Tilted; Exploring the determinants of interest rate spreads in the Ugandan banking system, the study complements research on interest rates by analyzing the determinants of interest rate spreads in Uganda after the adoption of inflation targeting, and proposes policy recommendations.

Adam Mugume, the executive director, Research at Bank of Uganda, emphasized the importance of the financial industry in the development of the country.

“There is no way you can have an economy that is developed when the financial sector is underdeveloped,” Mugume said while making opening remarks at the event.

According to the study, Uganda maintained an interest rate between 12 and 16 percentage points between 2007 and 2018, a figure relatively higher than Kenya which peaked at 10 per cent in the same period.

For a while now, the deposit lending spread – a gap between the deposit and lending rates in banks – has been determined by the cost of bank credit and the level of interest rates.

EXPENSIVE BORROWING

Experts believe that high bank lending interest rates have reduced Uganda’s economic growth and made borrowing an expensive source of capital for investment. Uganda’s private sector depends heavily on commercial bank rates, accounting for more than 90 per cent of the credit in the market.

IGC, on their part, believe that the high bank lending rates and spreads have been influenced by factors that have continued to affect the banking sector in Uganda as a whole.

The report further identifies competition in the banking sector, high operational costs, unfavorable margins from profits coupled with high operating costs as the main reasons as to why banks in Uganda offer higher rates compared to their peers in the region.

Other banks also feel that they are being pushed out by government-funded banks and the fact that the number of defaulters from loans have increased, something that has left many of them counting losses.

Rashmi Pillai, the executive director, Financial Sector Deepening Uganda (FSD), an organization that promotes the use of financial products, sees banks as financial intermediaries whose mediation should offer a platform for business growth to fuel economic growth. This, she added, would be mutually beneficial to both customer and bank.

“A high interest rate spread caused by high cost of borrowing affects the growth of businesses and their profitability; it impacts retail borrowers trying to match the shortfall between current expenditure and income. But more importantly, if financial intermediation is not done well or if there are big impediments to efficient financial intermediation, it handicaps economic growth,” Pillai said.

UGANDA’S RATES

According to the report, Ugandan banks are lagging behind in terms of asset composition. Relative to regional peers, the level of bank advances (loans) from Uganda’s banking sector is low while holdings of government securities are higher than in Rwanda and Kenya in comparison.

“Less than 50 per cent of the banking assets in the recent past have been loaned,” Rashmi weighed in when asked about the variation in capital among Ugandan banks.

Further research done by FSD shows that Uganda Government bond yields are at least double compared to their Southern African Development Community and East African Community counterpart economies. Government bonds or risk-free (zero-risk) assets pay a huge return of about 10 per cent. They provide the floor for any other bank lending rate.

“High government borrowing especially if not channelled to productive investment can have detrimental effects,” Rashmi emphasized.

Rashmi added that bank loans become expensive because the floor rate itself is already high to begin with. Similarly, borrowing discourages the banks to grow their loan portfolio and find new green-field projects to invest their capital.

The study also revealed how interest spreads could also be driven by high operational and administrative costs, something Jeffries attributed to duplication of infrastructure.

“Cost-to-income ratio for Ugandan banks is in the range of 50 per cent to 60 per cent which is not out of line with its peers but could still be driving lending rates,” Jeffries said while speaking to the panel via video conferencing.

SOLUTIONS

Quite often in the banking sector, capital is an indicator of a bank’s well-being and in Uganda, banks tend to hold onto capital, which, according to Pillai, means that capitalization is persistently high. This begs the question: why?

“Liquidity mismatch! Simple as that,” Pillai said while examining why banks tend to hold onto capital.

She added: “Depositors save their money for extremely short durations. There is a high degree of volatility as to when depositors withdraw their money. In contrast, borrowers are looking for longer-term financing. Therefore, short-term deposits cannot finance long-term borrowing, thus creating a liquidity mismatch.”

Among the recommendations made by the study is encouraging bank competition as a solution to high interest spreads. A competitive environment would mean less control of the sector by the established players.

“Long-term growth of smaller/medium-sized banks to challenge the dominant large players. Competition could also help reduce higher than normal bank profitability, thus reducing interest rate spreads by encouraging the consolidation of smaller banks, perhaps by increasing minimum capital requirements,” the report recommends.

The report further recommends greater competition through regional banking integration in line with EAC policies. This, the report adds, would allow banks licensed in one EAC member state to do business in another on the basis of a single banking license.

In the case of Uganda, duplication of infrastructure is partly responsible for the low competition in the market. Jefferies advises that the banking sector needs to be ruthless in this approach if they are to avoid falling into a sinking hole.

“Continued transition to electronic platforms from branch-based banking, consolidation of smaller banks would also reduce duplication of infrastructure and enable economies of scale, re-examining whether regulatory requirements add unnecessary costs and registering collateral as security for loans would greatly bring down the costs of running a bank”, Jefferies said.

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