positive shock to the _s_<sup>_R_</sup> = _ρ_ parameter and the above conditions 1 and 2 make this ideal for our analysis.<sup>8</sup> It is also important to highlight that the NBE Bills are not a profitable investment, as they pay a fixed remuneration of 3% per year, lower than the minimum deposit rate, 5%, or the average lending interest, 12% (National Bank of Ethiopia 2012)<sup>9</sup> .

In order to test the implications of Propositions 1 and 2, we collect confidential data on the monthly balance sheet of all Ethiopian private banks between 2010 and 2013, on publicly available Annual Reports data on profits between 2008 and 2013, and we build a unique city-level map of Ethiopian branches, where for every bank we know in which cities all new branches have been opened, with respective month and year between 2000 and 2015.

Propositions 1 and 2 provide two fundamental elements to test the model: a shock to _s_<sup>_R_</sup> promotes deposit growth; and cross-sectional variation in _η_ characterizes a differential impact to the shock. Ethiopia is an exceptional context in which to test this model because as well as a large timeseries variation in _s_<sup>_R_</sup> , we find a large cross-sectional variation in some characteristics associated with _η_ . Figure 4 presents the total assets of the 14 Ethiopian banks on March 2011, before the policy implementation, and there emerges a natural distinction between big and small banks. Indeed, there is a large discontinuity between the sixth bank, Bank of Abyssinia (BOA), with assets close to eight the developing world, where banking systems have much higher shares of private and foreign participation. Despite a relatively low level of financial development, the Ethiopian financial sector is stable and presents a well-capitalized banking sector, registering profitability levels well above the regional average (IMF 2013b).

> 8The theoretical model predicts a stronger effect of regulation in the presence of a low initial level of regulation (low _ρ_ ) and high riskiness of the financial system (high 1 _− p_ ). We believe that given the level of financial risk in this economy, the Ethiopian banking system meets the criterion, given the absence of any deposit insurance scheme and the simultaneous presence of a remarkable asset and liability volatility. The variation coefficients of deposits and private sector loans, which can be interpreted as an index of dispersion of such variables, stands at 14% and 18%, respectively. This indicates that roughly 15% of a bank balance sheet is withdrawn and deposited back in a year. This is extraordinarily high compared to the 2–5% recorded in the Euro Area (Deutsche Bank 2012) or the USA (PricewaterhouseCoopers 2011). This concern was expressed also by the banks themselves. Indeed, during our interviews with local bank executives, we found that this is a core problem of local banks and we found supporting evidence for our “maturity mismatch” risk assumption going through the theoretical model.

> 9Therefore this policy as well as mandating safe assets, also lowers the return on private sector lending, as banks are forced to purchase government bonds with a negative remuneration for every loan. As a consequence, this piece of financial regulation also includes a direct tax on lending. We show in Section 4 that this effect also leads to an increase in safe assets, _s_ , by changing the relative prices of bank assets and favouring the purchase of safe assets. However in this context, the main effect comes from the mandatory purchase of NBE Bills, as reported during our extensive consultations with Ethiopian central bank executives and private bankers. At the same time, it is important to highlight that the tax element is relatively small. In fact, before the policy a unit loan would deliver a 12% return, while after it would deliver the same gross return, minus the net remuneration of this bills _−_ 2% times the amount of the purchased bills 0 _._ 27, hence 12% _−_ 0 _._ 27 _×_ 2%, this result in a 0 _._ 045% tax on lending returns.

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