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Derg period all banks were nationalized. The National Bank of Ethiopia (NBE) was at the apex of the banking structure and was engaged in all the functions of a central bank. The financial sector the socialist government left behind constituted only of four banks, each enjoying a monopoly in its respective market, namely the NBE, the CBE, the Construction and Business Bank and the Agricultural and Industrial Development Bank. In addition to these banks, there were also two other financial institutions: Ethiopian Insurance Corporation (EIC) and the Pension and Social Security Authority (PSSA). On the average the CBE alone comprises more than 90% of total deposit and 71% of the total loans (Alemyahu Geda 2003).

Financial Reform period (post 1991)

The Monetary and Banking Proclamation of 1994 established the NBE as a judicial entity separate from the government and outlined its main functions. Monetary and Banking proclamation No 83/1994 and the Licensing and Supervision of Banking Business No 84/1994 that allows the private sector (owners have to be Ethiopian nationals) to engage in the banking and insurance businesses marks the beginning of a new era in Ethiopia’s financial sector. Following this proclamation the country witnessed a proliferation of private banking and insurance companies.

The financial system of Ethiopia is underdeveloped with the domination of banking sector. According to NBE (2011), the number of banks operating in the country reached 17 with 970 branches. In terms of ownership, fourteen were private commercial banks and the remaining three state-owned, 14 insurances with 221 branches and 31 microfinance institutions.

4.2. Monetary policy

Monetary policy refers to a bundle of actions and regulatory stances taken by the central bank to regulation money supply and interest rates in order to control inflation stabilize currency and further bringing general economic stabilization of a country.

A higher participation of financial intermediation sector as a source funds for production will significantly a broad scope of action taken for monetary policy. All other things equal, average share of credit extended to the private sectors should be associated with more efficient policy (Felix Rioja &et al, 2006). Thus the appropriate approach of monetary policy is crucial not only to the financial system but also to the whole economy.

According to NBE (2010/11), the ratio of M2/GDP, an indicator of financial deepening, went up merely by 6.7% to 29.1% in 2010/11, partly indicating the tight monetary policy measures taken to mitigate the inflationary pressures. Money multiplier defined as narrow money to reserve money and broad money to reserve money remained the same at 1.1% and 2.1%, respectively.

4.2.1. Monetary Policy Instruments

The introduction of a wide range of monetary instruments by central banks engenders competition, efficiency and transparency and broadens financial intermediation in the banking system. It also promotes liquidity management of commercial banks and gradually leads to the development of well functioning money and financial markets which could serve as catalysts for economic growth and development. So far, the use of such instruments has been extremely limited in Ethiopia due to the underdevelopment of the money market and the virtual non-existence of a financial market