AN ANALYSIS OF THE EFFECTIVENESS OF CENTRAL BANK IN REGULATING THE BANKING SECTOR IN UGANDA
BY
NATUMANYA MEDRINE LLB/43807 /143/D U
A RESEARCH REPORT PRESENTED TO THE SCHOOL OF LAW IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE A WARD OF BACHELORS DEGREE IN LAW OF KAMPALA INTERNATIONAL UNIVERSITY.
SEPTEMBER, 2018 DECLARATION
I Natumanya Medrine declare that this research report is my original work and to the best ·of my knowledge, it has never been presented elsewhere in any university or institution of learning for approval.
~ Signed .. .~~ - · · · Date _.l.q .. (. ..l.9.. (.. .?.-o '-2
NATUMANYA MEDRINE LLB/43807 /143/D U APPROVAL
I, the undersigned certify that I have read and hereby recommend for acceptance by Kampala International University a research report titled, "An analysis of the effectiveness of Central Bank in regulating the banking sector in Uganda".
Signed Date ...... t., .. ( . J.~~ MR. SEWAYA M'Qi(AMUD
(SUPERVISOR)
ii DEDICATION
I dedicate this piece of work to the Almighty God, my Lovely parents Mrs. Joan Natuhwera Tukundane. and Mr. Tukundane Julius Nkora.
iii ACKNOWLEDGEMENT
I extend a vote of thanks to a number of people who unreservedly contributed towards the accomplishment of this research work. I also would like to acknowledge the assistance and role played by the following personalities to the successful completion of this study. I cannot say exactly how grateful I am to my supervisor, Mr. Sewaya Muhamud, his guidance in this study was beyond measure. Thank you also for providing me with professional advice, encouragement and your time that has spurred me to success.
I also extend sincere thanks to my friends; Susan, Everlyn, Adellah, Geoffrey and Aston, and not forgetting my beloved sister; Fiona and family members for their inspirations in my studies.
May the Almighty God Bless you abundantly.
iv TABLE OF CONTENTS DECLARATION ...... i
APPROVAL ...... ii
DEDICATION ...... iii
ACKNOWLEDGEMENT ...... iv
LIST OF ACRONYMS ...... viii
CHAPTER ONE ...... 1
GENERAL INTRODUCTION ...... !
1.1 Background ofthe Study ...... :.1
1.2 Statement of the problem ...... 5
1.3 Research questions ...... 5
1.4 Purpose of the study ...... 6
1.5 Objectives of the study ...... 6
1.6 Literature Review ...... 6
1.7 Methodology ...... 9
1.8 Chapterisation ...... 9
CHAPTER TWO ...... 11
REGULATORY FRAMEWORK OF BANK OF UGANDA ...... ll
2.1 lntroduction ...... 11
2.2 Bank defined ...... !!
2.3 Justification for Bank of Uganda Regulatory Framework ...... II
2.3.1 Depositor Protection ...... 11
2.4 Monetary Stability ...... 12
2.5 Efficient and Competitive Financial system ...... 13
v 2.6 Consumer Protection ...... ·...... 13
2.7 Methods Used in Commercial Bank regulation and Supervision ...... l4
2.8 Strengthening Prudential Regulation-and Supervision ...... l6
2.9 Conclusion ...... !&
CHAPTER THREE ...... 19
COMMERCIALBANK ISSUES TOWARDS REGULATING BANKING SECTOR ...... 19
3.1 Introduction ...... l9
3.2 The causes of bank failure ...... l9
3.3 Review of Monetary Policy Frameworks ...... 20
3.4 Legal fi:amework for the operation ofbanking system in Uganda ...... 22
3.5 Banking Regulation in Uganda ...... 22
3.6 Legal Framework for the Operation of Banking System ...... "" ...... 23
3.7 Licensing ...... 24
3.8 Legal Control of Banking Staff ...... 26
3.9 Code of banking practice in Uganda ...... 26
CHAPTER FOUR ...... 27
BANKING REGULATORY FRAMEWORK, LIMITATIONS AND BANKING CRISES MANA G EMENT ...... 2 7
4.1 Basic Principles ofRegulation ...... 27
4.2 Limitation faced by Bank of Uganda-regulatory framework Precarious Public institutions .. 27
4.3 Principles in Managing Banking Crises ...... 31
4.4 Protecting the Payment System ...... 31
4.5 Limiting Government Involvement in Banking ...... 32
vi 4.6 Insolvency Procedures for Banks ...... 32
4.7 Sharing the Cost of a Crisis ...... 32
4.8 Early Remedial Action ...... 33
4.9 Banking Sector Reforms ...... 33
4. I 0 Factors Influencing Future Regulations ...... 33
4. I I Conclusion ...... 35
CHAPTER FIVE ...... 36
RECOMMENDATIONS AND CONCLUSION ...... 36
5.I Study findings ...... 36
5.2 Recommendations ...... 37
5.2.1 Clearly Defined Principles ofRegulation ...... 37
5.3 Strengthening Market Discipline ...... _...... 40
5.4 Avoiding Speculative Bubbles ...... 40
5.5 Cross-border Capital Flows ...... 41
5.6 Close Coordination between the Central Bank and the Government...... 4I
5.7 Supervision of Financial Conglomerates ...... 42
5.8 Evaluation of Management Quality ...... 42
5.9 Commercial Bank Restructuring ...... , ...... 42
5.10 Liquidation ...... 43
5.11 Government Contro1 ...... 43
5.12 Conclusion ...... "...... 43
BIBLIOGRAPHY ...... 44
vii LIST OF ACRONYMS
BoU Bank of Uganda
CEPR Centre for Economic Policy Research
CRR Capital Requirements Regulation
FIA Financial Institutions Act
FSAP Financial Sector Assessment Program
IMF International Monetary Fund
UDB Uganda Development Bank
URSB Uganda Registration Service Bureau
viii CHAPTER ONE
GENERAL INTRODUCTION
1.1 Background of the Study
In order for every country to establish its goal a sound commercial financial Institution must be established to promote and finance development in various sectors of the economy with particular emphasis on agriculture, industry, housing, tourism and commerce. That is why the Uganda Development Bank is required to finance projects that are technically feasible commercially and socially desirables and in most cases priority is given to existing projects requiring small assistant to improve their operation and projects that create new job opportunities for the locals. 1
The fundamental rules of sound commercial banking call for holding of assets that are liquid in order to meet demand for cash in exchange for deposits. It's the ability to satisfy this demand that maintains confidence in the banking system. The term liquidity describes two attributes of being able to turn an asset into cash quickly and to do so without loss. Assets have to be acceptable to other banks or persons willing to supply cash. In many cases the amount of cash that can be obtained depends on the market and only by waiting until the full maturity date can the face value be obtained devoid ofloss.
The expansion of banking facilities into the interior of Uganda started in 1947 as a result ofthr.ee British Banks, the National Bank of India, Standard Bank of South Africa and the National bank of South Africa, that operated a network of branches, sub-branches, agencies and mobile units. The deposit potential created by the agricultural economy is what justified extension of banking facilities. The process however encountered difficulties as the economy had not developed sufficient infrastructure to allow economic operations of banks. In addition, the population was still suspicious of banks preferring to accumulate their wealth either in cash or in property such as land?
1 Sayers: Modern Banking, Delhi University press. (1967) 2 Wangenheim and BayOn. Electronic Fundamentals and applications; Integrated and discrete Systems. London. (2004).
1 There are a number of commercial banks that are locally owned which were started by business conglomerates or person with major industrial and commercial holdings and include such banks as the now closed Teefe Trust Bank Greenland Bank and International Credit Bank. The business persons also in their other capacities have been beneficiaries of directed credit programme frqm development fiance institutions. There has since been a progressive build up of numerous savings accounts though many of them carry nominal balances. The use of current account facility is still limited but it is expanding fast as more and more people enter the trade and the manufacturing sectors.3
In Uganda the financial system regulations tend to be patchy and lack coherence because regulations have been expanded to specific problems. Futihermore the Ugandan supervisory agencies tend to emphasize "passive supervision", that is, verification of the conforming of banks' procedures with the prevailing regulations, at the expense of'' active supervision", which can be defined broadly as an in-depth assessment of the quality of management of the risk factor, and if the institution's pmifolio. In times of financial instability, passive supervision is usually insufficient to signal deterioration in a financial institution early enough. Given the general introduction to the banking industry, this study seeks to analyze the regulatory framework of Bank ofUganda.4
Banks are subject to greater amount of regulation and control than other business organizations because when a bank fails the local economy is deprived of resources such as credit and savings and this destabilizes the entire macro-economic programme of a country. Thus the failure of a financial institution affects more than the fortunes of its shareholders and creditors (depositors).5
The historical experience suggests that banking regulation was not a natural produce but rather a by-product of reaction to conflict. The Great Depression of 1930 with all its social and political consequences was pmily due to series of mistakes, lack of coordination and rigidities in the conduct of monetary policy by the authorities and Central Bank of Principal countries. The
3 Yang and Jun. (2002). "Customer Loyalty in e-commerce", Journal of the Association for Information Systems, 3, 27-57.
4 AC [2000]:Banking Act Cap5 5 Henry Kibirige [1997]: The Uganda Banker Vol 5 Cap I Pg 49.
2 restrictive impact of each reduction in bank credit as a consequence of the crisis on investment and production was amplified by the multiplier effect and international trade. In every country the crisis led to and was amplified by bank failures. The close relationship between economic and financial crisis and between macroeconomic regulations and banking stability became more evident.6
Internationally as the financial institution moved freely from one national market to another and the volume of cross boarder activity grew, the need for international coordination of banking supervisory practices became more evident. Ideally a set of rules on the overseeing of financial institutions engaged in transactional banking activities was agreed upon by the competent monetary and financial authorities of their base countries. These rules were set up by the Basle Committee on banking supervision.7
The International Coordination of Banking Supervisory was established in I 974 to encourage co operation in the prudential supervision of international banking. Among the principle features of these rules for effective bank supervisory system was principle requiring that banks publish on regular basis financial statements. In all, the international rules were realization that national financial markets can no longer be protected by national laws alone in an open global environment. It was also a realization that failure of one bank may adversely affect the other banks.
The Bank of Uganda is a public body wholly owned by the Government created by an Act of parliament passed on May, I966.8 The Bank of Uganda was established in I966 to succeed the Afi"ican Currency Board that was established in I 9I 9. With its headquarters in London the Board had since I 920, served the whole East African including at one time or another Uganda, Kenya, Tanganyika Zanzibar, Somaliland and Eritrea.
The Bank of Uganda is constitutionally independent of governmentS in carrymg out its responsibilities; however it works in close corporation with government especially the Treasury which primarily concerned with the financial pplicies of the government of the day. 9 The Bank
6 Marketing Strategy ( 1997). 7 Section 18(1) and (2) of the Acts ofConstitituion Act, Cap. 2 8BOU Act, 2000; AC No.5 9 A1t. 162(2). The /995 Constitution ofthe Republic of Uganda.
3 of Uganda is committed to and is duty bound to work for the advancement of banking in the country. It has since 1984 taken on the obligation of providing full technical and practical support to the institute of Bankers so that the latter may perform more effectively its responsibilities of creating a strong professional foundation for the banking industry. The ultimate goal is to improve the standard and quality of banking services inculcating professionalism and technical skills among Ugandan Bankers.
The Bank of Uganda has a board of directors which is the supreme policy making body of the bank. The board is chaired by the Governor and in his absence the Deputy Governor, both of whom are appointed by the president on the advice of the cabinet. The other· members are appointed by the minister of finance, the secretary to the treasury as an ex-official member of the board. The Governor and Deputy hold office for such periods not exceeding four years as may be determined by the president at time of their appointment and are eligible for re-appointment. The newest department is the Management Information system which has vigorously embarked on a comprehensive programme of computerizing all the operations of the bank. The programme aims at improved efficiency. Over the years, amendments have been made in the Bank of Uganda Act to enhance the bank's ability to discharge its vital and special functions. The most current legislation is the Bank of Uganda Act. 10
Uganda like many third world countries has fully embraced banking as a vehicle for economic development. When evaluating the overall impact of the banking sector on the economy of Uganda, stress should be put on the legal environment in which commercial banks operate.
Given the growth of the economy, the existing banking regulations and controls have not been responsive enough to these changes to maintain a sound banking industry. Effectiveness of the Financial Institutions amendment Act 20 I 6 depends on the interpretative way of the administering agency conferred upon it by statute and where this is lacking problems arise. Today most banks make easy money and are not innovative.
10 Bank of Uganda Act, Act 5/2000.
4 1.2 Statement of the problem
Financial crisis has become a worldwide phenomenon in recent years. Ever since 1970, bank insolvency has become increasingly common. Although banks are normally private businesses, governments rightly consider them crucial in the running of the economy. Consequently, they assume the vital role of promoting the development of a stable financial sector and its regulation overtime. The banking industry is offering or performing services which are connected with money, especially keeping money for customers and paying it out on demand. But as we know there is more to banking than just keeping money. Today, the business ofbankii1g is looked at in the context of managing risks, both financial and non-inancia I risks which include solvency, capital adequacy, liquidity, profitability, interest rates, market credit and foreign exchange risks. However, the banking sector has been facing challenges include; credit risks, technology hung on, human resource risks among others. The legislative enactments dealing with regulation and control of financial institutions seem to be inadequate. The system of liberalization of the economy which started in Uganda in 1992 affected the banking industry most especially through expanding the number of business operation banks can be involved in. It seems further that the regulatory structure has not been responsive enough to these economic changes maintain sound banking industry. 11 Therefore, it is upon the above background that the researcher has decided to carry out a research study on the effectiveness of central bank in regulating the banking sector.in Uganda.
1.3 Research questions
a) What is the nature oflegal regime on bank supervision? b) What are the challenges faced by Central Bank in regulating banking sectors? c) What are the causes of Commercial Bank failure in Uganda? d) What are the solutions for the challenges facing bank's operations in Uganda?
II ibid
5 1.4 Purpose of the study
The overall objective of this study is to establish the effectiveness of Central Bank in regulating banking sector in Uganda.
1.5 Objectives of the study
a) To analyse the nature of legal regime on bank supervision. b) To examine the challenges faced by Central Bank in regulating banking sectors. c) To analyze the causes of Commercial Bank failure in Uganda. d) To find out the solutions for the challenges facing bank's operations in Uganda.
1.6 Literature Review
The law regarding banking in citing various sections in the American Banking Statutes, some are similar to those in Uganda. The regulations have been widely discussed, its purposes, implementations and effects. It therefore provides a proper insight into the modern law of banking which Uganda can emulate. 12
Milton Fredman in his article on bank regulations pointed to the system of bank regulation as an example of government activity that cannot be satisfied. 13 Professor M.M. Semakula concurred with Friedman in his book, "Central Banking in Africa and challenge to Development" when he pointed out that central banks in carryingout their activities are subject to a great degree of political interest. Prof. Semakula emphasized that Central Banking is vital in recent years highly because politicians are relying increasingly on monetary policy to curb inflation but want to distance themselves from its unpopular side effects. In Uganda like many least developed countries, Central Banks as agents of governments. To this extent the contemporary view refleCts increasing concern of bankers at the extent of political intervention in the regulatory activities of the Central Bank. There is a fear of a possibility of serious damage to the economic systems as a result of inexpert and unconsidered applications of this power of bank regulations.
12 Kenneth Sponge (1990) 13 Edward Franklin, (1990); Issues in financial regulation
6 The historical development of Central Banks as the regulatory body been looked at by critics like Sayers to negate bank regulations. 14 Sayers said that the primary requirement for least developing countries territories of the world in the context of monetary matters is at the regulation and control of a complicated and mature financial systems but encouragement of long term development in basic sectors of the econmny15. In these areas, he went on to say, the contribution a Central Bank can make to regulate direction and guidance of financial situations as may exist must be a secondary and lesser consideration.
Governor Butcher while commenting on bank regulation and deregulation said that; "the existing systems of bank regulation are not only overlapping and confusing but in many respects jails to stif.ficiently serve public interest because it limits competition and freedom ojbusiness." 16
Philip Cagan is also of the view that people who engage in regulation do not always understand its purpose. Cagan concludes that;
"the regulation spawns more regulation in response to evils perceived by regulators is a principle as old as regulation itselj." 17 He points to the disadvantage of over regulation stating that the initial financial system is over regulated, with each regulation supporting the other, it may be difficult to implement a gradual effective reform and yet rapid structural changes carry a risk of monetary control and broader financial instability require careful management.
The Financial Institutions Act forms the most exhaustive discussion on the subject and this comprises of the parliamentary Debates to the Financial Institutions Bill. 18 Tumusiime Mutebile portrayed that debates carried on by people who represent thousands of people perhaps most adequately reflect the views of an entire community in a constituency be they financial people or just observers whose confidence in our financial Sector was well below zero 19 and Leo Kibirango both of whom offered the enactment of the Financial Institution Statute as one of the vital ways in which the financial sector could he reshaped and the financial institutions prope1ty
14 Supra note 1 15 Edward Mervin; Capital Funds in least developed countries, role offinancial institutions pg20 16 Supra note 12S 17 Ibid 18 Editor Hansards, Parliament Building debates from April 27 May 4, 1993 19 Tumusiime M. (1989); Economic stabilization, facing the challenges from 1986, the choices and results to date. P.S. MPED No.5 Seminar on Uganda's Economy by Minister of Finance and Uganda institute of bankers, international Conference Centre 12-16 December.
7 controlled, regulated and supervised as a pre-requisite to economic growth it was later amended as the 2004 Financial Institution Act and now we have 2016 Financial Institutions (Amendment Act).
Given the views of the above writers, it's obvious that bank regulations are met an element of hostility. This therefore poses the question of the role of the specific regulations in serving their intended purpose and whether the regulations prevent both banks and their customers from obtaining optimum returns on their investment. The short coming and defects of the financial institution which did not go a long way in improving the economic situation at that time adding that there was no institution that catered for African enterprise.20
The only basis of relevance however of these works is to give us an insight into the character of these financial institutions in the past and simply serve to give us a better understanding of how the state of affairs of these institutions came to be what it is today.
If Uganda is to create and implement a successful development agenda in 2015 and beyond, it must build strong institutions of economic governance. Academics and economic policy makers have learned many lessons about macroeconomic policy and central banking over the last fifty years, and these lessons have influenced radical changes in the practise of monetary policy and the governance of central banks around the world, including in Uganda. In some important respects, including the operational independence of the central bank, the adoption of an inflation targeting monetary policy framework and risk based bank supervision, Uganda has been among the pioneers of radical reform in Africa.21
In order to fill the gaps, the central bank should have clearly defined policy goals which it can realistically be expected to deliver, given the monetary policy tools it has at its disposal. That is why the BOU has, as its primary policy objective, the control of inflation. A well formulated and implemented monetary policy should be able to achieve a target for inflation, on average over a medium term horizon, although not in every single month over ·that horizon because prices are
20 Bossa G.R. The Uganda Credit and saving Bank. EDRP No.98 MISR 1966 PG.2 21 Emmanuel Tumusiime-Mutebile, Governor of the Bank of Uganda, to the Tenth Annual Meeting of the African Science Academies, Kampala, 2014.
8 subject to short term shocks, such as those caused by food supply shocks. If a central bank is given a clear policy objective to control inflation over the medium term, it is then relatively straightforward to judge its performance, by measuring the outcome against the policy objective, and thus to determine whether or not the central bank is doing a good job. The BOU aims to hold annual core inflation to a maximum of 5 percent over the medium term. The public should judge the BOU on how well it performs relative to its target for inflation. Over the last 24 months, annual core inflation in Uganda has averaged 4.8 percent; hence the inflation outturns indicate that the BOU's monetary policy has been successful over this period.Z2
1.7 Methodology
Many sources have been used in carrying out this research. They include Text Books, Articles and other references. Further literature is from the World Bank, International Monetary Fund(IMF) who through the 1980's and much of this decade have been pre-occupied with issues of financial sector liberalization and dispending as a means of bringing out an economic turnaround in the developing countries through policy, legislation and institutional reforms. It's therefore important to review some of the materials that's have been used including; Books, legislations, and law journals.
Furthermore, statutes, cases laws and journal articles have also been used. Besides, internet materials were also used.
1.8 Chapterisation
This thesis is subdivided into five chapters. The first chapter gives a general introduction to the study including origin and historical development of banking in Uganda, it provides a background to the study, it clearly shows what the study is about and what it sets out to achieve. It sets out the general introduction, statement of the problem, the objectives of the study, the hypothesis, methodology, literature review and chapterisation. Chapter two discusses the law applicable in the Regulatory frame work and Chapter three deals with the root cause and challenges facing banking sectors in Uganda. Chapter four looks into the findings of the field
22 Ibid
9 research study and chapter five provides the recommendations and he way forward. It also provides a platform for discussions with the aim of earmarking and suggestion ideas for reform.
1.10 Significance of the study
The study will add literature review to the already established information about the variables hence acting as a source of literature review to the future academician's who may get interested in researching about the same study variables of bank effectiveness and banking seCtor.
The study also will help the researcher to acquire practical skills that will help in carrying out more research in some future time. This is because during the process of carrying the study, she will come up with new inspiring problem in the area.
The study is particularly important for the academic sphere. It is hoped that the findings will generate more knowledge that will help other academic scholars to further their studies in bank effectiveness and baking sector.
10 CHAPTER TWO
REGULATORY FRAMEWORK OF BANK OF UGANDA
2.1 Introduction
This chapter examines the current laws in Uganda that governs the bank supervision and regulation, a review of the law governing the bank supervision was also be made. The researcher went ahead to use the related literature from different sources as stated in the methodology.
2.2 Bank defined
According to Financial Institutions Act (FIA); bank means any company licensed to carry on financial institution business as its principal business, as specified in the Second Schedule to this Act and includes all branches and offices of that company in Uganda.23
2.3 Justification for Bank of Uganda Regulatory Framework
2.3.1 Depositor Protection
A depositor is someone who has left funds with a bank or any financial Institution to either keep it safe or earn profits and depositors Protection is the safe guard to ensure. that you will not be left out of pocket of the custodian of cash decides to run off with it. Depositor's protection is the basic reason for banking regulation. Banking poses a number of unique problems for customers and creditors. First many bank customers only want to write and cash cheques and carry out other financial transactions through a bank. To do so, they must also maintain a deposit account. As a result, bank customers assume the role of bank creditors and become linked with the fortunes of their bank. A second problem for bank depositors is that deposit safety is related to capital in a bank and the condition and market value of its assets which includes loan and securities.24
23 FIA, Cap I OS 24 Mugenva, Yasiin ( 2011). 11Government tightens grip on banks". Daily Monitor. Kampala. Retrieved 7 June 2018.
11 2.4 Monetary Stability
Regulation would prevent fluctuations in business activity and problems at individual financial institutions from threatening to interrupt the system of payments. Section 26 of Financial Institutions Act stipulates capital requirements for starting commercial bank and already functioning banks. This is also stipulated undet: S.l425 which states that the authorized capital of bank shall be thirty billion shillings which shall be subscribed by the government time to time and may be increased by a resolution of parliament to ensure adequacy to the operation of the Bank. Furthermore section 28 26 provides for a financial institution to have on-going capital so as to encourage a flexible banking system that can always meet the public transaction needs and discourage disruptions in the payment system. There is a Deposit Insurance Fund provided for under section I 0827 which removes any reason for insured depositors to panic at the sign 'of banking crisis. Although deposit insurance has costs and risks, it has provided stability in the payment system and given bank regulators greater flexibility in resolving individual bank problems.
A banking licence granted under Financial institutions Act is not within the contemplation of civil rights under the constitution. Thus, in Merchant Bank Ltd v. Federal l'vfinister of Finance28the Minster made an order revoking the licence of the plaintiff for breaching regulations regarding liquidity ratio and other conditions and the proper running High Court sought a declaration order that the order was void and different from injunction to be granted to restrain the minister from winding up the bank. The counsel to the Bank argued that the licence can only be revoked by the court or other tribunal established by the constitution?9
The bank further argued that it is only the court that has the power to deter mine the civil rights of any citizens including a corporate body. The Federal High Court dismissed the action and the Supreme Court it was held that a licence to engage banking business can be revoked by the Minister. It was further held that a licence was a privilege and it was for the minister and not the
25 Financial Institutions Act 26 Ibid Note 20 27 Ibid 28(1961) ANLR pt. 4598 29 Ibid 12 court to exercise the powers. The function of the coutt begins when it is alleged tliat the powers have not been exercised in accordance with the provisions of the law.30
2.5 Efficient and Competitive Financial system
Efficiency is defined as getting the greatest production from a given set of resources. While competition is a vehicle for achieving this efficiency. Since banks are forced to operate efficiently if they are to keep their customers and remain in business.
Competition and efficiency depend on the number of banks operating in a market, the freedom of other banks to enter and compete and the ability of banks to achieve an appropriate size for serving their customers. For instance too few banks in a market could encourage monopolization. As a result regulators are concerned with the concentration of resources in the banking industry and the levels of every, expansion and consolidation.
However banking regulation must not take an approach that restricts commercial banking activities or place them at a competitive disadvantage with less regulated firms. In addition to the above, regulation should foster a banking system that can adapt quickly to ch?nging economic conditions and technological advances.31
2.6 Consumer Protection
Another goal of banking regulation is to protect consumer interests in certain aspects of a banking relationship. This can be attained by first, to require lenders to provide borrowers a meaningful disclosure of credit terms so that they can readily compare and m·ake informed choices between credit offerings. This can be effected by appointment of an auditor as provided for in section 68 who makes a report upon the annual balance sheet and accounts of the financial institution The disclosure is intended to protect borrowers from abusive practices and make them more aware of the Costs and commitments in a loan contract.32 The second purpose for consumer protection is to ensure equal treatment for all financial customers in areas such as housing, employment and education. Consumer protection objectives are generally consistent with good
30 ibid 31 Bank of Uganda (8 June 2018). "Bank of Uganda: Supervision Overview". Kampala: Bank of Uganda. Retrieved 8 June 2018. 32 Ibid
13 banking principles, credit disclosure and informed customers should benefit bankers offering competitive services.
The Act that established the Central Bank of Uganda is another statute that governs banking 33 regulation . The Act vest on the central Bank of Uganda extensive regulatory and supervisory power over the operation of licensed banks and financial institutions. Apart from the power to issue and revoke banking licences, it can also carry out periodic inspections into the affairs of any bank like regulating bank laws, sanction banks which violate banking regulations (as imposed by it) and assume control and management of failing banks. For instance, to date, in a bid to sanitize the financial industry, the Bank of Uganda has revoked the licenses of many banks.
Any organization desirous of carrying on banking in Uganda must first be incorporated under Uganda Registration Service Bureau (URSB) l99834as a limited liability company. As it was 35 held in the case of Akinwale and Ors v.R , only a company or corporate body can operate a bank in Uganda. An alien or foreign company subject to the provisions of any law regarding the 36 37 rights and capacities to engage in trade or business . Section 54(4) every foreign company intending to carry on business in Uganda must take all steps necessary to obtain incorporation as a separate entity.
2.7 Methods Used in Commercial Bank regulation and Supervision
Banking supervision is used to verify that regulations are followed and that the banking system is healthy. Supervision allows for proper information disclosure and early remedial actions.38 Of course the supervision of both compliance and quality is primarily the responsibility of each banker, through proper internal controls. But in case bankers fail to fulfill this function properly, the supervisor's function is essential to identify and correct insolvency problems, and, if necessary, to set the legal grounds for action. The main elements of banking supervision are disclosure, off-site and on-site surveillance, inspection and external auditing.
33The BOU Act No 24 of 1991 as amended by Act No 3 of 1997 now Cap. C4 LFN 2004 34Cap. 51 L.F.N. 1990 now Cap. C20 L.F.N. 2004 35(1962) ANLR 193 at p.200 36Sec. 20(4) ofCAMA 37 !bid 38 S.79 Ibid 14 The Financial Institutions Act (as amended 2016) empowers the Bank of Uganda to conduct Commercial Bank regulation and supervisions. Section 4939of Financial Institution Act 2004 provides for proper disclosure by banks as an essential tool for market discipline, for remedial action by the bank's managers and for government control. Proper full information should be disclosed to the public as well as to the supervisory authority, If there is no proper disclosure, depositors and investors will not be able to tell a good bank from a bad bank and improve market discipline, managers will not have adequate justification for stringent remedial action, and governments will not be able to detect problems until it Liquidates.40
As an ann of banking supervision external auditors as stipulated in section 6241 can perform a useful role by conducting on-site inspection on behalf of the authority to ensure that information provided by the bank accurately reflects its financial position. Section7942 empowers the Bank of Uganda to inspect financial institutions in three ways. The first is on- site examination where the Central Bank physically visits and examines all prudential norm requirements inclusive of capital adequacy at least once every two years. In between the full scope examination, Bank of Uganda undertakes limited scope on financial institutions to purposely check on the implementation of previously recommended corrective measures.
Due diligence or special inspection methods is used to analyze the situation and results got from off-site and on-site inspections so that a third opinion about the bank in questions is got. In this method every aspect of the bank is investigated, examiners carefully evaluate the five critical elements that determine soundness of a bank. These elements are capital, asset, quality management, earnings and liquidity In order to determine and evaluate the quality of the loan portfolio to which examiners devote the largest portion of their time during on-site examination, the documentation collateral and payment records of most large loans and a sample of small loans are reviewed. The loan concentration sufficiency of the loan loss reserve and methodology employed to calculate it are assessed.
39 Ibid Note 31 4°Financial Institutions Act, 2016 41 Ibid 42 Ibid 15 2.8 Strengthening Prudential Regulation-and Supe1-vision
Strengthening the legislative and institutional framework for the prudential regulation of financial markets has involved enacting new legislation to replace the 1969 Banking Act and that of 1993, which had become outdated and its provisions were deficient in many ·respects. The authority to license banks lay with the Minister of Finance rather than the Bank of Uganda. The Bank of Uganda also required Ministry of Finance permission before taking action related to prudential matters Minimum capital requirements were too low, having been eroded by inflation The Act failed to delineate appropriate prudential requirements to be followed by the banks. Instead it specified a number of allocative requirements. The Bank of Uganda found it difficultto implement measures without having recourse to the courts, nor was it able to issue prudential guidelines to the banks where appropriate.
The 2004 Financial Institution Act has rectified most of these legislative defects. In addition to banks, the statute covers credit institutions, building societies, bringing all these financial institutions under the supervisory authority of the Bank of Uganda after fulfilling a certain requirement58, It gives the Bank of Uganda more independence from the Ministry of Finance in licensing and regulating Financial Institutions, though rejected applicants have the right of appeal to the Finance Minister who also must be consulted before prudential regulations are issued and before the Bank of Uganda liquidates insolvent Financial Institutions, It's also more flexible than the 1969 Banking Act in that it gives the Bank of Uganda the authority to issue prudential regulations pertaining to capital adequacy liquidity, data to be supplied for supervisory purposes.
The statute further imposes restrictions on insider lending, large credit exposures and investment in non-bank business and purchase of real estate. It also gives the Bank of Uganda a range of options for dealing with Financial Institutions that act imprudently, infringe regulations or have otherwise became insolvent. The Bank of Uganda can issue, seize and desist orders, impose fines on management or take over the management of the offending. Financial Institutions and reorganize or liquidate it.
Developments during 1998 and 1999 when the Bank of Uganda used it's powers under the Financial institution Statute to take action against distressed local private banks; indicate that the
16 reforms outline above have enabled the Bank of Uganda to adopt a more purposeful approach to prudential regulation. Insolvent banks no longer receive automatic overdraft facilities from the Bank of Uganda.
While the reforms have clearly strengthened prudential regulation in Uganda, two problems in particular have the potential to impede the Bank of Uganda efforts to ensure that Financial Institutions are managed prudently. First there may be little that it can effectively do to ensure that commercial Banks comply with prudential regulations. The Bank of Uganda cannot realistically eliminate insider - lending The new banking legislation imposes strict limits on insider loans, but if their presence in a bank's potifolio is concealed by fraudulent accounting, bank examiners may not be able to detect then and take action in time to prevent the bank becoming distressed
The regulatory and supervisory institutions should improve supervisory agencies' ability to identify problems, reinforcing their power to take corrective action, and establish 'clear rules for implementing necessary measures. Such changes require an improvement to the qualifications and experience of the staff working for the supervisory agencies. Supervisors will need resources to train their staff in both in-situ supervision and in analytical capabilities for desk-based reviews. Staff members must be open to understanding new developments in the market place.
Commercial bank assets consist of cash, loans, securities and investments. Liabilities include demand deposits, saving and time deposits and borrowings. The difference between assets and liabilities is known as the net worth of the bank.43
The net worth of a commercial bank cushions and protects the depositors against bank insolvency. A bank is solvent if it can sell its assets and obtain enough funds to meet its outstanding liabilities. The value of assets must always exceed the value of liabilities. When t)le net worth of a commercial bank becomes negative, that then it is technically insolvent and bank supervisors could at this point close the bank immediately.
43 Ibid 17 2.9 Conclusion
What is believed as the essential elements of an institutional framework for central banking in the post 2015 era have been seen in the above chapter. The essential elements are clear policy mandates for the central bank focused on monetary policy and bank regulation; a primary monetary policy objective of controlling inflation over the medium term, the operational independence of the central bank and a clear separation of monetary and fiscal policy. Over the last two decades, legislative, institutional and policy reforms have been implemented in Uganda which have put in place a framework which incorporates these essential elements, although there is still some way to go to make them fully effective. Therefore the Bank of Uganda is well placed to support Uganda's development agenda.
18 CHAPTER THREE
COMMERCIALBANK ISSUES TOWARDS REGULATING BANKING SECTOR
3.1 Introduction
This chapter examines the problems and causes of commercial bank failure in Uganda. The mechanisms of bank failure have a common outcome, the inability of banks to deliver funds that depositors demand. If the rate of growth of bank depositors is higher than the deposits interest rate, this will pose no problem. In this case, depositors are actually transferring financial resources to the banking system and banks are able to remain liquid even if they roll over all their loans and make even more. The failure of banking system in Uganda has been a source of major concern to both the government and general public.
3.2 The causes of bank failure
The assessments are based on the internationally adopted regulatory standards using the assessment methodologies prescribed by the standard setters. Evaluations of regulatory systems in the Financial Sector Assessment Program involve the participation of practicing regulators from central banks, ministries of finance, and regulatory agencies. This approach offers member countries a peer review of their national regulatory systems. Fund staff has been providing periodic feedback to the standard setting bodies on the assessment experience with individual standards as reflected in the recent revisions to the insurance regulatory standard and the securities standard assessment methodology. 44
There are few areas where the interconnection between economics and politics are more obvious than within the field of banking and financial regulation. We know from the literature on finance and growth that regulations and enforcement are of utmost importance for a well-functioning financial system. And this certainly was the case also for Sweden in the nineteenth century.45 Thus there will always be a need for financial and banking regulations. But, as highlighted by Raj an and Zingales, part of these regulations are in fact necessary to counteract monopolizing and lock-in effects that may lead to less efficient financial and banking systems. The recent
44 Wafida, Walter (3 June 2011). "Bank regulations. Daily Monitor. Kampala. Retrieved 19 Apri/2016. 45 Ogren, A. (2009). 19 Centre for Economic Policy Research report on lender of last resort and bank bail-outs also argues that all policy interventions has to be made with the explicit aim not to distort competition.46
It is important to notice that several policy interventions actually are directly meant to decrease the possibilities of diversification, which theoretically is one of the most impmtant ways to counteract systemic risk. And as systemic risk also is what leads to contagion we should be somewhat skeptical of the benefits of extended use of regulations whose aims are to oppose the possibilities for diversification and ask what the real reasons behind the adoption of such policies are. Thus one problem when studying regulations concerns the reason for their implementation. The causes for implementation are often obfuscated by rhetoric, as self interest in regulation never can be disregarded as a plausible cause but for political reasons such self-interests are not accepted as arguments for the implementation of regulations.47
Financial and banking regulations usually becomes high on the agendas for policy makers, public opinion and researchers in times of financial distress. And financial crises in history were usually also the breeding ground for various politically appointed committees on the financial and banking system aiming to propose regulations meant to solve the presence of financial distress through regulatory schemes. 48Today, even on the global scale, agreements can be seen as direct effects of prior financial crises.49
3.3 Review of Monetat-y Policy Frameworks
Generally, all the selected countries have made good progress in formulating a comprehensive monetary policy framework, which, however, remains a "work in progress" in many cases. In most countries, the establishment of a comprehensive monetary framework has been hindered by the low level of development of the financial system. Furthermore, in some instances, political considerations and now the current global financial crisis have forced deviations. Developments of this nature carry credibility and reputational risks for the central banks, and hamper the effectiveness of monetary policy. Sri Lanka, for instance, had to resort to a blunt easing of
46 Ibid 47 Mishler, Lon; Cole, Robert E. (1995). Consumer and business credit management. Homewooa: lnvin. pp. 128-29. ISBN 0-256-13948-2. 48 Beck, T. et a! (20 I 0) 49 Coval, J., Jurek, J., and Stafford, E. (2009)
20 monetary conditions while Armenia had to de facto suspend its inflation targeting framework. While price stability has been recognized as the primary objective of central banks, the implementation of the suppmtive monetary policy framework has varied greatly, and is being especially tested by the global financial crisis. 5°
The communication by the Central Bank of Republic of Uganda of its monetary policy stance is consistent with what is expected under a fully fledged inflation-targeting framework. Monetary aggregates, however, remain indicative targets under the International Monetary Fund (IMF) program, as the Central Bank of Republic of Uganda continues to use a broad set of indicators. In the meantime, given the peg to the Indian rupee, Nepal's monetary policy framework aims mainly at bringing liquidity in the banking system to a level viewed as consistent with limiting the inflation of non-traded goods and maintaining a satisfactory level of international reserves. The excess reserves of banks at the central bank are the operational target, and broad money the intermediate target. A standing facility allows the banks to borrow from the central bank, and over a last resort discount window. The interest rate at this window is the policy bank rate, which 1 serves to signal the monetary policy stance. 5
Besides interest rate policy, the CRR remains an important policy instrument in all countries, but is sparingly used. Changes in the CRR have allowed central banks to at times broadly at the level of free reserves within the banking system, and, thus, the ability of banks to extend loans and in the process expand Ml or M2. This remains the main instrument of monetary policy used in Tajikistan. Other central banks have changed their cash reserves requirement only sparingly, preferring to use less blunt and more market-based instruments. But the global financial crisis has forced Georgia, Sri Lanka, and Tajikistan to cut the cash reserve requirement with a view to 2 addressing systemic liquidity problems. 5
50 Lipton, Eric; Martin, Andrew (July 3, 2009). "For Banks, Wads of Cash and Loads ofTrouble". The New York Times. Macon, Ga: The New York Times Company. Retrieved 13 July 2018. 51 Ibid 52 Ibid 21 3.4 Legal framework for the operation of banl Existing academic literature on financial customer protection spans law and economics, but is rather limited. One strand of literature derives from behavioral economics and is closely linked to financial literacy. Behavioral economics has often been used to examine customer behavior and the reasons behind certain customer choices. This strand of literature acknowledges that the approach of standard models in economics that is, rational customers and competitive markets 53 may not always hold in actuality • In the financial sector specifically, some stt!dies have argued that customers are subject to certain behavioral biases, including vulnerability to marketing such 4 as being likely to take up offers that are framed in simple terms. 5 Customers may not be well informed, they can get confused when they are presented with many alternatives, and can eventually make systematic mistakes, which could be exploited by providers. In this regard, even well-established and efficient disclosure requirements may not be sufficient. For example, Barr et al. 55 note that disclosure of useful information to the mortgage borrower prior to signing is crucial, and it would be effective only to the extent that it can be comprehensible and to the point. Hence they suggest developing financial market regulations based on behavioral models in which the underlying reasons of certain decisions by the households are investigated, rather than modeling the way in which rational households should make their decisions.56 It is Suggested that the use of financial literacy as an avenue of remedy, in addition to well-designed financial customer protection regulations. The results of behavioral research could be useful in designing effective regulations in the credit market. 57 3.5 Banking Regulation in Uganda Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between 53 Ardicet al. (20 10) 54 Benartzi and Thaler, 2002; Bertrand eta!., 2004; Agarwal eta/., 2006; Campbell, 2006 55 Barr eta!. (2008) 56 Campbell (2006), Banking legal framework; McMillan Publishers 57 Elliehausen (2010), Banking sewctor in Uganda; Longman Publishers: London 22 banking institutions and the individuals and corporations with whom they conduct business, 8 among other things. 5 Given the interconnectedness of the banking industry and the reliance that the national (and global) economy hold on banks, it is impottant for regulatory agencies to maintain control over the standardized practices of these institutions. Supporters of such regulation often base their arguments on the "too big to fail" notion. This holds that many financial institutions (patticularly investment banks with a commercial arm) hold too much control over the economy to fail without enormous consequences. This is the premise for government bailouts, in which government financial assistance is provided to banks or other financial institutions who appear to be on the brink of collapse. The belief is that without this aid, the crippled banks would not only become bankrupt, but would create rippling effects throughout the economy leading to systemic failure. 3.6 Legal Framework for the Operation of Banking System The most significant legislation to affect banking transactions in Uganda was the Banking Act 59 1952 as amended by the Bank of Uganda Act 2000 . The Provisions of the Banking of Uganda Act made it mandatory for a valid license to be obtained before any banking business could be transacted in Uganda. An application for a license shall be forwarded to the Governor of the Central Bank of Uganda and all licenses to be issued shall be with the prior approval of the Minister of Finance. 60 The Act that established the Central Bank of Uganda is another statute that governs banking 61 regulation • The Act vest on the central Bank of Uganda extensive regulatory and supervisory power over the operation of licensed banks and financial institutions. Apart from the power to issue and revoke banking licences, it can also carry out periodic inspections into the affairs of any bank, sanction banks which violate banking regulations (as imposed by it) and assume 58 Collins, D., J. Morduch, S. Rutherford, and 0. Ruthven (2009). Street refporm and consumer ptotection in Uganda; Fountain Publishers. 59Cap 28 LPN 1990 60See Sec. 3 Subsection (5) of BOPA as amended 61 The BOU Act No 24 of 1991 as amended by Act No 3 of 1997 now Cap. C4 LPN 2004 23 control and management of failing banks. For instance, to date, in a bid to sanitize the financial industry, the Bank of Uganda has revoked the licenses of many banks. Any organization desirous of carrying on banking in Uganda must first be incorporated under Uganda Registration Service Bureau (URSB) 199862as a limited liability company. As it was 63 held in the case of Akinwale and Ors v.R , only a company or corporate body can operate a bank in Uganda. An alien or foreign company subject to the provisions of any law regarding the 64 65 rights and capacities to engage in trade o'r business . Section 54(4) every foreign company intending to carry on business in Uganda must take all steps necessary to obtain incorporation as a separate entity. Statutory declaration of compliance signed by a legal practitioner. Where the Corporate Affairs 66 Commission refuses, the applicant must be notified within 30days. By Section 56 , the National Council of Ministers may exempt foreign companies from complying with the provision requiring foreign companies to register in Uganda before they can operate. Foreign companies operating in Uganda before the Act should have the word "Uganda" on their names. 3. 7 Licensing After incorporation as a company in Uganda, the company must obtain a banking licence from the minister of finance after consultation with the Central; Bank. The applicant must submit a copy of the memorandum of understanding and articles of association as well as the certificate of incorporation. The Bank of Uganda Act67provides that no banking business shall be transacted in Uganda except by a company duly incorporated in Uganda which is in possession of a valid licence granted by the Ministry of Finance authorizing it to do so and unless before its incorporation in Uganda the objects of the company as defined in it Ministry of finance shall have been submitted to the minister in writing through the BoU for its consideration and approval accordingly. 62 Cap. 51 L.F.N. 1990 now Cap. C20 L.F.N. 2004 63(1 962) ANLR 193 at p.200 64 Sec. 20(4) ofCAMA 65 Ibid 66URSB Act 67Bank of Uganda Act, 2000 24 68 By Section 5(3) , if the applicant is already carrying on business outside Uganda, a copy of its latest audited accounts and balance sheet must be submitted. By Section 8 of the Act, the minister may by order revoke any licence for the following reason: if the holder ceases to cany on business in Uganda or is in liquidation, where the bank operation is detrimental to the interest of the depositors or creditors or has insufficient assets to cover its liabilities. The minister may however take any of the following steps prior to revocation; Appoint an expert to advise the bank on the proper conduct of the business; The minister will report the circumstances to the Federal Executive Council who may order the revocation, The minister must give the bank reasonable notice of its intention to revoke and allow the bank to reply with a written statement. A banking licence granted under the Act is not within the contemplation of civil rights under the constitution. Thus, in Merchant Bank Ltd v. Federal Minister of Finance69the Minster made an order revoking the licence of the plaintiff for breaching regulations regarding liquidity ratio and other conditions and the proper running High Court sought a declaration order that the order was void and different from injunction to be granted to restrain the minister from winding up the bank. The counsel to the Bank argued that the licence can only be revoked by the court or other tribunal established by the constitution. The bank further argued that it is only the court that has the power to deter mine the civil rights of any citizens including a corporate body. The Federal High Comi dismissed the action and the Supreme Court it was held that a licence to engage banking business can be revoked by the Minister. It was further held that a licence was a privilege and it was for the minister and not the court to exercise the powers. The function of the court begins when it is alleged that the powers have not been exercised in accordance with the provisions of the law. It must be noted that where there is any dispute relating to breach of or non-compliance with certain formulates required by Jaw for the lawful operation of banking business, the Federal High 68 !bid 69(1961) ANLR pt. 4598 25 Court is the appropriate cotnt70 for the action because it involves government measure except the federal government is a necessary party. 3.8 Legal Control of Banking Staff According to Financial Institutions Act, bank as a legal entity operates via the activities of some people such as managers, Directors a principal officers. It is therefore imp01tant to consider the legal control of these staff with respect to banking business and operations. 11 In the case of Uganda Commercial Bank Ltd v. Ajayi , the Court of Appeal held as follows; Where in the course ofhis duties and using the bank focilities, an officer ofthe bank receives money jivm the customer which he either uses or jivudulently converts to his own use; the bank is liable to the customer notwithstanding the foci that it had adopted all necessmy measw-es to p1-event the officer jivm doing so. In the likely manne1; where the officer ofthe bank faudulently withdraws money jivm the account ofcustomers, the bank is liable to the customer. 3.9 Code of banking practice in Uganda The Code is a voluntary code of conduct which sets standards of good banking practice for us ·to follow when dealing with persons who are, or who may become, individual and small business customers and their guarantors. Bank of Uganda in June 2011 issued the Financial Consumer Protection (FCP) Guidelines to all supervised financial institutions (commercial banks, credit institutions and microfinance deposit-taking institutions). All commercial banks are members of the Uganda Bankers' Association (UBA) and subscribe to the UBA's Code of Good Banking Practice. The Code is designed to encourage higher standards for the benefits of customers and is similar in spirit to the BOU Financial Consumer Protection Guidelines. The Code is available to consumers from their bank on request or via the Uganda Bankers' Association.72 70See Jamal Steel Structures v. African Continental Bank Ltd (1973) I All N.L.R. (part 3) 28; See also the Federal Revenue Court Act No 13 of 1973; Sec.228-230 ofthe 1979 Constitution and Sec. 249-252 of 1999 Constitution of the Federal Republic of Uganda. 71 (2002) FWLR (pt. 92) at p. 1716 PerTABA! J.C.A. 72 Ugandabankers.org 26 CHAPTER FOUR BANKING REGULATORY FRAMEWORK, LIMITATIONS AND BANKING CRISES MANAGEMENT 4.1 Basic Principles of Regulation Prudential regulation is an appropriate legal frame work for financial- operation is a significant _contributor to preventing or minimizing financial sector problems. Prudential regulation is part of the overall concept of bank supervision. It's a necessary supplement to market deregulation and provides both bankers and supervisors with the rules of achieving sound banking. If bankers follow the regulations which are inspired by traditional banking system the supervisor will hardly have to step in. But if bankers depart from the rules of the game, the supervisor will have to impose remedial action for the ... good of both the Financial System and the real sector.73 It's self-evident that supervisory and regulatory authorities should be independent of political manipulation in their on-going responsibilities and that they should have adequate powers and resources to pursue their clearly defined objectives However, they need to be accountable for the use of their power and the use or non-use of their discretion. Regulatory agencies should clearly have authority and power to license institutions, to conduct supervision, and to conduct examinations of institutions. In addition, a series of basic principles are suggested for the effective and efficient conduct of regulations.74 4.2 Limitation faced by Bank of Uganda-regulatory framework Precarious Public institutions This problem is manifest at different levels which are insufficient among the staff of regulatory agencies to identify the risk taken by private institutions, insufficient authority to take corrective 73 Aristobulo, (1990). The roots of Banking crises: Microeconomic Issues; the World Bank, p.95 74 David T, Llewellyn, (1999). The financial system and economic development, the Uganda Banker Vol. 7 No.2 June p.28 27 action once problems have been identified, incorrect incentives for the supervisory authorities that often cause them to hesitate when measures in cases of potential bank insolvency.75 The essential component of the process of banking supervision is the inspection that takes place on-site with a sample of individual loans. This helps determine the current and future status of those loans and thus their potential for timely repayment. This type of review requires a high level of sophistication on the part of banking inspectors. This task is perhaps the weakest link in the supervision chain in developing economies. Since without clarity on the future perspectives of a loan, it's impossible to correctly assess a bank's condition. Furthermore, supervisory agencies' ability to identify losses is of limited use unless have sufficient power to enforce corrective action. Supervisors should have enough authority to impose sanctions if compliance with prudential regulations wanes. Depending on the institutions being supervised, such sanctions can include fines; dismissal from management posts in cases of imprudent practices, restrictions on the activities banks may undertake proceeding in the extreme to liquidation. The problem is that even when supervisory agencies have formal authority to take corrective measures, the administrative requirements as to the evidence they must gather are so exacting that it's extremely difficult for them to compel a bank to increase its capital reserves or apply more prudent policies in specific areas. 4.2.1 Lack of Tradition in the operations of Financial Markets Quite clearly the solvency of the banking systems does not depend solely on the role played by public regulatory agencies. Rather it needs to be supplemented by responsible actions by bank management itself as well as monitoring by those institutions, shareholders and depositors. In other words market discipline is a must to all concerned. Despite the processes of financial liberalization that commenced, the financial systems have not had the benefit of a learning curve which is the benefits of competition that allows them .to perform their risk-assessment role properly. A bank's net-worth, the initial composition of its assets and liabilities, its available information, human capital and incentives system all reflect pre-existing controls that condition bank's response to reforms. When the system is devoid of 75 Christian Larraine, (1991) 28 qualified bankers and the incentives guiding banking operations revolve around government directives, an abrupt shift toward liberalization could generate significant losses. 76 Liberalization policies have typically been associated with excessive expansion in lending. In fact increased confidence stemming from the reforms can endanger overly optimistic expectations about the future. Free of lending restrictions, banks respond to new potential demands from sectors previously subject to controls most after consumer loans. Their experience in establishing prudent lending limits is limited since the restrictions previously in place bared them from the newly attainable levels. 77 Where the tradition of bank monitoring by depositors and shareholders is weak, managers have little incentive to change their behavior. Bad management of pre-crisis situations aggravates these negative incentives since bank shareholders and large holders of bank liabilities have not always been forced to pay for their risk-taking practices. Government intervention can harm incentives for disciplined management, for instance, by creating expectations of rescues among owners and creditors of financial institutions. Such face saving measures include weak exist policies for troubled institution and overly generous last resort lender policies. The real problem is that governmental support has been de facto rather than de jure and has normally exceeded the explicit insurance involved.78 4.2.2 Accounting Standards and Asset Classification System Acciordidng to Section 2 pati (b) of the FIA ACT, 2004, all accounting entries in financial ledgers and all financial records to be kept by a financial institution shall be kept and recorded in the English language using the system of numerals employed in Government accounts.79 Independent of the level of development attained by an economy, a realistic review of bank assets and an appropriate estimate of income and expenditures constitute fundamental aspects in determining those institutions' financial soundness. If most of the assets are in fact loans, an evaluation of the quality of the portfolio is crucial to asce1iaining a bank's financial status. 76 Benartzi, S. and R.H. Thaler (2002). "How Much Is Investor Autonomy Worth?" Joumal of Finance, 57(4): 1593-1616. 17 BIS (2009). Issues in the Governance ofCentral Banks: A Report from the Central Bank Governance Group, Basel, Switzerland. 78 Ibid 79 Sec 2 B j2004] FIA Act Cap 2 29 Typically when the loan classification system fails, profits are overvalued and realistic provisions cannot be established to confront current or future losses. Furthermore, interest on non-performing assets cannot be suspended since very often bank managers are anxious to conceal their portfolio's real condition. The first problem lies in the poor quality of the information available. Uganda lacks reliable historical data bases containing financial statements, borrower data bases, risk controls to apply ad cross-check this information. All of these are vital in terms of guiding the in-Situ supervision process and focusing on those aspects presenting the greatest potential weakness and risk. 4.2.3 Lack of Portfolio Diversification One of the vital weaknesses in Uganda Banking System is the absence of international diversification in their portfolios. Specifically, emphasis is placed on the case of small scale economies with exports concentrated in a few commodities that offer banks limited options for diversification, in these circumstances, the financial system can only be isolated from shocks in the domestic economy through international diversification. However the presence of international lending in developing economies like ,Uganda is almost non existence. In those cases where international diversification is present, its usually due to more direct investment by foreign barks than to cross-border lending. 80 In addition to a tack of expertise in evaluating cross-border loans, international diversification has been hampered by the scarcity of international currencies and/or restrictions on the free low of capital. Moreover these loans constitute new challenges for supervision particularly in terms of country risk. This risk is naturally different from the exposure associated with the individual borrower and includes both sovereign and transfer risk. If a bank is unable to recover, its cross border loans, the result may be a direct, negative impact on its capital. This can lead to insolvency unless proper reserves or diversification are in place. 81 The current legal system is deficient on the loan recovety. A number of securities mortgaged to the financial system by credit defaulters cannot be disposed of quickly as cases take long to settle. This leads to financial institutions to have large non-performing advances on their books. 80 Campbell, J.Y. (2006). "Household Finance," Journal of Finance, 61(4): 1553-1604. 81 Ibid 30 However a commercial court to expeditiously dispose of these cases has been established although it's still in its infancy stages. A credit rating bureau is also proposed to give information to flrith-ijal institutions regarding the performance of borrowers so that defaulters do not re enter the, financial system. Non- performing Assess Recovery Trust has been established for bad debts in Uganda Commercial Bank.82 4.3 Principles in Managing Banking Crises 0 Numerous banks have recently failed and ftnther failures are expected if special efforts are not made to move them out of crisis situation. The way a bank is handled will largely determine its effect on th~ financial system. Therefore banking failures should be handled in accordance with the following guidelines. 4.4 Protecting the Payment System Along with conducting monetary policy and overseeing banking and financial markets, the central bank has a mandate to protect the payment system. In meeting this mandate, the Central Bank helps to maintain public confidence m a country's financial system, even during times of crisis. As a general rule, authorities must seek to minimize the disruption to the payment system that would Occur if one or more major banks are unable to meet their obligations. In certain unusual circumstances the central bank might extend temporary credit to a troubled bank so it could meet it's obligations during a crisis. Therefore the bank might weather a period of adversity until it regains the strength and confidence of depositors and other counter parties to operate independently in the market place or until authorities can arrange a more permanent and orderly solution to it's problems. The central bank as lender of last resort, can limit the spread of financial problems from a troubled institutions to the payment and financial system more generally, however that does not address the institution's solvency problems. Protecting the payment system should be the highest priority in crisis situations because the damage that could result from the collapse of the system could greatly exceed the negative effects on inflation. 82 Henry B. Kibirige, (I 997) 31 4.5 Limiting Government Involvement in Banking Governments should not be bankers. If they became involved in banking as a consequence of bank failures, they must move away from it quickly and in an orderly fashion as possible. The "good bank-bad bank" approach has been increasingly used as a way to speed up market oriented solutions. In this case, the government or deposit insurer accepts some losses or assumes risks of future losses in order to facilitate the transfer of deposits, other liabilities and some or all assets to new owners that have real capital at stake. Selling off the good bank is the easy part of the equation. If the bad bank can be sold, government involvement will be further reduced. However, the price will be low, since investors will face uncertainties regarding the value of the bank and potential legal risks. If the price of the bad bank is too low, it will most probably be kept on the government's books. But because this solution has a potential impact on money supply, and bad banks have to be financed, sometimes for substantial amounts, it should be avoided if possible. To contain the losses and prevent government agencies from becoming the internal managers or liquidators of failed banks. 4.6 Insolvency Procedures for Banks Insolvency procedures for banks must accommodate the existence of many creditors and allow for proper resolution. Because a failure can have a domino effect, rei I at ions must allow supervisors to take control of the bank before it reaches the point of defaulting on its obligations Furthermore if a bank is to be closed; the fate of depositors must be clearly defined at the outset and the rules consistently applied. Persistent depositor uncertainly while banks are being closed, damages depositor confidence, increased' contagion effect and fuels capital flight. 4.7 Sharing the Cost of a Crisis Banking crisis management will be more efficient if early decisions are made as to how the cost of the crisis will be shared among the shareholders, depositors and tax payers. Improvisation as the crisis unfolds will likely lead to the most damaging Outcome for taxpayers. There is need to establish that the banking crisis must be properly accounted for in the fiscal budget. 32 Furthermore; the availability of timely, reliable information on the banking system is important for adequate crisis management. Reliable information on large loans, equity, and real estate investments trust funds, proprietary funds, loans to affiliates and offshore operations is also crucial for implementing private sector solutions and therefore minimizing the cost to tax payers. 4.8 Early Remedial Action If a bank failure is imminent, early action is the only way to achieve an orderly solution, avoid a contagion effect, minimize the impact on the payment system and reduce the cost to the tax payer Resolution procedures should be imposed on weak institutions before they fail below a critical level, whether through liquidation and pay-off, government loans and open bank assistance, nationalization or merger. Pro-active authorities contribute to strengthening the banking sector and reducing potential costs to the tax payer Market uncertainties created by delayed decisions contribute to an overall loss of confidence in both the bank and the currency. 4.9 Banking Sector Reforms The Financial Sector Reform Programme begun in 1991 with the Support of a World Bank Financial Sector Adjustment Credit. It has three major elements; institutional reforms to the Bank of Uganda and the Public Sector banks, legislative changes to the banking laws and the Bank of Uganda Act, and financial liberalization. As with financial reform programmes elsewhere in Africa, it has several inter-related objectives which include, strengthening techniques of monetary control stimulating competition in financial markets, enhancing the efficiency with which financial services are provided and financial resources allocated in solvent and banks, improving prudential regulation and supervision. 4.10 Factors Influencing Future Regulations 4. 10.1 Technological innovations By speeding up transactions, creating new banking competitors and services, altering many banking operations and support functions, electronic banking is producing many significant changes in our deposits and payment system. 33 Electronic banking in Uganda has experienced rapid growth in recent years, for instance in Bm·clays Bank, Standard Chartered Bank and Tropical Bank. Automated teller machines, automated clearing houses and other processing operations and computeriz~d bank Support functions are presently the most common examples of electronic banking. Such developments will help bring banking closer to the customer and could eliminate the need to deal with physical banking office on many routine transactions. 83 Other significant facts of electronic banking are its ability to increase the speed of transactions and to bring new competitors into individual banking markets. As transaction become faster and more convenient customers will be able to shift their funds more readily between various types of bank account, liquid investment and other holdings. Consequently the need for maintaining high, idle transaction balances could diminish.84 In terms of competition, electronic banking will lower the costs that banks and other institutions face in entering new markets. Electronic banking and the computerization of many financial operations are enabling some non depository institutions to begin offering many bank-like services. Before such technological advances, the regulatory barriers and extensive office and personnel requirements in banking had discouraged most forms of non-bank entry. 85 4. 10.2 Growing competition from other Financial Institutions A second factor intensifying competition in banking services is the emergency of new competitors. This expansion has been in response to a number of financial innovations, unmet needs or profit opportunities and certain regulatory restrictions placed on banks.86 Savings and loan association and credit unions have become more direct competitors of banks over the last decade as a result of their now and shape draft account and limited demand deposit 83 Judith (Real names Withheld), Bank employee of Tropical Bank. Interviewed 26'" May 20 II 84 CGAP (2009). Financial Access 2009: Measuring Access to Financial Services around the World, Washington, DC: CGAP and the World Bank. 85 Bertrand, M., S. Mullainathan, and E. Shafir (2004). "A Behavioral-Economics View of Poverty," Ugandan Economic Review, 94(2): 419-423. 86 Ibid 34 powers. These accounts greatly increased the number of institutions offering checkable deposits which had previously been available only at commercial banks.87 Many non-banking forms are also competing more directly with banks in offering customers a source of credit or means of obtaining funding. In the past, banks had an advantage in lending due 'the close relationship they could maintain with customers and the financial information generated from these connections. However increased financial disclosure growth of credit bureaus and other credit rating services and better investor access to such information have enabled others to penetrate bank credit markets. Businesses with good credit rating for instance can often secure financing at lower cost either through non bank lenders or directly through commercial paper and other debt markets. As a result banks have lost some of their traditional credit customers and face lower profit margins in lending to others.88 4.11 Conclusion The purpose of this chapter has been to illustrate findings from the field Research and outlines key characteristics of an efficient and stable Financial System, limitation faced by Bank of Uganda Regulatory framework and how future Regulation tan be obtained. It is salient to note that Regulation and supervision mechanisms are needed for the creation of appropriate incentives for all the major players including regulators and supervisors. 87 Zingales, L. (2004). '"The Costs and Benefits of Financial Market Regulation," Law Working Paper No. 21/2004, European Corporate Governance Institution 88 Wilson, T., N. Howell, and G. Sheehan (2009). "financial growth," Journal of Consume~· Policy, 32(2): 117-140. 35 CHAPTER FIVE RECOMMENDATIONS AND CONCLUSION 5.1 Study findings These research findings highlight the importance of financial literacy and disclosure requirements in mitigating information asymmetries in the market for financial products and services. The key challenge for the applied research going forward is to identify effective forms for disclosure. For credit products, evidence suggests that disclosing loan terms to customers can help reduce borrowing costs. There is no universally accepted set of disclosure requirements (i.e., which terms and conditions are to be disclosed and when, how information should be presented, etc.) Fot example, Ebers (2006) suggests that information overload reduces the usefulness of disclosure. One approach used to address this issue is through a standardized format in which information is disclosed to 89 customers, which often includes plain language requirements. 0 Financial customer protection regulation in low-access environments should make sure that plain language is used and that the use of complex formulas and calculations is avoided .. Other studies (Collins et al., 2009, and FSD-Kenya, 2009) suppmi this claim. For example, customers prefer and better understand when they are quoted the dollar amount of payments and the number of months it will take them to pay off the loan, instead of the details of compounding. Certain products are necessarily more complex and will require more information to be disclosed, though in the absence of financial literacy, it is unlikely that this complex information will be understood by the customer. For example, a U.S. Government Accountability Office (GAO) study finds that people with limited language proficiency are less likely to have bank accounts and more likely to be susceptible to fraudulent practices (US GAO, 201 0). In an earlier study on review of regulations on the disclosure of rates and fees, the U.S. GAO (2006) comes to 89Peterson, 2003; Ebers, 2004; Porteous and Helms, 2005; Wilson et al., 2009; Brix and McKee, 2010. 36 a conclusion that disclosure forms are complicated, and may contain conflicting information, confusing disclaimers.90 The primary objective of banking reform is to provide the conditions for sustainable economic growth by improving the mobilization of savings, ensuring the efficient allocation of resources and improving the effectiveness of monetary policy. Experience has shown that over regulated Financial Systems discourage financial savings, create distortions in investment decisions and generally rail to intermediate effectively between savers and investors. These issues became increasingly important as an economy develops. 5.2 Recommendations 5.2.1 Clearly Defined Principles of Regnlation Financial regulation should have only a limited range of objectives. In the final analysis the objectives are to sustain systematic stability and to protect the Bank clients and that the most appropriate forms conducted by Bank of Uganda should be relied upon such as Inspection of financial records of Banks and books of record. The case for regulation which scribes it's objectives, depends on various market imperfections and failures especially externalities information which in the absence of regulation, produce sub-optimal results and reduce consumers welfare. In other words, the objective of regulation should be limited to correcting identified market imperfections and failures. Regulation should not be over-loaded by being required to achieve, other and wider objectives, such as social outcomes. Constructing effective and efficient regulation is difficult enough with limited objectives, and the more it is overburdened by wider consideration the more likely it's to fail in all of them. 5.2.2 Regulation should Enhance Competition There needs to be a public recognition and encouragement of consumer awareness of the limitation of regulation; that it has only limited role; that even in this restricted dimension it can fail that not all risks are covered and that the optimum level of regulation and ·supervision falls short of eliminating all possibility of consumers making wrong choices in financial contracts this 90 Peterson, 2003; Ebers, 2004; Porteous and Helms, 2005; Wilson el at., 2009; Brix and McKee, 2010. 37 was according to a Bank Employee of Tropical Bank Consumers need to be clear about the limitations of regulations as it's not part of regulation, supervision or authorization to protect the consumer against all possibility of loss. This is emphasized for two main reasons. 91 Firstly, in the absence of such recognition, the demands placed, upon regulation will become excessive to a degree that they can only be met by an excessively expensive, intrusive and rigid system to the extent that the costs are likely to greatly exceed the benefits. Secondly, there is the ever-present moral hazard that excessive and unrealistic expectations about what regulation can achieve reduces incentives on the owners and managers of regulated firms to monitor and control themselves, and for their customers to exercise due diligence. 5.2.3 Skilled Personnel In some respects there is an unequal contest between regulatory agencies and regulated firms ·in that frequently career attractions are better in the regulated firms than in regulatory agencies Regulatory agencies often become fruitful recruitment grounds for regulated institutions For these reasons the regulator should be remunerated at a proper and competitive market rate to attract and retain well qualified personnel in competition with the private sector. Given the importance of regulation, paying low salaries for budgetary reasons for whatever motive, including comparability with public sector remuneration is likely to be false economy. 5.2.4 Regulation to be in Terms of Contract Laws, regulations, and supervisory actions provide incentives for regulated firms to adjust their actions and behavior, and to control their own risks internally. They can usefully be viewed incentive contracts with in a standard principal-agent relationship where the· principal whose authority may be created by law, is the regular and the agent is the regulated firm Within this general framework, regulation involves a process creating incentive compatible contracts so that regulated forms have an incentive behave in a way consistent with the social objectives for the regulator to set appropriate objectives, adopt well-designed rules, and to act in a timely fashion for instance, in the face of pressure for forbearance. If incentive contracts are well designed they will induce appropriate behavior by regulated firms. Conversely, if they are badly constructed 91 Mr. Saviour Odhiambo, Bank Accountant in Tropical Bank. Intrerviewed on 2ih May 2011 38 and improperly designed, they might fail to reduce systematic risk and other hazards regulation is designed to avoid or have undesirable side effects on the process of financial intermediation, for instance impose high cost. At centre stage is the issue of whether parties have the right incentives to act in a way that satisfies the objectives of regulation. 5.2.4 Emphasis on Internal Risk Analysis More reliance needs to be placed on institutions' own internal risk analysis, management and control systems. This relates not only to quantitative techniques such as value-at-risk models but also to the management culture of those who handle models supervise traders. Risks are too complex to be covered by simple rules, and there are several hazards in relying upon a prescriptive rule-book approach to regulation. There is in practice no alternative to placing the primary responsibility for risk control on the shoulders of internal management, owners and auditors of regulated firms. There needs to be a clear shift of emphasis towards establishing incentives and sanctions to reinforce away from generalized rule-setting towards establishing incentives and sanctions to enforce such internal control systems. These incentives and sanctions need to include disclosure requirements and fiduciary rules for internal managements, for instance, rules establishing the "responsibilities of directors, managers, legal advisers and Bank clients in order to avoid challenges that face the Bank such as poor flow of Information and corruption.92 5.2.5 Appropriate Management Incentives There are several procedures, processes and structures that can reinforce internal risk control mechanisms. These include internal auditors, internal audit committees, procedures for reporting to senior management and perhaps to the supervisors and making a named board member responsible for compliance and risk analysis and management systems. Supervisors can strengthen the incentives for these by, for instance, relating the frequency and intensity for their supervision and inspection and ensure appropriate sanctions are applied two internal management once there is noncompliance. 92 Ibid 39 5.3 Strengthening Market Discipline Having a stable, solid financial system, also calls for a strengthening of market discipline as a complement to adequate supervision. The primary components of that added strength are; Limited insurance for deposits, greater market transparency, and a credible mechanism for allocating losses among the private sector. Market monitoring as a complement to supervisory activities requires that depositors and investors perceive that they may lose their funds and savings should a bank become insolvent. Market discipline requires fostering transparency about the status of the institutions. For the market to operate in a framework of rewards and punishments, it needs to be able to distinguish between solid and potentially problematic banks, as well as to demand appropriate risk premiums. Transparent information should permit a careful evaluation of the banks' exposure profile, its jroftabi I ity and the capital available to cover those risks. This can be accomplished through annual and quarterly financial statements, with cetiain information contingent upon certain events, such as an increase in provisions, expectation of significant losses or an increase in bad loans. 5.4 Avoiding Speculative Bubbles During a boom, banks tend to lend imprudently, invest heavily in assets whose prices are rising and enter into new business without assessing the risks involved. When the bubble asset values fail the decay of borrower's financial positions undermine banks' solvency and may lead to failure. A sound economic environment for banking, which means a good economic programme, fiscal restraint and prudent monetary policy backed by a strong institutional framework to support monetary stability. An independent central bank is crucial in this process, since it serves to counteract the influence that politics and elections, as one of the most vital causes of speculative bubbles in Uganda. Another imp011ant source of instability can be found on the fiscal side especially when governments are the direct beneficiaries of wind fall export revenues or receive substantial income from privatizations. 40 5.5 Cross-borde1· Capital Flows Uganda has relied excessively on short term foreign borrowing and have underestimated the disruptive effects of volatility on the financial markets. Heavy capital inflows generated a boom n many countries in the 1980s and early 1990s. Subsequently, problems arose as the euphoria came to an end Heavy capital out-flows and high interest rates hurt the banks .and the fear of a massive bank collapse further fueled capital flight. As a general rule, it's desirable to allow capital to move freely into and out of a country. However the degree to which a country can sustain financial liberalization will ultimately depend on the soundness of macro-economic fundamentals, the health of its banking system and the quality of banking supervision. Deregulation without strong bank supervision leads to imprudent banking, since bankers will be tempted to get into new businesses and take unwarranted risks. 5.6 Close Coordination between the Central Bank and the Government A central bank's ability to withstand attacks on the exchange rate depends on the soundness of the foreign exchange rate 16gime and the strength of the banking system Often t[tese policy areas are beyond the powers of the Central Bank. Therefore the government and the Central Bank must collaborate in resolving conflicts. By cooperative efforts they can avert and manage attacks on the exchange rate, promote restabilisation of the financial markets and prevent major damage to the financial system. The foreign exchange regime contributes to reducing financial uncertainties and thus allows for lower real interest rates. The critical factor lies in the decision making process with respect to foreign exchange policy, an area where responsibilities are usually shared by the government and the Central Bank. Cross boarder capital flows cannot be; dealt with and achieve financial market stability if the foreign exchange policy ties the hands of the central bank. If foreign exchange policy is decided by government, not by the Central Bank, the rules must ensure that the decisions are made after proper consultation with the Central Bank and are implemented by mutual consent. 41 5. 7 Supervision of Financial Conglomerates The operation of financial conglomerates are a significant part of the economic land scope in Uganda, however their presence generates complications both domestically and internationally. These are a series of minimum standards for the supervision of international banking conglomerate which include the responsibility of the supervisor in charge of the home office, the need for simultaneous authorization by officials in the host country and the country of origin, and the need for continual exchange of information among regulators. 5.8 Evaluation of Management Quality One of the weakest areas in banking is the afore-mentioned evaluation of management despite the fact that it's one of the crucial mechanisms that permit banks to make future function properly, management evaluation is the determinate variable in predicting a banks future particularly during times of economic turbulence A solid internal auditing system, effective use of all management information systems, strategic development plans and continuing development of human resources are key essentials to good management. To endow bankers and bank regulators and supervisors with the skills they need, the focus should be on preparing them to conduct evaluations in the following areas; capital, assets, market risks, profits and management. Flexible examiners who can see the big picture are preferable to specialists who analyze isolated trends within the bank. 5.9 Commercial Bank Restructuring The objective of restructuring a bank is to improve its performance by restructuring solvency and profitability, improving the bank's capacity to provide financial intermediation between savers and borrowers and restoring the public's confidence in the bank Financial restructuring tries to restore solvency (not-worth) by improving the bank's balance sheet through raising additional capital, reducing liabilities and boosting the value of assets. 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