Bank of Uganda (BoU) Deputy Governor, Dr. Louis Kasekende has said the Central Bank regulations can’t stop banks from collapsing.
Kasekende made the remarks on Wednesday while giving a key note address at the 7th Annual International Leadership Conference organized by Makerere University Business School (MUBS).
His address centered on the topic: Governance in the Financial Sector: Is the Financial Sector over Regulated?
“…the primary objectives of banking regulation are to safeguard depositors’ funds and to prevent a systemic financial crisis, so we should evaluate the benefits of regulation in terms of those objectives,” Kasekende said, adding: “The BOU, in common with other bank regulators around the world, does not aim to prevent every single bank failure. In principle it would be possible to do this, by restricting banks to invest only in safe assets, but that would prevent banks from making one of their most important contributions to the economy, the extension of credit to the private sector.”
He revealed that bank regulation has costs as well as benefits for the economy, and that regulation is optimal, in the economic sense of maximising welfare, when there is a balance between costs and benefits.
He noted that banking industry is by far the most important component of the financial markets in Uganda, with commercial banks accounting for around 80 percent of the total assets of the financial system.
He explained that extending credit is inherently risky, because not all borrowers will be able to repay their loans.
Consequently, bank regulators accept that banks must incur some risk if they are to perform their proper functions, and that optimal bank regulation, therefore, cannot prevent all bank failures.
He added that bank regulation aims to ensure that banks do not take excessive risks and also that they properly manage their risks, for example by adequate diversification of their loan portfolio, so that bank failures are the exception rather than the norm.
“One of the most important tools of bank regulation is the minimum capital adequacy requirement, which is based on the globally agreed approach set out in the Basel Capital Accords. Capital adequacy requirements stipulate that banks must hold a minimum amount of regulatory capital as a percent of their risk weighted assets,” he said, adding that in Uganda, banks must hold total capital which is at least 12 percent of their risk weighted assets.
The purpose of these capital adequacy requirements is to ensure that banks hold a buffer which can absorb losses and thus protect their deposits, he explained.
“If a bank suffers losses because of, for example, bad loans, these losses are first absorbed by the bank’s capital. It is only if the losses exceed the bank’s capital that the bank’s depositors or other creditors will incur losses,” he said.
To safeguard depositors, the BOU is mandated under the Financial Institutions Act, 2004 to implement prompt corrective actions, which are triggered by a failure of a bank to comply with the capital adequacy regulations or by other indicators of financial distress.
He further revealed that these prompt corrective actions are designed either to restore the bank to a sound financial condition, for example through recapitalisation by its owners, or if that is not possible, to trigger intervention by the BOU to resolve the failing bank in some way, for example by closure or by selling it to another bank, before significant losses to its deposits can occur.
What is the record of Uganda with respect to bank failures and losses of deposits?
The current legal framework for bank regulation was put in place in 2004 when Parliament enacted the Financial Institutions Act, legislation which strengthened bank regulation following the bank failures that had occurred in the 1990s.
He said since the enactment of the Financial Institutions Act, 2004, there have been three bank failures in Uganda: two very small banks in 2012 and 2014 and one larger one in 2016.
He was referring to National Bank of Commerce, Global Trust Bank and Crane Bank.
The combined deposit market share of the three banks, at the time that each one was closed, was about seven percent, he said.
“Because the BOU intervened in these banks in a prompt manner, in line with the mandatory prompt corrective actions stipulated in the Financial Institutions Act, depositors did not lose any of their money,” he said, adding: “In all three cases, the BOU was able to transfer the failed banks’ deposits in full to other banks through Purchase of Assets and Assumption of Liabilities transactions, using the powers conferred on the BOU by the FIA.”
He noted that had the BOU delayed its interventions in these failed banks, the losses which they incurred would have grown much larger and as a consequence it would have been much more difficult to ensure that depositors’ funds were repaid in full.
Consequently, in terms of the objective of safeguarding depositors’ funds, I think that it is fair to argue that bank regulation has been successful, in that bank failures have been few in number and that, when banks have failed; prompt regulatory intervention has protected their deposits from losses, he noted.
He added that given that the banks which failed collectively comprised less than 5 percent of the banking system’s deposits, Uganda has not come close to suffering a systemic banking crisis.
“Hence the second strategic objective of the BOU’s bank regulation, that of preventing a systemic financial crisis, has also been achieved,” he said.
He noted that the more stringent are bank regulations, the more difficult it will be for banks to incur risks (i.e. by investing in risky assets) and this in turn will impede the growth of bank lending and stifle the overall dynamism of the banking system.
Does the performance of the banking system since the enactment of the Financial Institutions Act, 2004 offer any evidence that bank lending has been stifled by over regulation?
In September 2004, the total loans of the banking system amounted to 37 percent of its deposits. At that time the Ugandan banking system was still a relatively low intermediation banking system.
Since 2004, however, rates of intermediation have risen markedly. In September 2017, the loan to deposit ratio was 64 percent. This ratio had been as high as 78 percent in 2011, during the credit boom of that year. Most of the increase in the banking system’s rate of intermediation took place in the five years immediately following the enactment of the FIA, 2004, which does not suggest that the more stringent prudential regulations embodied in the FIA have impeded bank lending to the private sector.
Another approach to assessing whether regulation has impeded bank lending to the private sector is to ask whether specific regulatory provisions have been a binding constraint on lending, he said.
“If a bank is only just able to comply with the minimum regulatory capital adequacy ratio, it cannot increase its holdings of risk weighted assets, for example, by expanding its loan portfolio, unless it also mobilises more capital. In such circumstances, the capital adequacy ratio will be a binding constraint on the growth of bank lending,” he said.
He noted that no system of regulation is perfect, but the record of banking sector performance since 2004, when the current banking legislation was enacted, indicates that the primary objectives of bank regulation have been realised and that this has been achieved without significant negative impacts on lending growth and intermediation.