Covid-19: Tough before it gets better for commercial banks

Uganda’s banking was poised for another record breaking year of improved profitability in 2020. But the effects of Covid19 may have applied the brakes on that growth. Even though there were signs of resilience and a stronger banking sector in the first two months of 2020, the government imposed lockdown from mid-March 2020 has led to sector-wide challenges.

Uganda’s economy is 47% driven by the services sector – the largest contributor to growth - that includes trade and tourism. Tourism became the first causality when it all came to a grinding halt with the closure of Entebbe International Airport on March 23 and the subsequent closure of hotels due to a lack of customers.

In fact, projections indicate nearly zero growth from the tourism sector between March and May 2020. Additionally, with the lockdown that led to closure of schools, arcades, bars and the 7pm to 6:30 am curfew, trading slowed down.

Reflection of economy
According to Bank of Uganda (BoU) statistics, trade contributes 20 per cent, private sector credit extensions, which is slightly behind building, mortgages, construction and real-estate at 21 per cent. With trade literally slowing down significantly, the banks also reduced credit facilities they provide to traders.

Even though the government maintained a steady flow of imports during the lockdown period, the subdued demand for some of the goods meant companies were not generating the required cash-flows in order to borrow more money or even get trade guarantees.

The Ministry of Finance State of the Economy reports for May and June 2020, show a complete slowdown in new lending to the private sector. In April 2020, commercial banks approved loans worth Shs490 billion and in May 2020, they approved loans worth Shs589.4 billion. These figures are far below the Shs1 trillion worth of loans banks approve on a monthly basis. The actual slowdown in lending is about 50 per cent although it will improve with further lifting of lockdown restrictions but it will be no-where near the pre-Covid-19 performance – at least not yet.

Going by the 2019 commercial bank results, interest income from lending to the private sector is the single largest contributor to incomes of banks. In essence, banks lend money to the private sector to make money and facilitate business growth. If banks are lending at just half of what they used to, then interest income will be suppressed, leading to reduced profitability.

Credit defaults
Commercial banks were given the lee-way by BoU to restructure loans for a period of up-to one year between April 2020 and March 2021.

This allowed commercial banks to let customers, on a case-by-case basis, extend loan repayments because these businesses were in distress. By end of May 2020, nearly Shs2 trillion worth of loans had been restructured, meaning that banks would accept to forego interest in the short term but still get their money back once the period of restructuring ends.

However, banks are also expected to take a hit because some of their customers are likely to default on the loan repayments no matter what sort of credit relief they receive. In fact, the latest financial soundness indicators from BoU released in July 2020 indicate that Non-Performing Loans (NPLs) to gross loans in the banking sector rose to 5.41 per cent in the first quarter of 2020.

This is the highest quarterly level of NPLs in the banking since December 2017. Projections indicate that NPLs at the end of 2020 may reach 10 per cent - a high last seen in 2016 at the height of the Crane Bank challenges that led to skyrocketing defaults.

As NPLs rise for the banks, this will also affect the profitability since commercial banks have to use part of their income to cover for expenses related to bad debts.

Already, some commercial banks like Tropical Bank faced such a challenge in 2019 when they had to dig into their own capital position to provide for increased costs needed to provide for loans that were going bad.

For some banks like Orient Bank, some decisions were made to merge some branches in order to cut down on costs. Several other banks also laid-off some workers to manage the rising costs. Sources within BoU and the banking sector indicate that the smaller banks will take the largest hit due to the lockdown measures.

Punching bags for high interest rates
Uganda’s interest rates are most certainly high but the challenge is systemic and is a reflection of the economy in general. When BoU started easing the Monetary Policy since March 2020 to accommodate increased borrowing to stimulate growth, the Central Bank Rate reduced twice to record levels of 8 per cent in April 2020 and then 7 per cent in June 2020.

Commercial bank lending rates remained sticky down wards reducing to 17.73 per cent in April 2020 but then rising to 18.84 per cent in May 2020. This rise led to Prof. Emmanuel Tumusiime-Mutebile, the BoU Governor writing to commercial banks on July 7, to reduce interest rates considering that the CBR had been reducing.

Mutebile also threatened to evoke the rule that allows BoU to cap interest rates. Through their association, the Uganda Bankers Association (UBA), banks also asked BoU to reduce some of the statutory limits to allow them flexibility to reduce interest rates even further.

Several bankers indicate what BoU is doing is posturing to show people that they are actually working. However, deep down the technocrats at BoU know that the current level of interest rates are a reflection of the risk profile that exists in Uganda. Several banks also indicate that interest rates are significantly lower for sectors of the economy that remain low-risk and high for those that remain likely to default.

Despite the Covid-19 challenges for banks, BoU indicates that the banks remain stable, even though some will be more exposed than others. The latest financial stability report from BoU indicates that banks are adequately capitalised to withsand the effects of Covid-19.

High operating costs
Cost-to-income ratio.
Commercial banks are only in the early stages of implementing agency banking, meaning their costs are still high. In 2019, the average annual cost-to-income ratio for the banking sector was 70 per cent, higher than the target of 44 per cent. With Covid-19, commercial banks needed to remain operational with workers working less hours than usual but yet the costs remain the same.

At the start of the lockdown that led to the ban on use of private cars, commercial banks were forced to hire vans to drop the workers from home to office and vice-versa. In fact, estimates indicate some banks spending about Shs200 million monthly to move workers to and from work. This became an additional cost to the banks.

Additionally, commercial banks still needed to keep the lights on and staff were operating for nearly half a day because they needed to get back home. Although not widely reported, commercial banks in the months between March and June 2020 were operating nearly in the red because costs increasingly rose faster than the monthly income.