AN ASSESSMENT OF COMMERCIAL BANKS’ INVESTMENT IN LOANS AND TREASURY BILLS

ABSTRACT
Investigating the determinants of profitability of commercial banks has been one of the
more popular topics among researchers in banking studies.

Hence, to contribute to the
existing knowledge, this study sought to analyze the extent to which investment in loans
and treasury bills influence the overall profitability of commercial banks in Uganda,
using a data set comprising 95 observations for 15 commercial banks over the period
1998-2005.

The study used a longitudinal research design, based on quantitative data
generated through document analysis of commercial banks’ monthly reports and returns
to Bank of Uganda.

Overall Profitability was measured using two profitability ratios
namely: Return on Assets (ROA) and Return on Equity (ROE) while the independent
variables included: volume of loans, volume of TBs, lending rates and yield on TBs.

The study found Volume of Loans and TBs having a positive correlation while Lending
Rates and average yields on TBs revealed negative correlation with ROA as an element
of the dependent variable.

With regard to ROE, Loan Volume, Lending rates and Volume
of TBs showed a positive relationship while average yields on TBs indicated a negative
correlation with this element of the dependent variable.

However, in the two analyses,
commercial banks’ investment volume in loans was found to be the only variable that had
a statistically significant influence in accounting for profitability of commercial banks in
Uganda.

On the basis of the findings, it was recommended that commercial Banks in
Uganda should aim at committing themselves to the implementation of strategies that
would enhance credit creation and disbursement while ensuring adequate recovery mechanisms. It was also proposed that additional efforts should be put in educating the
clientele about the banks’ loan products and prudent borrowing practices.

CHAPTER ONE
INTRODUCTION
1.1 Background to the study
Due to the crucial roles that banks hold in the financial sector, this research evaluates the
profitability of the commercial banks in Uganda.

The performance evaluation of
commercial banks is especially important today because of the fierce competition and
globalisation of world economies.

Evaluation of banks’ performance is important for:
depositors, shareholders, investors, bank managers and regulators.

In a competitive
financial market, bank performance provides signals to depositors and investors with
regard to whether to invest or withdraw funds from the bank (Abdus & Kabir 2000).
Similarly, it flashes direction to bank managers whether to improve its deposit service or
loan service or both, to improve its performance.

For that reason, identifying the key
success factors of commercial banks enables the design of policies that may improve the
profitability of the banking industry (Buyinza, 2010).

The importance of bank profitability can be appraised at the micro and macro levels of
the economy.

At the micro level, profit is the essential prerequisite of a competitive
banking institution and the cheapest source of funds.

Indeed, without profits, any firm
cannot attract outside capital (Gitman, 2007). Thus, profits play a key role in persuading
depositors to supply their funds on advantageous terms.

By reducing the probability of
financial trouble, impressive profits figures also help reassure a bank’s other
stakeholders, viz: investors, borrowers, managers, employees, external product and
service suppliers, and regulators (Anya Nwaokoro, 1996). It is not merely a result, but also
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a necessity for successful banking in a period of growing competition in financial
markets. Hence, the basic aim of a bank’s management is to achieve a profit, as the
essential requirement for conducting any business (Bobakova, 2003).

In Uganda, after a long period of economic, financial management and political
instability, in 1987 the government adopted a rehabilitation and recovery programme to
rebuild the economy and restore macroeconomic stability under the auspices of the
International Monetary Fund, the World Bank and the donor community at large.
Financial sector reforms in Uganda were implemented as part of the stabilisation and
beginning in 1990, a number of reforms were implemented in the financial sector in
order to achieve the main goals of increased efficiency and financial deepening.

During
this period however, developments in the financial system were disappointing and in
view of this, Nanyonjo (2001) argues that bank restructuring did not yield the expected
results.

According to her, despite some improvement, the quality of commercial bank
assets remained weak during the post reform period. By the end of June 1997, about 30
percent of all commercial bank loans in Uganda were non-performing.

This not only
reflected weak management and procedures, but also poor credit discipline. In addition,
profitability of several banks deteriorated during the same period which Nanyonjo
(2001) attributes to the presence of non-performing loans in bank portfolio.

This
indicator showed some worrisome signs, and hinted a progressive deterioration of bank
soundness.

As a result, several banks indeed experienced solvency and liquidity
problems and were closed down during the 1998/1999 financial year.

Therefore,
although the Government of Uganda through the Central Bank has often sought for
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permanent measures that would enhance the profitability and stability of banks operating
in the Uganda’s banking industry, if the historical antecedents of financial sector reforms
are anything to go by; they have not completely succeeded in achieving this feat.

Against
this backdrop, the broad aim of this study was to identify, on the basis of empirical
evidence, significant determinants of bank profitability in Uganda.

However, its scope
was delimited to volume of investment loans and treasury bills, lending rates and yield
on treasury bills as determinants of bank profitability.

As postulated by intermediation theories, Loans are the traditional business of
commercial banks.

However, in the case of Uganda’s banking industry, the experiences
of the last two decades appear to have negatively impacted on this role. In the 1980s and
1990s, the industry was riddled with high levels of Non Performing Assets (NPA).

The
ratio of NPA to total loans fluctuated between 26% and 39% between 1995 and 1999
(Bank of Uganda (BOU) Annual Supervision Report, 1999).

As a result, many banks re-designed their investment portfolio. They turned to other safer alternative investments
than lending, such as the Treasury Bills (TBs).

As a result, commercial banks investment
in TBs grew by 417% between 1995 and 1999 (BOU Annual Supervision Report, 1999),
compared to growth in loans of 40% for the same period.

Financial sector reforms and
aggressive loan recovery efforts resulted into substantial reduction of the NPAs from
7.2% in 2003 to 2.2% in 2004 (BOU Annual Supervision Report, 2004). Nonetheless,
commercial banks’ balance sheets reflect a strong preference for liquid and low-risk
assets, which has implications for their soundness and overall profitability (Tumusiime-
Mutebile, 2005).
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Thus, the conventional wisdom in the Ugandan banking industry is that investment in
TBs is an alternative source of risk free income.

TBs are a short-term monetary policy
instrument used by BOU to control liquidity in the economy.

However, it is also a risk
free asset for investors, attracting commercial banks to use it as an alternate investment to
loans. As at December 2003, the volume of commercial banks investment in TBs stood at
Shs 886 billion, exceeding the volume of loans for the same period, which stood at Shs
847 billion (BOU (Annual Supervision Reports, December 2003).

The Yield on a TB is a function of the interest rate, amount invested and its maturity
period.

The interest rate on TBs and hence the Yield is volatile. For example, BOU uses
bi-monthly auctions to sell TBs.

A Reference rate is computed for each Auction as a
moving average rate for the last three consecutive auctions, based on the 91- Day TB.
The average TB reference rate was 7.72% during the Financial Year (FY) 1998/99,
sharply rose to 19.28% in FY 1999/00, dropped to 5.33% in FY 2001/02 and hiked to
18.58% in FY 2002/03 (BOU Annual Report, 2002/2003).

On the other hand, the yield
from traditional lending activities is a function of the lending rate and the amount loaned.
The weighted average lending rate of commercial banks for the five year period between
FY 1998/99 and 2002/03 varied within a range of 22.96% as the highest in FY 1998/99
and 17.57% as the lowest in FY 2001/02 (BOU Annual Report, 2002/2003). The lending
rate is thus stable compared to the interest rates on TBs.

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The overall profitability of an investment is established using return on investment
ratios, which gives an indication of a business firm’s efficiency of operation (Van Horne,
1980). Profitability ratios include the Return on Assets (ROA) and return on Equity
(ROE). ROA compares net profits after taxes to total assets; while ROE compares net
profits after taxes to the Net Worth of the firm. ROA and ROE for the commercial
banking industry has been fluctuating over the years. For example, the industry’s ROA
was 4.21% in the year 2000, but had declined to 2.7% by 2002. ROE stood at 45.10% in
2000, rose to 50.85% in 2001, fell to 24.4% in 2002 and in 2004, had risen to 37.4%.
(BOU Annual Supervision report, 2004).

1.2 Statement of the problem
Commercial banks in Uganda are increasingly investing in TBs as an alternate asset to
loans. Volume of investment in TBs grew by 417% over the period 1995 – 1999,
compared to growth of 40% in loans over the same period, and in 2002 and 2003, the
volume of TBs exceeded that of loans.

Conversely, the average TB reference rate was
7.72% during the Financial Year (FY) 1998/99 and sharply rose to 19.28% in FY
1999/00; while the weighted average lending rate of commercial banks for the five year
period between FY 1998/99 and 2002/03 varied within a range of 22.96% as the highest
in FY 1998/99 and 17.57% as the lowest in FY 2001/02.

Although commercial banks have relatively increased their investment in TBs as an
alternate investment to their traditional business of extending loans, there is absence of
systematic understanding of how this is associated with the overall profitability of the
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banks as measured in terms of ROA and ROE.

This study therefore set out to analyze the
extent to which commercial bank’s volume of investment in loans and associated lending
rates and volume of investment in TBs and associated yields influences the overall
profitability of commercial banks in Uganda

1.3 Purpose of the study
The study sought to establish the relationship between volume of investment in loans and
associated lending rates and volume of investment in TBs and associated yields on the
overall profitability of commercial banks as measured in terms of ROA and ROE.

1.4 Objectives of the study
i. To establish the relationship between the volume of commercial banks’
investment in loans and their overall profitability in terms of ROA and ROE
ii. To establish the relationship between commercial banks’ lending rates and their
overall profitability in terms of ROA and ROE
iii. To establish the relationship between the volume of commercial banks’
investment in TBs and their overall profitability in terms of ROA and ROE
iv. To establish the relationship between commercial banks’ yields from TBs and
their overall profitability in terms of ROA and ROE