Increase in reserve ratio will help banks compete favourably

In an interview with Business Power, Financial Service Partner at PricewaterhouseCoopers Uganda, Mr Uthman Mayanja, tells Martin Luther Oketch how the increase in commercial banks’ capital will go a long way in boosting competitiveness among Uganda’s banks in the region.

The Bank of Uganda has drawn plans to increase capital requirements for commercial banks from the current Shs4 billion to an amount that has not yet been specified. What is the rationale for this move?
This move is necessary for at least three important reasons. Uganda currently lags behind other East African countries with capital requirements ranging from the equivalent of Shs10 billion in Tanzania to Shs35 billion in Rwanda. Both Tanzania and Kenya are in the process of raising their minimum capital requirements.
This means that if the banking market in the region is opened up to allow banks originating in one country to do business in any other country as part of EA Common Market, Ugandan banks would find their ability to compete against the East African counterparts severely constrained. This is because capital to a bank, just like any other business, is a measure of how much business it can afford to do. Therefore Ugandan banks would find themselves unable to compete for large ticket business with their EA counterparts unless they too have the same or more capital to do so.
Secondly, the central bank has for a long time held the objective of seeking to not only deepen but also widen our financial markets. Through this, the central bank is looking for more access to bank accounts by Ugandans and the availability of a suitably priced range of products to suit our range of economic activities. To expand banking services to rural areas, urban centres require investment in infrastructure, systems and people and this requires capital to achieve.
The logic, therefore, is that if banks have more capital at their disposal, these investments will be easier to make and together with other interventions of the central bank, the goal of increasing access to banking services and reducing the cost of finance can be achieved.
Thirdly, the deeper your pockets are, the greater your chances of weathering a financial storm – and these are some of the lessons we can learn from the recent world financial crisis. A case in point is Barclays PLC which managed to raise equity finance just before the credit crunch hit its peak and therefore not only sailed through the crunch, but was also able to pick up strategic assets from the former Lehman Brothers.
In this respect, one might add the practical economic reality of Uganda today where if you have $2 million, you can either buy a residential property in Kololo or Nakasero or you could apply for a banking license. Anybody who sees something wrong with that picture would easily agree with the urgent need to raise the capital requirements for commercial banks.

Will this increase be affordable for Uganda’s small banks, especially those of indigenous origin?
Fortunately, most Ugandan banks have either already raised share capital well in excess of the current limit or built up significant reserves of retained earnings. As a result, although the proposed increase is not yet known, one suspects that most banks would be able to meet the new requirements by simply capitalising part or all of their reserves. In some cases, however, banks will need to put in additional capital. Furthermore, going by precedent, the central bank would allow banks sufficient time to raise the new funds.
This in itself is a good thing because if particularly indigenous local banks are not able to raise additional funds from their shareholder base, a lucrative option would be to float shares on the Uganda Securities Exchange and this would bring along numerous benefits including expanding the local bourse thereby providing additional investment options for Ugandans.
Another way out would be for those banks that are not able to meet the capital requirements on their own to merge and form larger entities that not only meet the capital requirements but are also able to compete more effectively in the current and future business environment.

Do you think a large capital requirement is enough to save the commercial banks from running bankrupt or having bad loans?
Having a large capital base has several advantages as it provides the resources to, among other things, invest in appropriate systems and technology; recruit, train and retain high calibre people; acquire a wider and larger spread of income earning assets such as loans, treasury bills and bonds; and to provide expanded levels of financial intermediation. More capital also allows banks to spread their risks as they can now invest in more sectors of the economy, more segments of their markets and different geographies.
Therefore, larger capital, if invested wisely, increases the income-earning potential of the bank whilst allowing its risks to be optimised. By having more capital, a bank can also absorb larger losses; however, because the bank is also doing large ticket business, its losses when they occur tend to be equally large. Therefore, a large capital base is not on its own sufficient to prevent banks from running bankrupt or having bad loans. In order for banks to avoid bankruptcy, they must rely on traditional banking prudence to avoid over-expansion and ensure that sufficient cash is always available to meet the demands of depositors and borrowers.

The recent financial crisis has caused widespread re-evaluation of public policy towards financial sector regulation. Many reform plans have been proposed but little has been resolved. What reforms do you suggest for Uganda’s financial sector?
It is important that we do not cry out for reform just because it is the latest craze in international markets. We should keep in mind that Uganda’s banking industry weathered the world financial crisis and even registered strong growth in 2009. I think this growth was largely fuelled, ironically, by the entry of new banks, which spurred the incumbent banks to invest more aggressively in their branch networks, technology platforms and new products. Therefore, whilst yields on government securities, equities and loans were falling, overall profits in the industry grew.
In this respect, our banking executives and their shareholders must be lauded for the courage and wisdom to keep investing rather than turn off the taps as the Western world was doing virtually without question. I believe the fact that Ugandan banks cannot invest more than 25 per cent of their core capital in equities also insulated them from losses that arose when the Uganda Securities Exchange index dipped. Another key factor is that our economy and banking sector are not sophisticated and the links with the international finance economy were very simple with exposure on the liabilities either directly linked to liquid assets or where it is de-linked, the contribution to total liabilities was small. Therefore when significant deposits from overseas dried up, banks were able to continue without a major shock to the system.

Currently there are 22 commercial banks in the country; do you think the number of banks is enough to meet the various financial requirements of the private sector, which is steadily growing?
It is not the number of banks that counts, but rather the access to these banks. In the UK, there are five mainstream commercial banks (albeit with more than 10,000 branches) serving a population of more than 60 million people. These banks offer advanced internet banking, debit cards and credit cards with supporting technology to enable payments for all sorts of goods and services to be made over those channels. As a result, people do not need large amounts of cash and therefore the demand on branches and ATMs is reduced. Moreover, UK banks allow each other cross-access to each other’s ATMs free of charge to customer.
The talk is that 22 banks are too many because it becomes very difficult to build up economies of scale. Without these, it is difficult to invest in expensive technology such as internet banking because it requires a large uptake to payback the investment made.

Uganda’s financial sector has been historically dominated by large financial institutions, in particular commercial banks of foreign origin. Currently commercial banks account for 83 per cent of the financial assets, do you think this is healthy?
It is not surprising that banks hold a predominant share of Uganda’s financial assets considering that they dominate our financial sector. But if we look at the banking cycle then we will understand that these assets are effectively held on our behalf as depositors. It is our deposits that provide banks with the largest source of funds to invest in assets so we should not just look at the matter as foreign bank asset holdings.
In addition, in this global era, the degree of foreign interest should not be an issue in itself because it is embedded in all economic systems. Today, China holds by far the largest amount of US$ reserves in the world. What is critical is the strength of regulation and protection that is afforded to bank customers as well as the national economy. And in the case of Uganda, it has to be said that there is a strong base of measures and an appetite for reform by the central bank – this needs to be supported by all those concerned to ensure that these remain relevant under changing circumstances and meet international best practices.
Having said that one must never hold all their eggs in one basket: For that matter therefore, it is important that liberalisation of the pensions sector is speeded up with enactment of the Retirement Benefits Authority Bill. It must be added that unless the 15 per cent required contributions to the National Social Security Fund are reduced, employers and employees will still find it difficult to save significant amounts with private pension providers. Once pensions are liberalised and constraints to growth are lifted, the share of savings going into pension providers will increase and so will their asset holdings, thereby diversifying our portfolio and reducing the risk in the country.

Lack of long term financing is still bites the private sector, what must be done to solve this problem?
The easy win in this respect is for the government and banks to do more to encourage Ugandans to save for the long-term. Through this, banks will have more funds to lend out for the long-term without having to worry about a liquidity shortage. The government can offer tax incentives, like exempting interest on long-term deposits from tax and banks to increase the return on long-term deposits. Other problems still remain on the borrower side. In many cases, long-term finance is available but the rates are prohibitive due to the risk profile. Government can do more to guarantee loans in priority sectors and provided there is a level playing field, this should increase access across the board. Borrowers also need to do more in terms of adhering to best practices of governance and control – with better financial information, transparency and effective systems, the bank’s view on the risk of the borrowers is likely to reduce and this should result in lower interest rates.

Lastly, what’s your opinion regarding the taxation policy in Uganda’s financial services sector?
There are some favourable and unfavourable aspects of taxation of financial services. Recent positive reforms in tax policy include stamp duty on mortgages. Previously, the Stamps Act provided for a rate of 0.5 per cent on the total value but this has now been amended to a flat rate of Shs100,000. This is a welcome move as the reduced rate will lower the cost of borrowing and therefore encourage the public to borrow more.
However, there are a number of other issues that the government should address from a tax perspective in order to promote the financial services sector. One of the key issues is VAT. Exemption of banking services from VAT has the effect of increasing operating costs for banks as it is difficult pass on the VAT cost directly to their customers. Eventually, however, customers still meet this cost as it is passed on through the charges we pay for banking services. A change to make financial services zero-rated would on the other hand enable banks to recover VAT on their expenditure and thereby lower the cost of banking, in the process, making banking more affordable to the ordinary citizens.
Certain aspects of financial services are currently subject to VAT or deemed to be subject to VAT. The two main areas are imported financial services including a variety of outsourced banking services, which are currently subject to VAT. This is a clear asymmetry that needs to be removed as it enables banks to access specialised skills or facilities that would otherwise not be accessible.
The other area is proceeds on sale of mortgaged property whose current VAT treatment is unclear. Considering that such sales are made to recover bad loans and are therefore an integral part of banking, reform is required to clearly exempt these proceeds from VAT. This treatment would maximise proceeds on recovery of bad loans, thereby reducing the overall cost of lending/ borrowing.