Lessons Ugandan Banks can draw from the Euro Zone

Lessons Ugandan Banks can draw from the Euro Zone

By Enock N. Twinoburyo

At the start of 2015, the Eurozone expanded its membership to 19 members when Lithuania joined. At the helm of its banking industry is the European Central Bank (ECB), which administers monetary policy of the member states - one of the largest currency areas in the world. Listed in the Treaty on European Union (TEU), the ECB is one of the world's most important central banks. The capital stock of the bank is owned by the central banks of all 29 EU member states.

In January 2015, the Eurozone inflation continued to decelerate into negatives, a ramification of prevailing aggregate demand deficiency in the currency zone. This is largely due to the financial crisis of 2008, which culminated into the Euro zone debt crisis. Referred to as the PIIGS (Portugal, Ireland, Italy, Greece and Spain), these countries had debt to GDP ratio of over 100%.

Ireland and Greece have since sought bailouts, the latter’s bailout programme hangs in balance and so is its EU zone membership. The crisis deepened the bank’s need for support from national governments. The governments on the other hand already had weakened fiscal positions. The crisis also led a threat of widespread bank failures in EU countries and near collapse of their financial systems, characterised by weak bank balance sheets and less desire by banks to lend due to depressed business confidence.

As a result, the European Commission has since proposed 28 new rules with the aim of setting up a European banking Union to better regulate, supervise, and govern the financial sector.

This was done in order to put an end to the era of massive bailouts paid for by taxpayers. It is believed that this will help restore financial stability. The measures in place include the establishment of a Single Supervisory Mechanism (SSM) effective November 2014, Single Resolution Mechanism (SRM)- expected in 2016, the European banking Authority(EBA), set up in 2012 and a future banking Union.  With the SSM and SRM, the Banks will no longer be "European in life but national in death", as they are supervised by a European mechanism and any failure will be managed by a truly European mechanism. The ECB will be stretched in trying to ensure that its monetary policy and supervision roles do not conflict. For instance it has to ensure that it does not set low interest rates to save the weaker banks.

ECB and EBA carried a year-long comprehensive exercise to assess the state of banks and through stress tests, 25 banks failed the asset quality review (AQR) conducted by the ECB on 130 of the largest banks in the Eurozone. In the stress tests performed by the European Banking Authority on 123 of the EU’s largest banks, 24 failed. They had capital shortfalls amounting to €24.6bn(0.09 per cent of assets worth €28tn) after comparing the projected solvency ratios under the adverse stress test scenario. This was against the threshold of 5.5% tier 1 capital relative risk weighted assets. Most of these 25 banks are concentrated in (use PIIGS) crisis economies in particular Greece, Portugal, Ireland, and Italy-, which is an indication that banks, are focused on deleveraging as opposed to lending due to the low business confidence.

AQR sets a foundation for the Single Supervisory Mechanism (SSM), with ECB having direct supervisory responsibility for most of these 130 banks. It is also indirectly responsible for the rest of the banks in countries that are members of the SSM. This sets a platform for confidence building and transparency but it remains no panacea for the Euro zone banks. The bank resolution remains a responsibility of the national governments until the SRM is in place, which will also remain hybrid resolution mechanism (national and SRM framework) and the full-fledged banking Union remains to be seen. (Beck, 2014).

In addition, there has been subdued financial performance of the euro area-banking sector observed since the onset of the financial crisis, with notable cross-country differences. In particular, the profitability of the euro area-banking sector which has been mainly challenged by the on-going deterioration in asset quality, with ensuing increases in impairment charges and provisions.  Deteriorating loan quality resulted in a steady and broad-based increase in non-performing loans (NPLs) in many countries from 2008 onwards, with pronounced further increase in some cases (ECB, 2014)

The EU banking lessons indicate the need for stringent bank supervision and resolution mechanism in a bid to sustain business confidence; first at national level especially when economies are in a boom (booms are fuelled by an underestimation of risks), as well as the hit by economic hardships.  In that respect, the EAC Central Banks that are moving towards establishment of a Monetary Union do carryout joint inspections of banks and have agreed to put in place a framework for cross-border bank resolution. - Secondly, the EU banking reforms are also guided by the Basel III regulatory reforms, which require higher capital charges for systemically important institutions and better internalisation of the risks their size poses to the financial system. Fourthly, the need to repair balance sheets and beef up capital to requisite capital threshold.

Uganda has a history of  bank failures in late 1990s, early 2000s and in 2014, when Bank of Uganda revoked Global Trust bank’s license. This was in accordance to the the framework of the Financial Institutions Act (FIA), 2004, which constitutes among other minimum capital requirements and liquidity requirements and restrictions on risk taking such as limits on large loan and foreign exchange exposures. This mandates the Central Bank to protect the deposits. Uganda has also embarked on the review of both the Foreign Exchange Act 2004 and the Foreign Exchange (Forex Bureaus and Money Remittance) Regulations 2006.The process is done in consultations with other EAC central banks.

Overall, Uganda’s financial system is sound while the risks to financial stability emanating from both international and domestic sources have eased. Information from the latest Financial Stability Report from Bank of Uganda indicates that the banking system is currently well capitalized and most banks would comfortably meet the Basel III capital requirements.   

On the regional front, the EAC Central Banks are to conduct self-assessments of their compliance with Basel Core Principles for Effective Banking Supervision (BCPs) annually and conduct peer reviews every two years. In addition the EAC have adopted a standardised approach for calculating a capital charge for operational risk. As well are to finalize the process of adopting the leverage ratio, following the Basel III approach, as a supplementary measure for the analysis of capital adequacy (Bank of Uganda, 2013).

In the recent past, 2-4 years, when the Ugandan economy has slowed or least grown at less than potential, there were increased risks on the banking sector, with heightened Non-performing loans, increased credit risk and dwindling profits as well as asset quality. (See table 1).

Table 1: Uganda Banking sector Indicators March 2012- September 2014

With the limited competition in Uganda banking industry, it is likely that the lower tier banks (with a high cost to income ratio) will increase risk-taking initiatives due to moral hazard. Lessons from the Euros zone indicate that the large banks- the too big to fail, may also increase their risk taking initiatives. It is also observed, that during the economic boom days, banks over expanded and subsequently are over leveraged (European Systemic Risk Board, 2014). Uganda outlook looks positive- with the expected oil activities likely to spur the level of economic activities (including bank activity) in the coming few years; which in itself calls for prudent monitoring of the bank’s asset quality and risks. According to IMF, 2014 – there is need to strengthen the macro-prudential framework to improve risk management in systemically important banks, introduce a capital conservation buffer, and introduce counter-cyclical financial regulation will help anticipate and deal with risks.

Indeed the Bank of Uganda has taken several measures to address these concerns including data collection on and monitoring loan to value ratios for property loans.  The Bank carries out quarterly stress testing to assess the resilience of banking sector to systemic risks.

In addition to that, BoU engages small and new banks as well as systemically important ones with a view of enhancing their loan quality and liquidity. Related to that, it has brought forward implementation of Basel III capital measures to January 2014 in a bid to strengthen bank resilience.

As such, there is need to insulate the banking system from the too big to fail, in part, by enforcing measures that will create more competitive business models, as well rebalance the financial activity away from banking industry. Continued supervision indeed is a necessary action.

The writer is a PhD fellow at University of South Africa

References

1.    Bank of Uganda (2014), “Annual Supervision report 2013”,June

2.    Beck, T. ( 2014), “After AQR and stress tests – where next for banking in the Eurozone?”,VoxEU.org, 10 November

3.    European Systemic Risk Board (2014), “Is Europe Overbanked?”, Advisory Scientific Committee Report 4, June.

4.    IMF (2014), “Uganda Third Review Under Policy Support Instrument”,Country Report No. 14/344, 21 November

5.    Bank of Uganda (2014), “Financial Stability Report  2014 Issue No. 6” June