Banks are the intermediary, or go-between, in Uganda’s financial system. They perform this role by carrying out three main functions. First, banks are institutions where people can deposit their savings and in return, earn interest on these savings. Secondly, banks are responsible for the payments system which we all rely on to pay salaries, pay bills, to trade and do business. Thirdly, banks issue loans to the general public. As of June 2016, the total amount of money lent out by banks in Uganda to the general public was Shs11 trillion. That is the equivalent of about 15 per cent of the country’s total Gross Domestic Product.
Where do banks get money from?
Banks raise capital mainly in three ways. The first is capital raised from its shareholders in form of share capital. The second major source of capital or funding for a bank is money mobilised from depositors in form of bank deposits. This money may be in the form of cash deposits on the bank’s customers’ current accounts, savings accounts or fixed deposit accounts. The third major source of capital or funding for the banks is borrowings from either the financial markets or from Bank of Uganda
How banks make money
Banks are in the business of mobilising money from savers in form of deposits and lending money to its customers. A bank’s main source of income is the revenue it earns from the interest it receives on the money it lends to its customers. Banks earn money by charging more interest on loans than what they pay on savings. In banking language, this is referred to as the net interest spread. A bank’s net interest spread is kind of similar to a manufacturer or trader’s gross profit margin. It is out of this interest spread that a bank earns its income out of which it finances its operating costs, covers the losses it incurs on loans that are not repaid at all or not repaid in full, pay the bank’s overheads, such as staff salaries and wages, fund its capital expenditure such as electronic banking platforms, pay taxes and if there is any left, then pay its investors a dividend as a return on their investment.
Determinants of interest rates on loans
Interest rates are determined by external factors which are beyond the Bank’s control and internal factors that are within the bank’s control. The external factors include the Central Bank Rate (CBR), the Treasury Bills rate, the rate of inflation within the economy and the cash reserve requirement by the Central Bank. The CBR rate is policy signal on the relative cost of credit, and it is aimed at influencing the lending behaviour of commercial banks. Currently, the CBR rate is 14 per cent.
There are also other internal factors. These include, the bank’s operating costs, that is the cost the bank incurs in maintaining its banking infrastructure including payments of salaries and wages to its staff; the cost of funds in form of the interest the bank pays for the deposits held, the costs relating to non-performing loans or bad debts and the liquidity premium costs which the bank incurs to ensure funding is always available to its customers at any time.
The high interest rates in Uganda is a reflection of the government’s policy with regards to how much it is borrowing from the local market, the country’s risk rating from an investor perspective and the high cost of doing business in Uganda. All these three factors together influence the rate at which banks lend to their customers.
Is capping interest rates the solution?
In my opinion, no. What is needed are long-term solutions to address the money supply side constraint and dealing with government borrowing and the high cost of doing business in Uganda. A cap on interest rates will be taking us back to the old times of Government price control. Interest caps are based on the notion that caps on loan prices will protect borrowers from excessive interest rates thereby increasing credit affordability and access to finance. Despite these good intentions, interest rate caps can actually hurt low-income populations by limiting their access to finance.
Experience from other countries
Interest rate caps have resulted in a slowdown in credit growth in countries such as Ecuador and Nicaragua. Interest caps may also result in loss of investor confidence resulting in capital flight. A very good example is what happened in Kenya. Shares of the largest Kenyan banks listed on the Nairobi Exchange plummeted by 10 per cent in response to the news of the introduction of the interest rate cap. The introduction of an interest rate cap in the West African countries hurt the poor most, as microfinance institutions withdrew from the remote areas of these countries.
Interest rate caps can also lead to less transparency, as was the case in South Africa when lenders introduced so many extra fees and commissions in response to interest-rate caps. This made loans more expensive overall. A cap on interest may also discourage supply of funds to the financial system, thus encouraging informal loan sharks. This will result in a black market for credit.
It may also discourage the current level of innovations in the banking sector which is aimed at high risk and low scale credit segment of the population. This sector includes mainly the Small and Medium sized Enterprises and low income and first time borrowers. This will in turn slow down the progress the government has made towards financial inclusion.
Interest rate caps also poses a danger to the employment of the more than 10,000 employees currently working for the banking sector in Uganda. For example, when interest rate caps were introduced in Zambia, two financial institutions laid off close to 100 people within one month.
Solutions to the high rates of interest
We need long-term solutions to address the money supply side constraint as well as dealing with the issue of government borrowing and the relatively high cost of doing business in Uganda. Legislating for a cap on the interest a bank can charge on its loans, may be populist from a political perspective but will not improve the current problems we have in Uganda with regards to access to affordable finance.
One of the challenges for banks in Uganda is lack of long-term sources of funding. They should mobilise more long-term capital from the market through pooling funds and long-term savings and deepening capital markets. This may require the Government to consider introducing a tax incentive to encourage a culture of long-term saving.
Promoting financial inclusion and bringing the informal economy into the financial system, through agency banking also needs to be fast tracked.
Consumer awareness and protection needs to be strengthened through investing more in financial literacy.
Credit risk should also be reduced in the market by strengthening the Credit Reference Bureau.
Banks should reduce their operating costs by undertaking collaboration projects that involve shared technology platforms to bring down the cost delivery of services while increasing outreach, foot print, and presence across the country.
Government should also commit to pay its suppliers on time. According to the Bank of Uganda, the major cause of financial stress for many of the local companies that are currently struggling to service their loans is delayed payments by the government.
Borrowers also need to be more disciplined. One of the main reasons why non-performing loans have increased to the highs of 8 per cent is because borrowers divert funds from their intended use.
The government must also improve its efficiency with regards to delivery of big infrastructure projects which have the potential of reducing the costs of doing business and result in multiplier effects that will help spur economic growth and financial inclusion.
In conclusion, any attempt to fix the price of credit by legislation through a cap on interest might make credit affordable in theory, but very few will be able to access it. What is needed is to address the underlying causes of the high cost of credit.
Francis Kamulegeya is the senior partner of PwC Uganda and a board member of PwC Africa. E-mail address [email protected]