High lending rates: Government should intervene in failed market

Tuesday September 27 2016

Private Sector Foundation executive director

Private Sector Foundation executive director Gideon Badagawa says in Uganda, interest expense significantly varies across banks at between 5 per cent and 50 per cent depending on the ability of the bank to mobilise deposits.  

By Gideon Badagawa

The cost of money has been blamed for the very high interest rates in Uganda. However, an analysis on the actual cost of money incurred by banks and the spread seem to be telling a different story.
According to the Annual published supervision report by Bank of Uganda (BoU), the cost of money (Interest expense)was only 12 per cent of the banks’ gross interest income as at June 2015 and 11 per cent both at December 2015 and June 2016, implying that the rest (about 90 per cent) was funded by the interest free deposits. The report further confirms that 88.1 per cent of bank funding in Uganda is from deposits, begging the question whether the Central Bank Rate (CBR) has a notable influence in determining interest rates. The percentage of interest expense contained in the lending rates was only about 2.89 per cent of the 25 per cent (market) interest rate in June 2015, 2.66 per cent of 24 per cent in December 2015 and 2.61 per cent of the 23 per cent in June 2016. This negates the argument that the high interest rates are a derivative of the high cost of money.
Even when we use the CBR as the traditional measure of representing the cost of money to banks, the spread was about 10 per cent in June 2016. The bigger banks actually have a far lower cost of borrowing of about 2.61 per cent, resulting into an actual spread of about 21 per cent on average. Put differently, if such banks were compared to a commodity trading company, it would mean that the gross profit of such business would be in the region of 88 per cent. Alas! This is abnormally high by any standards and goes even higher if we compare interest expense to interest income.
Looking at the Non-performing Loans (NPL), a significant component of interest rates is risk associated with loan losses measured by the NPL percentage. This accounted for about5.3 per cent of the interest (lending) rate in Uganda (as at Dec 2015) according to the BoU report. Where a bank had good risk management practices, large profits were made on loans since the anticipated loss was not actually incurred. Private Sector Foundation Uganda (PSFU) has carefully studied one bank and found that the NPL was about 1.6 per cent at June 2016 meaning it saved about 3.5 per cent of its lending rate as windfall profit - simply from better loan management. This prudence is commendable and should be rewarded through fiscal incentives for instance. But reprimand should also be considered if commercial banks do not exercise prudent loan management. This is part of their responsibility.
A collection of all the benefits from interest expense spreads and NPL have enabled especially large banks to realise about 14.89 per cent of the 25 per cent (commercial) interest rate or about 60 per cent of the cost of loans as windfall profits. This is because bank costs and return requirements are adequately covered even at 10.21 per cent interest rates. Again this is clear from the BoU Annual supervision report of December 2015.
It is not surprising for banks to have reported a profit of Shs30 for every Shs100 at December 2015 according to the report. From the statistics provided, Banks that have deposits to lend, and can control risks, end up making very high profits with more than half in windfall income. The windfall explains why one major Bank herein Uganda has made Ushs45 for every Ushs100 mobilised in revenue at June 2016.
From our analysis, many banks do not significantly borrow in order to lend. They instead use interest free deposits and make more money through credit creation than through borrowing. The question comes back to BoU. Should the CBR remain the indicative rate for determining interest rates? The real determinant of interest rates, in my opinion, is the alternative investment options available to banks through the issuance of Government paper (TBs). At June 2016, major Banks had lent Shs1 UG shilling to Government for every Shs2 lent to all other borrowers. Government then became the number one client for the banks! This is unwarranted and is the bigger source of the problem.
The questions to raise to BoU are: What is the primary purpose of issuing government paper? Is it to mop up excess liquidity or to mobilise domestic resources in order to fund the ever-increasing government (recurrent) expenditure?
As an advisor to government, why should BoU not emphasise the need for fiscal discipline and to cap the Domestic Borrowing Requirement (DBR)?

Imperfect market/market failure
In Uganda, interest expense significantly varies across banks at between 5 per cent and 50 per cent depending on the ability of the bank to mobilise deposits. This is in spite of the Spread being similar across all major banks! One would have hoped that banks with low interest expense would have priced their products much lower than those with high interest expenses. This would, in essence, improve their competitive advantage. But this is not the case! Besides, changes in lending rates correlate positively with the CBR only when the latter is raised.
Reduction in CBR doesn’t attract similar reduction in interest rates. All these point to serious market imperfections where competition alone cannot reduce the high interest that borrowers pay. This is a market failure that requires correction through government intervention. Kenya’s intervention to cap at 4 per cent was mainly to address this imperfection in the highly competitive market. Our Government must act and we suggest as follows;

Check government borrowing from domestic markets
Existence of a lucrative risk free investment in form of government paper provides competing investment options into which banks invest money. One of the solutions is for government to drastically reduce spending and bring down the appetite for issuing the very attractive government paper. Open Market Operations (OMO) should largely remain instruments for stabilising the market against price shocks.

Create Credit Guarantee Schemes
Credit Guarantee Schemes are important in eliminating risk, which contributes to high lending rates. Such schemes comprise setting up funds for key sectors of the economy such as agriculture and manufacturing among others. Guarantee Schemes can be funded by tax payers through the national Budget.

Introduce Windfall tax (redistribution of profits)
As seen from the analysis, 60 per cent of the cost of credit is windfall profits and profit levels are extremely high at 16 per cent Return on Equity according to BoU. Taxing windfall profits is an equitable measure as banks would pay only a percentage on the windfall profit made. The banking industry can accommodate a windfall tax of more than 50 per cent without affecting the stability of the financial system. Results of Stress Tests conducted by the BoU at December 2015 showed that no bank would have aggregate capital shortfall even when interest income reduces by 50 per cent (equivalent to halving interest rates).The windfall tax collected could be directed to the recapitalisation of UDB so as to provide affordable credit to productive sector for the benefit of the entire economy including the banking industry itself.

Interest rate capping should be taken with high caution
Capping is straight forward and easy to implement although calculations must be done to establish the desired rate. However, it has the effect of being misconstrued as government interference albeit in failed markets. The other drawback is that the CBR is too high and the margin on it (even when capped at 5 per cent) would make the resultant interest rates (of 19 per cent) too high to achieve the desire effect especially in agriculture and industry. However, lower rates (in Kenya) of between 15 per cent to17 per cent will make the Kenya private sector more competitive even in Uganda’s home market.

The author is the executive director, Private Sector Foundation Uganda.

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