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COMMERCIAL BANKS’ INVESTMENT IN LOANS AND TREASURY BILLS AND THEIR OVERALL PROFITABILITY

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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 (Anyanwaokoro, 1996). It is not merely a result, but also 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 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).

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.

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

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

To establish the relationship between the volume of commercial banks’

investment in loans and their overall profitability in terms of ROA and ROE

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

To establish the relationship between commercial banks’ yields from TBs and

their overall profitability in terms of ROA and ROE

1.5 Hypotheses

The volume of investment in loans affects the overall profitability of commercial

banks in terms of ROA and ROE

Lending rates impinge on the overall profitability Commercial banks in terms of

ROA and ROE

Volume of investment in TBs influences the overall profitability of commercial

banks in terms of ROA and ROE

The yield from TB investments has an effect on the overall profitability of

commercial banks in terms of ROA and ROE

1.6 Scope of the study

1.6.1 Subject scope

The researcher studied the overall profitability of commercial banks in Uganda in terms

of ROE and ROA. The study covered commercial banks volume of investment in loans

and associated lending rates and volume of investment in TBs and associated yields as

variables that affect the overall profitability of commercial banks. All commercial banks

licensed in Uganda as at 31st December 2004 were studied.

1.6.2 Geographical scope

The Geographical area of the study covered Kampala city only, since all commercial

banks have their head offices in Kampala. The study covered a period of eight years,

from 1998 to 2005.

1.6.3 Time scope

The time scope of the study was spread over eight years starting from 1998 to 2005. The

data was collected from all commercial banks that were licensed in Uganda as at 31st

December 2004.

1.7 Significance of the study

The findings were helpful in identifying some of the determinants of banks profitability

in Uganda and therefore provide vital information to bank managers, for the development

of effective strategies for enhanced performance. Profitability of banks impacts on

financial sector soundness and stability. The study therefore has important policy

implications that may help banking sector regulatory authorities in Uganda to come up

with future policies and regulations for improving and sustaining the banking industry

soundness and stability.

The outcomes of the study may also serve as useful pointers to macroeconomic issues for

further investigation by Uganda’s economic authorities.

Thirdly, though similar studies have been conducted elsewhere (such as Athanasoglou et

al., 2005), the United States of America (Berger et al., 1987; Berger, 1995b and

Angbazo, 1997), Tunisia (Naceur and Goaied, 2001 and Naceur, 2003) and Colombia

(Barajas et al., 1999), there is no econometric study to our knowledge that has

exclusively examined determinants of bank profitability within the Ugandan context;

therefore the present study fills an important gap in the existing literature and improve the

understanding of bank profitability in Uganda.

1.8 Conceptual framework

Relationships between Uganda’s Commercial banks’ investment portfolio in loans

and TBs and the overall profitability of the banks in terms of ROE and ROA

There is a relationship between the volume and associated return of commercial banks’

assets and the overall profitability of the banks as measured in terms of ROE and ROA.

Commercial banks may invest in either loans or TBs as alternate investment options.

Loans and TBs as alternate commercial bank assets have different risk and return

profiles. Therefore, Commercial banks ‘ volume of loans and associated lending rates and

volume of TBs and the associated yields should have a relationship with the overall

profitability of the commercial banks in terms ROA and ROE. This hypothesis draws

insights from portfolio theories (modern and classical), which analyze the risk-reward

characteristics of investment portfolios. The conceptual framework below builds upon

this literature to develop a model to evaluate the effect of commercial banks asset

allocations in volume of loans and associated lending rates, and volume of TBs and

associated yields, on commercial banks’ overall profitability in terms of ROA and ROE.

For simplicity, the model focuses on only establishing relationships among the above

named variables.

Conceptual Framework

Commercial banks’ investment in loans and TBs and their overall profitability in

Uganda

Source: Variables developed from literature review are based on the works of De Young

& Karin (1999); Wang J.C. (2003); De Young & Rice (2003); Allen & Santomero

(1996), Smith et al (2003), Van Horne (1980) and others.

1.10 Structure of the study

To achieve its broad aim, the study is organized into five chapters and organized in the

following manner. Chapter one provides the introduction, including: background to the

study, Statement of the problem, purpose and objectives of the study, research hypotheses

significance of the study, scope and the conceptual framework. Chapter two provides a

Commercial Banks

investment in Treasury

Bills

 Volume

 Yield

Commercial banks

investment in loans

 Volume

 Lending rate

Overall Profitability of

Commercial Banks

 Return on Asset

(ROA)

 Return on Equity

(ROE)

Confounding variables

 Inflation

 Exchange rates

 Political stability

 Other Investments

 Management

review of the relevant literature on related topics while chapter three outlines the

methodology and tools used in the study. Chapter four provides the analysis,

interpretation and discussion of the findings. Lastly, chapter five contains a summary of

findings, conclusions, recommendations and areas of further research.

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