BoU sees tough times ahead for banks, but confident on stability

The central bank is counting on tougher capital demands to mitigate potential risks to the financial system, following a stormy year for the banking sector during which the regulator took over management of one of the largest lenders.

“From end December 2016, all commercial banks will be required to set aside a capital conservation buffer of 2.5 percent of risk weighted assets (RWA),” Bank of Uganda’s Financial Stability Report for the 2015/16 financial year says. “In addition, domestic systemically important banks (DSIBs) will be required to hold a capital surcharge of 1-3.5 percent of RWA.”

Emmanuel Tumusiime-Mutebile, the central bank governor, spoke about the new requirements in November at a dinner hosted by the Uganda Banker’s Association. He said Bank of Uganda is raising the minimum statutory capital adequacy ratios “in order to lock in most of the higher capital that banks currently hold.”

The report acknowledges that there were more risks to financial stability in 2015/16 due to “the worsening of credit quality,” even as it notes that “threats to systemic stability remain low” because of “strong capital buffers.”

One bank bucked the sector’s prudent buffers and had to be taken over by the central bank because of the threat it posed to the financial system’s stability. Crane Bank, one of three domestic systemically important bank, was “a significantly undercapitalised institution as defined by law” and posed “a systemic risk to the stability of the financial system.”

The worsening credit quality in the sector was evident by the rise in nonperforming loans in the year, from 4% of total loans in June 2015 to 8.3% in June 2016 – the highest recorded NPL ratio in 15 years, according to the report. The money banks set aside to cover potential losses on loans played a big role in the fall of the sector’s returns on assets and equity, the report said.

Most bad loans were due to delayed government payments (24% of total NPLs), insufficient cash flows (22.7%), and diversion of funds (14.9%), according to a March 2016 survey by the central bank, according to the report.

Meanwhile, the building and construction sector registered the biggest rise in non-performing loans, which went up by Shs203.7 billion. Even then, no sector was spared. They rose by Shs124.3 billion in the agriculture sector and by Shs101.8 billion in the trade and commerce sector.

Profits for the entire banking sector also took a big hit, falling to Shs485.6 billion in the year to June 2016 from Shs556.3 billion in the previous corresponding period. Despite this, only five banks made losses in the period compared to seven banks in the previous period.

The fall in profitability was caused by an increase in loan-loss provisions and higher expenses. Loan-loss provisions rose to Shs364.1 billion versus Shs153.7 billion, while expenses rose by Shs347.7 billion, the report said.

“The banking system’s return on assets and return on equity dropped from 2.8 percent and 17.7 percent respectively in June 2015 to 2.2 percent and 13.8 percent respectively in the year to June 2016,” it added.

Indicators of Banking Sector Profitability
June 2013 June 2014 June 2015 June 2016
Net profit after tax (YoY) (Shs. Billion) 498.1 358.8 556.3 485.6
No. of loss making banks 7 8 7 5
Net interest margin (%) 12.2 11.5 10.9 11.9
Return on Assets (%) 3.3 2.1 2.8 2.2
Return on Equity (%) 20.3 12.8 17.7 13.8
Cost of deposits (%) 4.1 3.7 3.3 3.4
Data: Bank of Uganda

The report identifies three risks to the banking sector in the current financial year. A slowdown in the economy will lead to lower earnings for households and corporations, resulting in a rise in nonperforming loans. Credit risks, particularly nonperforming loans, and inadequate liquidity could also cause problems.

More time is needed for the sector to deal with the bad loans it currently as, in addition to the issues that lead to defaults. But the worst may yet be to come. “Indicators show that watch loans, the category of loans that are a step from NPLs, are still increasing,” the report says. Watch loans rose 56% in 2015/16 to Shs1243.2 billion from Shs796.0 billion.

Still, banks are handling credit risks as best as they can. Lending has gone down, with only personal loans increasing in the period. Total bank credit grew by only 3.7% in the year to June 2016 versus 19.7% in the previous period. By September 2016, the report shows, loan approvals to the real estate sector, which accounted for 25% of total loans in June 2016 and 19.9% of total NPLs, had gone down.

In addition to the tougher capital demands, Bank of Uganda said it “implemented several supervisory measures on DSIBs including more intrusive inspections and reviews, signing MOUs with the Board of Directors, calling for new capital and the takeover of the management of one DSIB which was severely undercapitalised in October 2016.”

And in measures that became active at the start of this year, all commercial banks must meet the Liquidity Coverage Ratio (LCR) in foreign currency and local currency. This follows tests which showed that six banks were below the minimum LCR requirement in foreign currency, despite meeting the consolidated (in both local and foreign currency) liquidity coverage ratio.