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EFFECT OF INTEREST RATES ON PERFORMANCE OF COMMERCIAL BANKS IN UGANDA.

case study centenary bank

MAKANGA BENARD 10/U/7493/EKE/PE

A Research Report Submitted To Department Of Economics And Statistics In Partial Fulfillment Of The Requirements For The Award A Bachelors Of Arts In Economics Degree Of Kyambogo University

June 2013
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Table of contents Introduction 1.0 Background of the study3 1.1 Statement of the problem.. 5 1.2 Purpose of the study...5 1.3 Objectives of the study5 1.4 Research hypothesis.5 1.5 Scope of the study6 1.6 Significance of the study.6 1.7 Organization of the study6 2.0 Literature review.....7 2.1 Introduction...7 2.2 Determinants of interest rates.8 2.3 Effects of interest rates on performance...10 2.4 Other factors affecting interest rates.13 3.0 Methodology.15 3.1 Introduction .15 3.2 Research design15.
3.3 Data Collection, Analysis and Presentation.15 3.4 Model specification.16 3.5 Model assumptions..17

3.6 Data Estimation and Testing Procedures.17 3.7 Limitations...18 References

INTRODUCTION 1.0 Background to the Study. Commercial banks play a vital role in the economic resource allocation of countries. They channel funds from depositors to investors continuously. They can do so, if they generate necessary income to cover their operational cost they incur in the due course. In other words for sustainable intermediation function, banks need to be profitable. Beyond the intermediation function, the financial performance of banks has critical implications for economic growth of countries. Good financial performance rewards the shareholders for their investment. This, in turn, encourages additional investment and brings about economic growth. On the other hand, poor banking performance can lead to banking failure and crisis which have negative repercussions on the economic growth.

Thus, financial performance analysis of commercial banks has been of great interest to academic research since the Great Depression Intern the 1940s. In the last two decades studies have shown that commercial banks in Sub-Saharan Africa (SSA) are more performing than the rest of the world with an average Return on Assets (ROA) of 2 percent (Flamini et al., 2009). One of the major reasons behind high return in the region was investment in risky ventures. The other possible reason for the high profitability in commercial banking business in SSA is the existence of huge gap between the demand for bank service and the supply thereof. That means, in SSA the number of banks are few compared to the demand for the services; as a result there is less competition and banks charge high interest rates. This is especially true in East Africa where the few government owned banks take the lion's share of the market. The performance of commercial banks can be affected by internal and external factors (Al-Tamimi, 2010; Aburime,).

According to Micheal p. Todaro (1992), interest rates is the amount the borrower must pay to the lender over and above the total borrowed expressed as the percentage of the total amount of the funds borrowed. ACCA (2003), explained the interest rates as a measure of the cost for the borrowing. Bank interest rates are rewards expected by the lenders (bank) for the period the borrower spends using the borrowed funds. It is the time value of money for the funds granted to borrowers in a specific period of time. Interest rates can be classified as either short-term or long-term. For example, you can take out a home loan with the interest rate fixed for 20 years. This is considered a long-term interest rate. You make the same payments over these years, regardless of whether interest rates rise or fall. Alternatively, when you use your credit card or take out a personal loan you are borrowing money at an interest rate that can change in the short term. As a general rule, short-term interest rates tend to be higher than long-term interest rates.

The benchmark interest rate in Uganda was last recorded at an average of 23% and the central bank rate (CBR) which is the major determinant of interest rates in Uganda was last reported by the Bank of Uganda at 12%. Historically, from 2011 until 2013, Uganda Interest Rate averaged 27.80 Percent reaching an all time high of 36 Percent in November of 2011 and a record low of 23 Percent in December of 2012. Usually, the central bank benchmark interest rate is the overnight rate at which central banks make loans to the commercial banks under their jurisdiction. Moving the benchmark interest rate, the central bank is able to make an impact on interest rates of commercial banks, inflation level of the country and national currency exchange rate. Reduction of interest rates should bring increase in business activity, a rise in inflation rate and weakening of national currency. In case of increase in interest rates the level of business activity is likely to drop, inflation declines and national currency strengthens.
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1.1 Statement of the Problem. Interest rates in the recent past have become a very sensitive factor in the operation of commercial banks. The central bank uses it as a tool to control the inflation levels and also to manage the foreign exchange rates to acquire stability in the economy. With these happenings the commercial banks have had to contend with periods of high interest rates which have affected the banks differently as different banks react differently to the impact of interest rate changes. This changes cause consumers to reduce their borrowings or halt them with the expectations that interest rates will eventually come down. Since one of the major sources of income for commercial banks is earned from interest related activities. It is of paramount importance that the commercial banks understand the impact of interest rates on their performance in order to maximize shareholders wealth. 1.2 Purpose of the Study. The study aims at determining the effect of interest rates on performance of commercial banks.

1.3 Objectives of the Study. I. II. III. To identify the determinants of interest rate. To analyze the impact of interest rates on commercial banks performance. To determine the other factors affecting performance.

1.4 Research Hypothesis I. Ho: interest rates have an impact on performance. H1: interest rates have no impact on performance.

II.

Ho. other factors have an impact on performance of commercial banks. .Other factors have no impact on performance of commercial banks.

III.

Ho. There are factors affecting interest rates. . There are no factors affecting interest rates.

1.5 scope of the study The study will be carried out in centenary bank which is one of the leading indigenous banks in the country. This means that the findings got will apply to all the other commercial banks in the country.

1.6 significance of the study The study will aim at determining the impact of interest rates on performance of commercial banks and the other factors determining performance. The study will also try to determine the determinants of interest rates.

1.7 Organization of the Study This research is divided into four subsequent chapters. Chapter 2 discusses the related literature while chapter 3 describes the model, methodology and data adopted and chapter 4 presents the results, while in chapter 5, the conclusions and policy recommendations arising from the findings are discussed.

2.0 Literature review 2.1 Introduction Since the introduction of Structural Adjustment Programs (SAP) in the late 1980s, the banking sector worldwide has experienced major transformations in its operating environment. Countries have eased controls on interest rates, reduced government involvement and opened their doors to international banks (Ismi, 2004). Due to this reform, firms of the developed nations have become more visible in developing countries through their subsidiaries and branches or by acquisition of foreign firms. More specifically, foreign banks presence in other countries across the globe has been increasing tremendously. Since 1980s, many foreign banks have established their branches or subsidiaries in Uganda. In the last two decades or so, the number of foreign banks in Uganda in general and Sub-Saharan Africa in particular has been increasing significantly. On the contrary, the number of domestic banks declined (Claessens and Hore, 2012.) These have attracted the interests of researchers to examine bank performance in relation to these reforms. A more organized study of bank performance started in the late 1980s (Olweny and Shipho, 2011) with the application of Market Power (MP) and Efficiency Structure (ES) theories (Athanasoglou et al., 2005.) The MP theory states that increased external market forces results into profit. Moreover, the hypothesis suggest that only firms with large market share and well differentiated portfolio (product) can win their competitors and earn monopolistic profit. On the other hand, the ES theory suggests that enhanced managerial and scale efficiency leads to higher concentration and then to higher profitability David C.(1990) categorizes the interest rate as the bank base rates, personal loan rates, deposit rate, inter bank interest rates, house purchase loan rates and the overall level of interest rates while

Wikipedia Articles(2007) categorized interest rates as simple interest rates, compound ,cumulative and real interest rates. According to APPS (1991), interest rates are regarded as purely monetary phenomenon, a payment for the use of money. The possession of the actual money wills our disquietude and the 6 Premium which we require to make us part with the money is the measure of the degree of our disquietude. By the way of contract, this theory emphasizes the supply and demand for money, arguing that it is the interaction of variables which determines the interest rates. It stated that the classical theory focuses on what might be termed as the economic variables and argues that the level of real interest rates is determined by the level of savings ( which provides the level of loanable funds) and the level of investment in the capital equipment ( which provides the demand for the loanable funds). This theory dismisses the relevance for the money, arguing that its use is to merely determine the absolute price level and does not influence the interest rate.

2.2 Determinants of interest rates Robert L.H (1969) asserts that when lenders or investors are uncertain about the future interest rates, they may wish to hedge their belts. In other words credit risk This introduces new dimensions into the interest rates calculations and gives rise to the term structure of the interest rates while APPS(1991) noted that the inflationary policies and the related monetary policies would often bring about an increase or the fall in the general level of the interest rates. In other words interest rates are determined by both credit risk and market risk Bank of Uganda was established in 1966 to provide regulatory, supervisory and advisory functions in the financial sector as stipulated in the Financial Institutions Statute, 1993 and policy regulations. The statute stipulates that the bank shall formulate and implement monetary policy directed to economic objectives of achieving and maintaining economic stability. The
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current Financial Institutions Statute 1993 which covers banks and credit institutions is weak and has been revised extensively by the Bank of Uganda. The Financial Institutions Statute 1993 will be repealed when the Financial Institutions Bill 2001 is enacted into law. When signed into law, the Financial Institutions Act 2001 will strengthen the prudential regulations governing banks and deposit taking by non-bank financial institutions. According to Musinguzi, P, Bategeka, L, Katarikawe, M. (1994), it will in particular raise minimum capital and on-going capital adequacy requirements, strengthen restrictions on insider lending and large loan exposures and introduce a requirement for mandatory prompt corrective action to be imposed on distressed banks by the regulators. According to By Umaru Kashaka the new vision editor, unless the cost and liquidity in the market improve, the lending rates will continue to be high Philip Odera, the chairman of the Uganda Bankers Association urged that the cost and availability of liquidity were some of the biggest determinants of commercial prime lending rates. With greater availability of low cost funding, banks will be able to pass this onto our borrowing customers in the form of lower interest rates because banks want to see the economy grow as this is in our collective interest and serves all parties, Odera added. He observed that contrary to public opinion, commercial banks do not like abnormally high interest rates as they negatively affect the banks too as nobody will be borrowing. When customer default rates increase quite alarmingly, many loans will then be written off, affecting overall profitability, he added. During the year 2009 the cost of borrowing in Uganda was high and this had a direct impact on Businesses. Inflation rates, though maintaining a downward trend throughout the year, remained high, at 10.9 percent in the final quarter of 2009. The major drivers for the inflation were

identified as increases in prices of fuel, beverages, tobacco, rent, utilities and food. Food prices remained high due to the increased demand for food products within the Eastern African region coupled with reduced supplies due to unfavorable weather conditions. The impact of the global recession on the Ugandan economy was mostly evident in the significant decline in inward remittances of donor funds and of remittances from Ugandans working abroad. This too had a direct impact on our business. The coming in of new players in the Ugandan banking sector in recent years has increased competition to levels never experienced before in Uganda. This has necessitated the Bank to prioritize strategies for both customer and staff retention.

2.3 Impact of lending/interest rates on performance. When the Government regulates the working of the market, supply and demand cannot interact freely to find the equilibrium quantity and price. When there is an artificial ceiling the allocation of resources is distorted if the equilibrium price is above the ceiling. The consequence is people who want finance, but due to their circumstances do not qualify at the ceiling interest rate are denied access. As this large segment of the market cannot access funds in the formal economy they have to resort to the informal economy. By limiting the interest rate chargeable, the government may force many actors in this sector out of business existence. By placing a ceiling on
the interest rate, but not providing an alternative means of finance, the government effectively excludes the people they were trying to protect. And, since interest rates are not allowed to rise above a given price, there are no incentives to expand the quantity of loans offered and this will create a shortage. Basically this will encourage people to consume more of the service than if the market price were charged. Charging a rate of interest on loan is the main source of income for almost all financial institutions in
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the banking industry. It is the only way by which they can recover their costs. The components of an interest rate in most loans includes, Cost of capital, Sufficient return to cover the risk of loan loss or bad debt, Operating costs and A profit margin. Given these, the banking or lending institutions can only survive by fully recovering all the costs of the first three components, and grow if they can also receive the last component.

The Impact of high interest rates witnessed in the second half of 2011, throughout 2012 began to bite. The newspapers classified section of advertising was on huge demand by companies that auction and sell property on behalf of the banks, with not less than 10 adverts in a given week, compared to about two or less in 2011.All this had its roots in 2011 when the economy was battered by double digit inflation, high commodity prices and a weak Shilling. In response to the bad economic indicators, Bank of Uganda (BOU) increased its Central Bank Rate. The rate at which commercial banks borrow money from 13 per cent in July to 23 per cent in November, 2011.Commercial banks also correspondingly hiked their interest rates for both new and old loans from an industry average of about 18 per cent to over 30 per cent. The high interest rates meant that individuals and businesses that were already financing loans had to pay more than they would have paid, because they took borrowed money at affordable rates. A combination of expensive loans and high cost of living put pressure on peoples wallets, explaining the inability for most borrowers to meet their loan re-payment obligations. This drove up the level of bad loans, increasing from 2.2 per cent in December 2011 to 4 per cent in June 2012. Prior to the tough economic environment, banks had offered loans to many people who may previously not have qualified as they competed to grow their loan books and client base. BOU records show that loans have been growing steadily since 2007, especially in mortgage, construction and real estate.
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The high interest rates regime, however, dampened the appetite for loans, leaving banks loan books constrained, amid low deposits which were also weighed down by the high levels of bad loans. Despite BOU reducing the CBR from 23 per cent in January 2012 to 12 per cent in December, the lowest since July 2011 when it stood at 13 per cent, most banks prime lending rates are still above 19 per cent.

Centenary Bank managing director Mr. Fabian Kasi told the Daily Monitor in an interview that the rate at which interest rates fall is not only determined by the CBR but also the availability of liquidity or funds in the banking system. Liquidity is what governs the pace at which interest rates come down. The CBR may remain flat or high but interest rates will fall if cheap liquidity comes in. The only source of frustration for people is that when you take liquidity out from the system, it means that interest rates rise quickly, if you dont bring back liquidity into the system at the same pace as you took it out, interest rates will come down but at slower pace, Mr Odera said. He added that once the economy experiences volatilities like what was witnessed in 2011, recovery takes a long period even when you put in the right things in place. Market analysts predicted that although banks posted impressive profits in 2011, a surge in non-performing loans would pose a big threat to the industry and that banks may not see exciting figures across the board like was the case in 2011. (Daily monitor 1st Jan 2013)

Banks have had to contend with periods of high interest rates which have affected the banks differently as different banks react differently to the impact of interest rate changes. This changes cause consumers to reduce their borrowings or halt them with the expectations that interest rates

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will eventually come down. Since one of the major sources of income for commercial banks is earned from interest related activities.

The research found out that on overall, there is positive relationship between interest rate changes and profitability of banks. As interest rate increases , profits of banks also increases This could be as a result of ability of banks to diversify their products to take care of the changing operating environment and their ability to tap in the fortunes brought about by increased interest rate by investing in high yielding treasury bills and diversification of funds. This study shows that the banks have come up with measures to take care of changes in interest rates so as not to affect them too badly although there is a reduction in the profit levels of some banks.

2.4 Other factors affecting performance

According to a research carried out by the International Journal of Economics and Financial Issues, Vol. 3, No. 1, 2013, pp.237-252,the other determinants of bank performances can be classified into bank specific (internal) and Macroeconomic (external) factors (Al-Tamimi, 2010; Aburime, 2005). These are stochastic variables that determine the output. Internal factors are individual bank characteristics which affect the banks performance. These factors are basically influenced by internal decisions of management and the board. The external factors are sectorwide or country-wide factors which are beyond the control of the company and affect the profitability of banks. The overall financial performance of banks in Kenya in the last two decade has been improving. However, this doesn't mean that all banks are profitable, there are banks declaring losses (Oloo, 2010). Studies have shown that bank specific and macroeconomic factors affect the performance of commercial banks (Flamini et al. 2009). In this regard, the
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study of Olweny and Shipho (2011) in Uganda focused on sector-specific factors that affect the performance of commercial banks. Yet, the effect of macroeconomic variables was not included.

The internal factors may include capital adequacy, management efficiency, asset base quality and quantity and liquidity management. On the other hand the external macro economic factors may include the macroeconomic policy stability; Gross Domestic Product, Inflation, Interest Rate and Political instability are also other macroeconomic variables that affect the performances of banks. For instance, the trend of GDP affects the demand for banks asset. During the declining GDP growth the demand for credit falls which in turn negatively affect the profitability of banks. On the contrary, in a growing economy as expressed by positive GDP growth, the demand for credit is high due to the nature of business cycle. During boom the demand for credit is high compared to recession (Athanasoglou et al., 2005). The same authors state in relation to the Greek situation that the relationship between inflation level and banks profitability is remained to be debatable. The direction of the relationship is not clear (Vong and Chan, 2009).

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METHODOLOGY

3.1 Introduction This chapter provides the description on how the study was conducted to achieve its objectives and purpose. It brings out the model specification used, variable definitions, Variable Measurement and variable Data required, Data source, Data estimation and Testing procedures. 3.2 Research Design. This quantitative research was based on secondary time series data from centenary bank and Central Bank statistical year books for the last ten years (2003 2012). Further, its an impact study that aims at establishing the impact of interest rates (independent variable) on performance of commercial banks (dependent variables) based on inferential statistics and identifying other factors affecting performance of these banks. Schematic Diagram showing the relationship between variables Independent Variable(S) Dependent Variable
Interest rate Commercial banks performance. (Net annual profits)
Capital Adequacy Asset Quality Management Efficiency Liquidity Management GDP

3.3 Data Collection, Analysis and Presentation

The secondary data used in this study were obtained from annual reports of centenary bank and bank of Uganda. The data collected using data collection sheet were edited, coded and cleaned. Then the data was analyzed using Microsoft Excel and econometric views (e-views) software.
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A multiple linear regression model and t-statistic were used to determine the relative impact (Sensitivity) of each explanatory variable in affecting the performance of commercial banks. 1.6 Model Specification. The model bases on the hypothesis that interest rates have an impact that may be negative or positive on performance of commercial banks. The dependent performance indicator used was net annual profits. The major determinants (independent variables) were interest rates, capital adequacy, asset quality, management efficiency and liquidity status which shall be proxied by selected ratios. The CAMEL ratios are the popular bank specific factors often used in representing bank specific factors in relation to performance. The central bank also uses CAMEL ratios to evaluate the performances of commercial banks. Barajas et al, (1998), Bazibu (2005), argues that when Banks are faced with high probability of poor performance, they hedge against the impending loss by reducing the lending rates and or increasing the deposit rates. Therefore according to this model, it is expected that banks with high probability of poor performance exhibit lower interest rates and those with a high probability of excellent performance exhibit high interest rates put symbolically as

Where:

P= Performance of Bank at time t m = Intercept CA=Capital Adequacy of bank at time t AQ = Asset Quality of bank at time t ME= Management Efficiency of Bank at time t LM =Liquidity Ratio of Bank at time t r= interest rate at time t = Error term where and t time identifier

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3.5 Model Assumptions: The following diagnostic tests were carried out to ensure that the data suits the basic assumptions of classical linear regression model: Normality: To check for normality, descriptive statistics were used. Kurtosis and Skewness of the distribution of the data were examined. Muliticollinearity: The existence of strong correlation between the independent variables was tested using Variance Inflation Factor (VIF) and correlation coefficient and found that there is no serious problem of multicollinearity in the study. Heteroscedasticity: To avoid the problem of heteroscedasticity of disturbance terms, weighted Generalized Least Square (GLS) was employed in establishing the relationship

3.6 Data Estimation and Testing Procedures.

Annual time series data on centenary banks financials and Ugandan macroeconomic variables for the period 2003 -2012: IV was used. The data was taken from the Publications of centenary bank, annual reports, personal interactions with bank officials and press releases and bank of Uganda annual reports and statistics. Ordinary Least squares (OLS) estimation was used in the estimation of equation. This choice was premised on the fact that OLS is best linear unbiased estimator (BLUE). Moreover, the greater part of the preceding empirical studies used this popular technique. However, the express use of this technique when analyzing economic relationships using time series data has some limitations (Phillips, 1986) that derive from the fact that macroeconomic time series data is nonstationary. This implies that, the variables may have a mean, variance, and co-variance not equal
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to zero. Working with such variables in their levels will present a high likelihood of spurious regression results. To this end, the researcher performed stationary tests using the Augmented Dickey Fuller (ADF) unit root testing procedure (Dickey and Fuller, 1979) for each of the variables in equation (3) which indicated variables to be I (1). But Valid estimates and inferences of time series data are, however, possible so long as a set of non-stationary variables are co integrated, that is, if there exists a set of linear combination of variables that are stationary (Engle and Granger, 1987). Accordingly, the co integration technique developed in Johansen (1988) and applied in Johansen and Juselius (1990) was employed in this study and two co integrating equations were established. We normalized for the interest rate spreads and thereafter proceeded to estimate a long run Interest rate spread model. It should be noted that if sets of non-stationary variables co integrate, then a corresponding error correction model (ECM), which attempts to restore the lost long term properties due to differencing of variables, can be specified and is consistent with long run equilibrium behavior (Engle and Granger, 1987).

3.7

Limitation

Results of this research should be taken with caution as some of the time series were not readily available on an annual basis especially for interest rates. This made the researcher to transform the existing monthly data into annual data through getting averages as follows;

Annual interest rates =

Nonetheless, the author made sure that this limitation is counteracted by the rigorous model and residual assumption tests.

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References. International Journal of Economics and Financial Issues Vol. 3, No. 1, 2013, pp.237-252 ISSN: 2146-4138 Determinants of financial performance of commercial banks in Kenya Vincent okoth ongore Assistant commissioner, Kenya revenue authority, Kenya. Aburime, u. (2005) determinants of bank profitability: company-level evidence from nigeria.Nigeria: university of nigeria, enugu campus Alexandru, C., Genu, G., Romanescu, M.L. (2008), The Assessment of Banking PerformancesIndicators of Performance in Bank Area. MPRA Paper No. 11600.Al-Tamimi, H., Hassan, A. (2010) Factors Infuluncing Performance of the UAE Islamic Conventional National Banks. . Department of Accounting, Finance and Economics, College of Business Administration, University of Sharjah. Athanasoglou, P.P., Sophocles, N.B., Matthaios, D.D. (2005) Bank-specific, industry-specific and macroeconomic determinants of bank profitability . Working paper, Bank of Greece. 1(1), Azam, M., Siddiqoui, S. (2012) Domestic and Foreign Banks Profitability: Differences and Their Determinants. International Journal of Economics and Financial Issues 2(1), 33-40. Andreas Dietricha and Gabrielle Wanzenriedb This version: January 2009 What Determines the Profitability of Commercial Banks? Bank of Uganda annual reports 2003-2012 Centenary bank annual reports 2003-2012 Bank of Uganda monetary policy reports 2003-2012

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