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Ease capital requirements for banks

 

Bank

Why government must support the banking sector to keep credit flowing to stimulate economic growth

COMMENT | SIMON MUTUNGI | Following the 2008 Global Financial Crisis, many banks collapsed worldwide while others had to plow through public funds in the form of government bailouts in order to survive. To avert a consequent repeat of this episode, the Bank of International Settlements (BIS), a global standard setting body for Central Banks, under the auspices of the Basel Committee on Bank Supervision (BCBS) amended its standards with the passing of the Basel III Accords. These increased the capital and liquidity requirements that banks are mandated to hold as buffers against shocks in times of crisis.

In 2009, Uganda became part of this risk management framework and the Bank of Uganda (BoU) subsequently implemented Basel III by requiring banks to hold a minimum Shs25 billion in capital. This was done with the passing of the Financial Institutions (Revision of Minimum Capital Requirements) Instrument No. 43 of 2010 in accordance with section 26(5) of the Financial Institutions Act 2004.

Later on, perhaps to restore public confidence in the banking sector after the Crane Bank debacle, the BoU in December 2016 would further raise the minimum statutory capital adequacy ratios to 10 percent (up from 8 percent) of the risk-weighted assets of the bank on top of holding a capital conservation buffer of 2.5 percent of their risk weighted assets. An additional capital surcharge of 1-3.5 percent was charged on the big banks considered as Domestically Systemic Important Banks which currently include Stanbic, Standard Chartered and DFCU.

Strong capital buffers ensure sound banking and indeed the BoU June 2018 Financial Stability Report showed that the banking sector remained well capitalised and that banks had adequate liquid assets. Simply put, now that Ugandan banks built up reserves in peace time, they should use the same to save the private sector in war time.

According to the latest BoU monetary policy, the COVID-19 pandemic has led to a severe contraction in economic activity due to a combination of global supply chain disruptions, travel restrictions, measures to limit contact between persons, and the sudden decline in demand. The lockdown is likely going to force many firms out of business as well as employees out of work. To help stimulate growth in the economy, the government must support the banking sector since it is a central player in the country’s economic growth and a conduit through which finances are distributed. To keep credit flowing to counter the economic havoc caused by the pandemic, I propose the dropping of the minimum capital requirements and compulsory reserve funds for these banks.

Although well intentioned, capital requirements eat into the banks’ capital available for loans disbursement. For instance, in 2015, Stanbic Bank had to pay out 30 percent of its earnings to meet these regulatory capital requirements. This means that banks are currently sitting on giant stockpiles of cash and other safe assets as required by law. By softening this requirement, the BoU will effectively be freeing up money that can then be loaned out to the private sector that is in dire need of it.

A rough conservative estimate would indicate at least Shs650 billion in liquidity being freed up if Uganda’s 26 Tier 1 commercial banks are allowed to relax these capital requirements. However, the BoU does not have to reduce the requirements to zero percent. A gradual relaxation could work as was seen in South Africa when the authorities dropped the minimum capital requirements and compulsory reserve funds for lenders, reducing the liquidity coverage ratio to 80% from 100%.

The United Kingdom, Europe and the United States too, have softened these requirements for their banks. These are committee members of the BCBS that set the Basel III capital requirement rules, but they have chosen to adjust accordingly in light of the Corona pandemic’s economic shocks. When international bodies set standards, we tend to follow them hook, line and sinker without adjusting to our circumstances, even when the standard setters themselves deviate from the very rules.

The suspension of the capital requirements should only serve as a temporary relief and the BoU should commit to reinstate the requirements when the dust settles. The freed-up liquidity should primarily target loans to household consumers and small-and medium-sized businesses. They are not to be used by banks to distribute earnings in the form of dividends and BoU should reserve the right to prohibit any payouts.

Luckily, the BoU has already issued a directive suspending any bonus and dividend payments in a bid to reserve capital. The BoU has also undertaken to provide exceptional liquidity support to any bank that seeks it during this time for one year. The BoU has also loosened restrictions imposed by the Financial Institutions (Credit Classification and Provisioning) Regulations 2005 in a bid to encourage the restructuring of credit facilities that may be at risk of distress. Furthermore, the Central Bank has commendably undertaken to grant exceptional permission to banks to restructure their loans to corporate and individual consumers including a moratorium on loan repayments for borrowers affected by the current pandemic on a case-by-case basis and at the respective banks’ discretion.

Another aspect in which BoU can enable banks to help the struggling private sector is to further reduce the interest rates by cutting the Central Bank Rate currently at 8%. This would motivate banks to lower their lending rates currently averaging 20 percent so as to enable businesses to apply for new loans or pay existing ones. South Africa has this year already cut its interest rates thrice to 4.25 percent whereas the Federal Reserve in the United States dipped to as low as 0 percent.

In conclusion, despite the need to pump liquidity into the economy, banks should be cautious not to disburse subprime loans as an increase in Non-Performing Loans will cripple the banking sector and possibly turn into a full-blown economic crisis as the world witnessed in 2008.

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Simon Mutungi is a PhD Fellow at Yale University and a Masters candidate in Development Finance at the University of Stellenbosch Business School

simon.mutungi@yale.edu

@shakamara on Twitter

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