Reports Leo Odera Omolo

UGANDA’S banking industry looks set for consolidation following the Central Bank’s key regulatory reforms that are contained in revisions to the Financial Institutions Act (FIA) 2004.

The changes will enable banks withstand shocks

Key among the reforms is the increase in capital requirements, broadening the scope of permissible non-bank activities, harmonisation of regulations under the East African Community (EAC) framework and addressing challenges from global integration of finance.

The reforms are contained in revisions to the Financial Institutions Act (FIA) that the Bank of Uganda has recommended to the Ministry of Finance.

Louis Kasekende, the Central Bank deputy governor, announced recently that these alterations will be influenced by global reform efforts and also take account of requirements of the EAC Common Market.

“We require a radical change to the minimum paid capital requirement for banks.

The current statutory minimum of sh4b, which was set six years ago, is far too low. It does not ensure that new entrants to the banking industry have sufficient capital to support their operations before they reach a scale where they can begin to generate profits,” he said during the Uganda Institute of Banking and Financial Services (UIBS) dinner held at Kampala Serena hotel on Friday.

Uganda has over 22 commercial banks following the Central Bank’s lifting of the moratorium against licensing new banks in 2005.

The proposed increment is in tandem with the regional trend, with Kasekende noting that Uganda’s capital requirement had fallen below minimum statutory levels imposed by her East African Community (EAC) neighbours.

Given the changing global and local environment, the need to make revisions in the capital adequacy requirements to cover risks is more urgent than ever before.

The Central Bank will introduce a capital charge for risk that is in compliance with the Basel I Accord and eventually introduce a capital charge for operational risks based on the Basel II accord.

Kasekende believes that while Uganda’s banking system is well capitalised, the evolution over the long term is likely to intensify risks that banks are exposed to.

“The changes I have just described will help to ensure that banks are better able to withstand shocks to their balance sheets.

I think that the higher minimum paid up capital requirement will also stimulate a degree of consolidation in the banking industry in Uganda, with fewer but larger commercial banks,” he explained.

While he didn’t mention the proposed minimum capital amounts, he said they would be in line with the region’s statutory requirements.

“The increase in part is motivated by the need to align our capital requirements with those of our partners in the EAC.

Kenya will raise its minimum capital requirement to Ksh1b (Ush25.7b), which is nearly $13m, by 2012,” he said. The Bank of Tanzania on the other hand requires commercial bank’s starting capital at Tsh6.6b (Ush9.67b).

It asks the banks to maintain a core capital of 10% minimum of risk weighted assets and capital to risk weighted assets of 12%.

However, analysts said the amounts for the minimum capital are likely to be in the region of sh10b, a figure that will be eventually raised to sh25b.

According to Kasekende, other aspects of bank regulations will also need to be harmonised, including permissible activities, restrictions on loan concentrations and liquidity requirements.

Kasekende points out that the current FIA restricts banks to traditional banking activities, denying them the leeway to offer insurance business or underwrite shares or act as securities broker.

The Central Bank wants FIA amended to allow banks provide “bancassurance” and Islamic financial products, among others

“I believe that there is a strong case for allowing banks to offer financial products for which there is a market demand provided that this does not undermine prudential standards and, critically, that the risks of these activities can be understood and managed.”

This will be a welcome move by banks and insurance companies because it is considered key in the growth of the insurance market in Uganda.

Kasekende was cautious about liberalisation of banking legislation to allow commercial banks engage in proprietary securities trading or brokerage activities.

“As the global financial crisis has demonstrated, proprietary trading carries potentially large risks for banks; risks both to the value of their assets and to their liquidity.

Furthermore, a banking system which is heavily engaged in proprietary trading may be more vulnerable to systemic risk, because of the pro-cyclical impact of marking securities to market and because of the heightened liquidity risks created by proprietary trading.”

He argued that it is very difficult to quantify market and liquidity risk of this nature, which is partly endogenous to the financial system.

“Financial institutions tend to underestimate these risks and often have powerful incentives to do so if trading activities are very profitable.

It is also less evident that all of the proprietary trading activities of financial institutions really provide significant economic benefits for the rest of society,” he stressed.

While the liberalisation policy has served Uganda well, some reforms are needed to cushion the sector from external shocks as the financial sector becomes more integrated with global markets.

Currently, Ugandan banks are net creditors with financial institutions abroad which cushion the sector from any loss on their external asset portfolios arising from foreign creditors withdrawing access to credit.

This situation is bound to change, said Kasekende, as Uganda acquires the characteristics of an emerging market economy.

“I would expect that Ugandan banks will eventually become net debtors to foreign financial institutions because economic growth in Uganda should create more investment opportunities which provide higher rates of return, even after adjusting for risk, than the cost of borrowing abroad.”

Kasekende proposed a form of tax to discourage purely short-term private capital flows though he acknowledges the difficulty in enforcing that.

“The main reason why I think that this is worth considering is that purely short-term portfolio flows, which are mainly intermediated in the domestic money markets, may exacerbate short-term volatility in the exchange rate while they do not provide any great benefits to the economy: they are far too short-term to provide resources for funding capital investment.”

He noted that this was critical as the EAC countries move towards a monetary union which will require exchange rate management.

Citing the transition towards the single currency in the Eurozone, he recalled that the countries faced similar challenges in the 1990s as short term capital flows created major difficulties for the alignment of currencies.

The deputy governor reckons a common market will create more efficient financial services as consolidation takes root.

“Some consolidation in the Ugandan banking sector will be necessary and beneficial.

In particular, larger banks will be better placed to take advantage of the expansion in the size of the market created by the common market and to reap economies of scale which can bring down the very high operating costs as a percentage of assets which afflict banks in Uganda.”

In effect, lower operating costs are expected to reduce intermediation spreads which will benefit bank customers in the real sectors of the economy.

Industry players welcomed the reforms, noting that they will provide institutions in Uganda a platform to compete at a regional level.

“To the extent that the reforms enhance both local and foreign institutions to be able to operate in an integrated regional and global level, they are a welcome development,” says Jared Osoro, a senior economist at the East African Development Bank.

However, other bankers were cautious about the impact of the rise in capital requirements on outreach, noting that consolidation may create fewer institutions that may not serve the countryside.

“If consolidation will create huge institutions that disenfranchise the public, the whole purpose is defeated.

On the other hand, if strong institutions create competition that is not cosmetic but compete on pricing and quality of service, then this is the way to go,” said the banker.

The new developments are also seen as a challenge for indigenous banks to position themselves to play in the big league as well as consider innovative ways of raising capital.

“We should see the nurturing of strong institutions irrespective of ownership such that they are in position to improve the quality of service and have extended footprint across the country,” said a banker.

Ugandan banks posted good performance last year according to financial results for the year ended December 2009, amid the global economic downturn.

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