i

CREDIT RISK AND BANK INTEREST RATE SPREADS IN

UGANDA


by
MAKANGA BENARD




ii

DECLARATION


I, MAKANGA BENARD, declare that this dissertation is my own original work and that it has not
been presented and will not be presented to any University for a similar or any other degree award.



Signed..
MAKANGA.BENARD

Date








Hamis, M. 2009
This dissertation is copyright material protected under the Berne Convention, the Copyright
Act 1999 and other international and national enactments, in that behalf, on intellectual property. It
may not be reproduced by any means, in full or in part, except for short extracts in fair dealing, for
research or private study, critical scholarly review or discourse with an acknowledgement, without
written permission of the Directorate of Postgraduate Studies, on behalf of both the author and
Makerere University.

iii

CERTIFICATION
The undersigned certify that they have read and hereby recommend for acceptance, a dissertation
entitled: Credit Risk and Interest Rate Spreads in Banking: A case of Uganda







DEDICATION
To My Family and Friends
























iv

ACKNOWLEDGEMENT


This research has been a result of the many efforts, whose contribution is greatly acknowledged. I
owe profound gratitude to my supervisors, Mr. Thomas Bwire and Dr. Joseph Ntayi for the many
hours they devoted going through the entire manuscript with a fine-tooth comb and pointing out
numerous ambiguities from the proposal stage to the final production. Without their dedication, this
study would not have been possible. I also wish to extend my heartfelt gratitude to all academic and
non-academic members of staff of Makerere University Business School, who in one way or the
other helped me, realize my dreams while at the University.

I further wish to most sincerely thank the staff of the Bank of Uganda resource centre for giving me
access to the data I was looking for.

Thanks also go to Hon. Mbagadhi Frederick Nkayi for all the material support towards the reality of
this work. May the good Lord reward you abundantly.

Lastly, I thank my familymy wife Namukose Zaujah and daughter Namwase Sumayah for their
encouragement. Above all, Glory is to the Almighty Allah for this wisdom. In HIM, all things are
possible.




All deficiencies that remain in the dissertation are entirely my own responsibility and should not be
attributed to any of the acknowledged persons or institutions.

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TABLE OF CONTENT

DECLARATION................................................................................................................................. ii
CERTIFICATION ............................................................................................................................. iii
DEDICATION.................................................................................................................................... iii
ACKNOWLEDGEMENT ................................................................................................................. iv
TABLE OF CONTENT ...................................................................................................................... v
LIST OF TABLES AND FIGURES ................................................................................................ vii
ABSTRACT ...................................................................................................................................... viii
CHAPTER ONE ................................................................................................................................. 1
INTRODUCTION............................................................................................................................... 1
1.1 Background to the Study ............................................................................................................. 1
1.2 Statement of the Problem ............................................................................................................ 3
1.3 Purpose of the Study ................................................................................................................... 4
1.4 Objectives of the Study ............................................................................................................... 4
1.5 Research Hypotheses .................................................................................................................. 5
1.6 Significance of the Study ............................................................................................................ 5
1.7 Scope of the Study ...................................................................................................................... 5
1.8 Conceptual Framework ............................................................................................................... 6
1.9 Organization of the Study ........................................................................................................... 7
CHAPTER TWO ................................................................................................................................ 8
LITERATURE REVIEW .................................................................................................................. 8
2.1. Introduction ................................................................................................................................ 8
2.2 Financial Liberalization and interest spreads .............................................................................. 9
2.3. Credit Risk ............................................................................................................................... 13
2.3.1 Credit risk trend in Uganda's banking system ....................................................................... 14
2.4 Interest rate spreads in Uganda. ................................................................................................ 16
2.5 Credit Risk and Interest rate Spreads ........................................................................................ 18
2.6 Client-Bank relationship and Interest rate spreads ................................................................... 21
2.7 Macroeconomic environment and interest rate spreads ............................................................ 22
METHODOLOGY ........................................................................................................................... 25
3.1 Introduction ............................................................................................................................... 25
3.2. Model Specification ................................................................................................................. 25
3.3 Variable Definitions, Measurement and Data Source ............................................................... 28
3.4 Data Estimation and Testing Procedures .................................................................................. 31
3.5 Limitation .................................................................................................................................. 32
CHAPTER FOUR ............................................................................................................................. 33
PRESENTATION, ANALYSIS AND INTERPRETATIONOF FINDINGS ............................. 33
4.1 Introduction ............................................................................................................................... 33
4.2 Objective 1: .............................................................................................................................. 33
4.3 Objective 2: .............................................................................................................................. 36
4.4: Objective 3,4&5. ...................................................................................................................... 38
4.4.1Time Series properties ........................................................................................................ 38


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4.4.2 Unit root tests ..................................................................................................................... 40
4.4.3 Cointegration tests ............................................................................................................. 41
4.4.4 Estimation of the error correction model .......................................................................... 43
4.4.5 Empirical Results ............................................................................................................... 44
4.4.6 Diagnostic tests .................................................................................................................. 46
4.5 Key Findings ............................................................................................................................. 48
4.5.1 Interpretation of Empirical results in relation to: ............................................................... 48
4.5.2 Comparison of Empirical studies on Interest rate spreads with the current study ............. 51
CHAPTER FIVE .............................................................................................................................. 54
CONCLUSION AND POLICY IMPLICATIONS ........................................................................ 54
5.1 Summary ................................................................................................................................... 54
5.2 Conclusions ............................................................................................................................... 55
5.3 Policy Recommendations.......................................................................................................... 55
5.4 Possible Areas for further research ........................................................................................... 57
References .......................................................................................................................................... 58
APPENDIX 1 ..................................................................................................................................... 70


























vii


LIST OF TABLES AND FIGURES




Figure1: Credit Risk trend in Uganda..34
Figure 2: Interest Rate spreads trend in Ugandas banking system.36
Table4.1: Descriptive Statistics39
Table 4.2: Correlation Analysis..39
Table 4.3: Results of Unit Root Tests for Variables in Levels40
Table 4.4: Results of Unit Root Tests for Variables in First Difference.41
Table 4.5: Johansen Cointegration Test42
Table 4.6: The Long-Run IRS Function.43
Table 4.7 General model results: Estimation of the IRS Equation.45
Table 4.8: Preferred/specific Model: 46
Table 4.9: Comparison of results of current study with those of others.52



























viii
ABSTRACT

The study investigates the effect of credit risk on interest rate spreads in Uganda for the period 1981-
2008, while controlling for macroeconomic factors (Inflation, Liquidity, T-bill rate) and client-bank
relationship. This was accomplished using a modern econometric technique that was adopted and
used on Ugandan macroeconomic data obtained from statistical publications of Bank of Uganda and
IMF. E-views 3.0 statistical package was used in estimating the regression model.

The study findings reveal that Credit risk, Liquidity, and the Treasury bill rate have a negative
relationship with the interest rate spreads in Uganda, while inflation was found insignificant in
explaining the high interest rate spreads. On the basis of these findings, it is recommended that while
there is still need for more investment in ensuring macroeconomic stability, there is greater need for
capacity building within the individual commercial banks human and technological resources for
better credit risk assessment and management. Moreover, it is imperative that commercial banks
reengineer their credit risk control processes by moving from their traditional mechanisms used to
control credit risk to loan portfolio restructuring, loan sales and debt-equity swaps. Overall, the study
recognizes the importance of a multidimensional approach to any policies directed at tackling the
problem of the high interest rate spreads in the Ugandas Banking system.

Finally, the fact that the variables under this study only explain 40% of the response variable is all
but evidence for need for more research in this area. To this end therefore, this study could be
complimented if more research is carried out on the quality of credit risk management systems and
interest rate spreads in Ugandas Banking system

1

CHAPTER ONE
INTRODUCTION
1.1 Background to the Study
Banking systems in Uganda have been shown to exhibit significantly and persistently large interest
rate spreads on average than those in other developing and developed countries (Nannyonjo, 2002;
Beck and Hesse, 2006). The size of banking spreads serves as an indicator of efficiency in the
financial sector because it reflects the costs of intermediation that banks incur (including normal
profits). Some of these costs are imposed by the macroeconomic, regulatory and institutional
environment in which banks operate while others are attributable to the internal characteristics of the
banks themselves (Robinson, 2002).


High Interest rate Spreads are an impediment to financial intermediation, as they discourage
potential savers with low returns on deposits and increase financing costs for borrowers, thus
reducing investment and growth opportunities. This is of particular concern for developing and
transition countries where financial systems are largely bank-based, as is the case in Uganda and
tend to exhibit high and persistent spreads.

Interest rate spreads arise out of the core functions of financial institutions most especially the
commercial banks which include lending and deposits taking. As banks lend, they charge interest
and for attracting deposits, they offer interest on deposit as compensation for their clients thriftiness
and the difference between the two rates forms the spread.

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The function of extending credit continues to present with it considerable risk especially that of
default (Credit Risk). For instance, financial defaulters/ credit risk nearly doubled in 2008 with an
all-time single biggest defaulter by volume being Lehman Brothers who in September 2008 failed to
pay $ 144 Billion of rated debt (Standard & Poor, 2009). Similarly, even financial institutions in
Uganda continue to wriggle through a similar condition with many getting scathed. For example, in
the late 90s, Ugandas financial system was grossly hit by mass credit default which culminated into
insolvency and hence closure of four (4) local commercial banksGreenland Bank, Cooperative
Bank, International Credit Bank and Trust Bank. This created a banking crisis and the remaining
local commercial banks experienced loss of customer confidence leading to poor financial
performance (Bank of Uganda, 2002).

Though many blamed this scenario on the profligate lending, it is also patent that most of these
banks, then faced with bigger portfolios of Non Performing Loans (Credit risk) supposedly were
using wider Intermediation Spreads at the time (34% in some of them) as a coping mechanism which
further interfered with the ability and willingness of borrowers to pay and so the spiral effect set in.
Hitherto, some technocrats at Bank of Uganda and in commercial Banks allude to the fact that
persistent credit risk /default risk, mainly buoyed by the blatant lack of accurate information on
borrowers debt profile and repayment history; could be the causal factor for the current wider
Interest rate Spreads.


3

Between 19872000, Ugandan policy makers embarked on an ambitious and far reaching financial
sector reform programme marked by the reforming of the legal and institutional frame work,
restructuring of state-owned financial institutions, lifting of entry barriers to private sector operators
in the financial sector, and the deregulation of interest rates from the government controls; with hope
that intermediation spreads among other things would narrow (Bank of Uganda, 2005). Sequentially,
the Credit Reference Bureau is another vehicle that was instituted by Bank of Uganda on the
rationale that timely and accurate information on borrowers debt profile and repayment history
would reduce information asymmetry between borrowers and lenders. This was expected to enable
banks to among other things lower credit risk and Interest rate Spreads and hence contribute to
financial deepening in the economy.
1.2 Statement of the Problem

Policy makers in Uganda have for some time been actively engaged in developing a panacea to the
persistently wider interest rate spreads with hope that this would promote competitiveness,
efficiency and stability in the domestic financial system and ultimately narrow the intermediation
spreads (Bank of Uganda, 2005).

Unfortunately, interest rate spreads in Uganda have remained higher than in most transition
Economies (Tumusiime, 2002; Beck and Hesse, 2006; Ministry of Finance Planning and Economic
Development, 2008). Lending rates continue to ride high while lower rates are being offered on
deposits. In 2005, for example, the average interest rate spread hit 20% with dispersions in the range

4

of 18% to 34% while at the same time, the net interest margins hit 13%, compared to 7.4% on
average in the sub-Saharan African region, 6.3% on the average in low-income countries, and 5% in
the world, and moreover, higher in comparison to neighbouring Kenya and Tanzania. Possibly, this
could be a result that Ugandas banking system is faced with unrelenting high probabilities of default
(Credit risk).

It is hypothesized that when banks are faced with clients with a high probability of default (Credit
risk), they hedge against the impending loss by increasing the lending rates and or lowering the
deposit rates (Widening the spreads). Moreover, high and inflexible interest spreads are indicative of
the existence of perceived market risks (Mugume and Ojwiya, 2009). This raises curiosity and hence
the need to investigate whether the higher interest rate spreads in Uganda are due to Credit risk or it
may as well be the case that, in addition to Credit risk, there are other structural factors which are
important in explaining the spreads.
1.3 Purpose of the Study

This study investigates the impact of credit risk on the commercial bank interest rate spreads in
Uganda.
1.4 Objectives of the Study
i. To analyze the trend of credit risk in Uganda's banking system.
ii. To portray the interest rate spreads state in the Ugandan Banking system.
iii. To establish the relationship between credit risk and interest rate spreads.

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iv. To establish the relationship between macroeconomic factors (Inflation, Liquidity, T-bill
rate) and interest rate spreads.
v. To establish the relationship between client-bank relationship and interest rate spreads.
1.5 Research Hypotheses

i. Credit risk, Liquidity, and T-bill rate have a positive relationship with interest rate spread in
Ugandas banking system.
ii. ClientBank relationship has a negative relationship with interest rate spreads in Uganda.
iii. Inflation has a positive effect on interest rate spreads in Uganda.
1.6 Significance of the Study

The fact that the study attempts to analyze the determinants of Interest rate spreads in Uganda, with a
view to identifying the role of credit risk in explaining the current state of interest rate spreads, is of
great policy and empirical significance. This is because the monetary policy framework of Bank of
Uganda and its implementation have been guided by a need to ensure, among others: i) realistic
interest rate spreads that encourage financial deepening; and ii) a safe, sound, efficient and
competitive banking system through discreet risk management. Moreover it is also a requirement for
the award of an Msc Accounting and Finance Degree of Makerere University.
1.7 Scope of the Study

This study covered credit risk as the principal independent variable and intermediation spread as the
dependent variable. The study also covered the other determinants of intermediation spreads

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macroeconomic variables (Inflation, liquidity, Treasury bill rate) and the client-bank relationship.
The study used time series data covering a period between 1981 and 2008. This period was chosen to
cater for both the pre-reform and the reform periods in the analysis.
1.8 Conceptual Framework

The conceptual model was inspired by the bank dealership model of Ho and Saunders (1981) with
extensions from later studies incorporating different factors to explain the interest rate spreads
(Angbanzo, 1997; Carbo and Rodriguez, 2007). The model bases on the hypothesis that credit risk is
the cause of the persistently wider interest rate spreads in Uganda. Credit risk has been proxied by
none performing loans to total loans advanced annually (Beck and Hesse, 2006; Calcagnini et al,
2009)

Barajas, Roberto et al, (1998) Bazibu (2005), Ho and Saunders (1981), Zarruck (1989) and Wong
(1997); all argue that when Banks are faced with clients with high probability of default (credit risk),
they hedge against the impending loss by increasing the lending rates and or lowering the deposit
rates (widening the spreads). Therefore according to the conceptual model, it is expected that banks
with high exposure to risky loans exhibit wider interest rate spreads. Moreover, scholars like Arano
and Emily (2008) have also pointed at the other factors like the macro-economic variables and
client-bank relationship as explanatory factors for the interest rate spreads. Therefore, the dependent
variable represents the level of interest rate spread (IRS) while credit risk, macroeconomic factors
and client -bank relationship represent the independent variable as illustrated in equation 1 below;

7

IRS=
( ) CB T L Inf CR f , , , ,
.. (1)
Where:
IRS- is interest rate spread over time,
CR-is credit risk over time,
Inf- is the inflation rate over time,
L- is Liquidity in the market over time,
T- is the 91day Treasury Bill rate over time,
CB- is the Client-bank relationship proxied by average life time of loans dispensed to clients by
banks over time.
1.9 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.







8

CHAPTER TWO
LITERATURE REVIEW
2.1. Introduction
Ugandas financial system had for a long time been characterized by several distortions: statutory
interest rate ceilings, directed credit, accommodation of government borrowing, exchange controls
and informal modes of intermediation (Nannyonjo, 2002). The formal financial sector was also
concentrated by two domestic commercial banks with excessively large branch networks and high
overhead costs. In addition, securities, equities and inter-bank markets were either non-existent or
operating inefficiently. Other constraints included deficiencies in the management, regulation and
supervision of financial institutions and a low level of Central Bank autonomy. The last two decades
have seen much of financial sector adjustments with intent to among others narrow the gap between
lending rates and deposit rates (interest rate spread).

Reasons for the financial reforms have always been premised on the Financial Repression hypothesis
of McKinnon (1973) and Shaw (1973) which contends that suppressive financial policies through
measures such as interest rate controls, mandatory credit allocation to preferential sectors, greater
reserve requirements and limitations to entry into the banking sector; among others, were responsible
for low deposit interest rates resulting in low financial savings, high lending interest rates, monopoly
power by banks, low financial intermediation, and concentration of credit in favoured sectors and
firms, especially in developing countries (Tressel and Detragiache, 2008).


9

Heeding the advice of McKinnon and Shaw, many countries, Uganda inclusive undertook to
dismantle financial repressive policies during the last three decades, although to a different extent
and at a different pace in the various regions of the world.

The financial liberalization process notwithstanding, one ubiquitous feature in the banking system of
Uganda is the wide interest rate spread. Whereas there are various factors that have been associated
to the wider interest rate spreads by prior empirical studies, this review of related literature will be
limited to the factors in the theoretical framework. Moreover, given the fact that this study covers
two series that is; the ex ante and ex post of the sector liberalization, the study begins by reviewing
literature on financial liberalization and interest spreads to reflect on the effects of these policy
changes on spreads.
2.2 Financial Liberalization and interest spreads

Typically, financial sector liberalization in Uganda has been associated with measures that were
intended to make the central bank more sovereign. As a result, it would mitigate financial
repression by freeing interest rates and allowing financial innovation, and trim down directed and
subsidized credit, as well as allow greater freedom in terms of external flows of capital in various
forms. This would increase the efficiency of financial intermediation proxied by narrow interest rate
spreads in financial institutions.


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In the late 80s and most especially the 90s, Uganda embarked on reforming her financial sector. This
was done in phases and it involved among others; the liberalization of the exchange rate which was
concluded by the introduction of the Interbank Foreign Exchange Market (IFEM) late in 1993,
strengthening of prudential regulations and bank supervision which led to the amendment of the
Bank of Uganda statute, introduction of the interbank and capital markets, the abolition of the
interest rate controls, Institutional reforms which led to an influx of new banks (both foreign and
domestic); and the development of non-bank institutions such as insurance companies and credit
institutions.

Though Cihak and Podpiera (2005), Tumusiime (2002), Nannyonjo (2002), Mugume and Ojwiya
(2009), Hesse and Beck, (2006), Brownbridge and Harvey (1998) provide some detailed positive
developments in the Ugandan financial sector accruing from the implementation of financial
reforms, they all concede to the fact that interest rate spreads are still high in the country. To them,
financial liberalization has always failed to nurture financial deepening proxied by among others,
narrow interest rate spreads. They point out that the world over, and especially in economies where
the market structure within which banks operate has remained concentrated, there are high non
financial costs of operation, high reserve requirement or deposit insurance and, most banks hold
higher capital ratios to cushion themselves against the high volumes of poor quality assets held.
Moreover this contradiction has further been attested to by the works of Mlachila and Chirwa(2002),
(2002),Jayati (2005),Noyer (2007), Pereira and Sundararajan (1990) and Aryeetey et al, (1997) who
argue that financial liberalization especially in developing countries has been proceeded by financial

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crises inform of higher spreads, mass defaults, bank bankruptcy, and currency crises mainly due to
the fragility of their domestic financial systems coupled with the very weak institutions and policies
that predated the liberalization process. Moreover the fact that most of the indigenous private sectors
in developing countries like Uganda largely consist of households and small scale enterprises that
operate outside the formal financial system (Aryeetey et al, 1997), makes the financial reforms out
of touch and ineffective in lowering the spreads as a bigger populace remains unbanked and
therefore remote.

Nonetheless, political economy theorists like Rajan and Zingales (1998), Chinn and Ito (2006)
basically have difficulties with the foregoing arguments and indeed insist that financial liberalization
helps in enhancing financial intermediation proxied by lower spreads as it dismantles the perfect rent
seeking environments created by financial institutions that operate in repressed financial regimes.
They further contend that opening up of the capital account helps attract foreign players in the
domestic capital markets which is a prerequisite for augmentation of developing market. Moreover
this is reinforced by Guiso et al, (2006) who in their study, find that financial liberalization in Italy
was proceeded by easier access to finances and significant slowdown in the interest rate spreads.

Rather, Guiso et al, (2006) positive relationship between financial liberalization and narrow spreads
in Italy could be due to the fact that this is a developed country with strong political and legal
institutions that constrain expropriation while ensuring maximum contract enforcement and
protection of creditors rights. For instance, Tressel and Detragiache (2008) found that financial

12

liberalization policies do increase financial intermediation proxied by narrow interest spreads in the
long run, but only in countries with well-developed political institutions that can limit the power of
the executive. They do not find any sustained effects of banking reforms in other countries. This
proof implies that guaranteeing sufficient checks and balances on political power as a necessary step
to improve the protection of property rights may be an indispensable condition for the banking
systems functioning to improve after liberalization. This is consistent with Acemoglu and Johnson
(2005), who find that more stringent constraints on the executive has a significant positive effect on
growth, investment, and financial development. The understanding here is that political checks and
balances shield citizens from expropriation from politically influential elites, thereby conserving
property rights which in turn, ensures that potentially all agents in the economy can access financial
sector loans when they qualify culminating into lower risk and spreads.

In most of the empirical studies on financial liberalization and interest spreads underlies the fact that
more controlled/repressed financial systems are neither the solution to narrowing spreads as this
leads to opacity, corruption and crony capitalism all of which are wasteful and set the foundation for
wider spreads (Jayati, 2005). This justifies the multisectoral approach adopted by countries like
China, and the other Asian tigers which provides for self correction mechanisms that cater for better
financing while protecting the economy during and after the reforms (Wyplosz, 2001).

The proceeding review attempts to explore the role of credit risk in keeping interest rate spreads
higher in the Ugandan banking system.

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2.3. Credit Risk

Credit risk is the risk of loss due to the inability or unwillingness of a counter-party to meet its
contractual obligations (Bank of Uganda, 2007). Models proposed by Straka (2000) and Wheaton et
al, (2001) have expressed default as the end result of some trigger event, which makes it no longer
economically possible for a borrower to continue offsetting a credit obligation. Though there are
various definitions of credit risk, one outstanding concept portrayed by almost every definition is the
probability of loss due to default. However, a lot of divergences emerge on defining what default is,
as this is mainly dependent on the philosophy and/or data available to each model builder.
Liquidation, bankruptcy filing, loan loss (or charge off), nonperforming loans (NPLs) or loan
delayed in payment obligation, are mainly used at banks as proxies of default risk. This research
paper has proxied credit risk by the ratio of Nonperforming loans to total loans advanced (Beck and
Hesse, 2006; Calcagnini et al, 2009; Maudos and Solis, 2009)

Other scholars like Bandyopadhyay (2007), Avery et al, (2004), Vigano (1993), Zorn and Lea
(1989), and Quercia and Stegman (1992) have explained credit risk using the creditworthiness
parameters like borrowers quality, financial distress and collateral position. They contend that
individual borrowers with characteristics such as divorced or separated, having several dependants,
with unskilled manual occupation, uneducated, unemployed most of the year; are prone to defaulting
on their credit obligations. This is supported by economic theories, most especially the human
capital theory which regard education and training as an investment that can increase the scope of
gainful employment and improve net productivity of an individual and hence their incomes.

14

However though, the benefit of education and training has been underestimated in most of the
studies on credit risk. Also, age and collateral position as creditworthiness factors raise a lot of
controversy as mixed arguments have been raised as to their impact on the credit risk (Bester, 1985;
Chan and Kanatas, 1985; Besanko and Thakor, 1987; Chan and Thakor, 1987; Vigano, 1993; Rajan
and Winton, 1995; Manove and Padilla, 2001; Vasanthi and Raja, 2006; Bandyopadhyay 2007;
Arano and Emily, 2008)
2.3.1 Credit risk trend in Uganda's banking system

By far the biggest risk facing banks and financial intermediaries remains credit risk- the risk of
customer or counterparty to default (Reserve Bank of Australia, 1997). In Uganda, the 1980s and
1990s saw the banking system coming under severe stress where many banks were riddled by high
levels of non-performing assets (credit risk) with some banks going insolvent. By 1995 the non
performing loans in the banking sector had accumulated to US$34million (Tumusiime, 2005).
Moreover Mugume and Ojwiya (2009) indicate that credit risk peaked during the 1990s and early
2000. Mugume and Ojwiya blame this on the adverse selection predicament caused by information
asymmetries that makes it hard to select good borrowers from a pool of loan applications. This
underpins the recent establishment of the Credit Reference Bureau (CRB), on the rationale that;

- timely and accurate information on borrowers debt profile and repayment history would
reduce information asymmetry between borrowers and lenders and that it would enable
lenders to make informed decisions about allocation of credit which would finally lower

15

default probabilities of borrowers and hence contribute to financial stability and efficient
allocation of resources in the economy,
- when financial institutions compete with each other for customers, multiple borrowing and
over indebtedness would increase and loan default would rise unless the financial institutions
had well developed credit information systems or access to databases that can capture
relevant aspects of clients borrowing behavour,
- information in credit registries would be vital for the development of a credit culture where
borrowers seek to protect their reputation and collateral by meeting their obligations in a
timely manner and that borrowers could also use their good repayment record as collateral
for new credit,
- Credit reference bureaus would provide the necessary infrastructure to ensure information
integrity, security and up-to-date information on borrowers.

Relatedly, the Bank of Uganda instituted an internal programme to strengthen Banking Supervision
with substantial resources being put into training and moving towards a risk-based approach to
banking supervision. Apparently, there have been reported improvements in the asset quality and
profitability of the Commercial Banks (Tumusiime, 2005; Kasekende, 2008). This might be partly
the reason for Ugandas improvement in her risk profile to a 'B' plus in the recent Standard and
Poors ratings. However, it should be noted that this improvement in asset quality may be as well be
a result of lack of capacity for banks to ably capture and measure credit risk, banks becoming more

16

risk averse reflected in a strong preference for liquid and low-risk assets as opposed to individual
lending.

On average, much has been invested in credit risk management as a requirement by Bank of Uganda.
This coupled with the creation of a Credit Reference Bureau, has to some extent improved the credit
risk assessment in banking. However with the continued entry of new banks, good credit judgment
might often be ignored due to competitive pressures as banks try to venture in nontraditional and
unsecured products which may escalate credit risk going forward. Given that some scholars have
linked credit risk with higher interest rate spreads, it might be a dream farfetched to have interest rate
spreads lower in the country.
2.4 Interest rate spreads in Uganda.

Crowley (2007), Barajas, Roberto et al. (1998) define interest rate spread as the difference between
the weighted average lending rate (WALR) and the weighted average deposit rate (WADR). Wider
spreads are always a proxy for an underdeveloped financial system characterized by inefficiency,
lack of competition and higher concentration of the banking sector; among others and the reverse is
also perceived to be true (Demirguc -Kunt and Huizinga, 1999; Mlachila and Chirwa, 2002;
Mugume and Ojwiya, 2009). Banking systems in developing countries have been shown to exhibit
significantly and persistently large intermediation spreads on average than those in developed
countries. However the difference arises in the causal factors.


17

In Uganda, just like in any other developing countries, persistent high intermediation spreads have
been of particular concern to the business fraternity and policy makers (Nannyonjo, 2002; Cihak and
Podpiera, 2005; Tumusiime, 2005; Beck and Hesse, 2006; Ministry of Finance Planning and
Economic Development, 2008; Mugume and Ojwiya, 2009). Lending rates continue to ride high
while lower rates are being offered on deposits. For instance in 2005, the average interest rate spread
hit 20% with dispersions in the range of 18% to 34% (Bank of Uganda, 2007). While at the same
time, the net interest margins hit 13%, compared to 7.4% on average in the sub-Saharan African
region, 6.3% on the average in low-income countries, and 5% in the world, and moreover, higher in
comparison to neighboring Kenya and Tanzania(Beck and Hesse, 2006).

Various views have been expressed as to why high interest spreads have persisted in Uganda. Beck
and Hesse (2006) postulate that the small financial system, the high level of risk, the market
structure and the instability of macroeconomic variables have played a bigger role in buoying the
spreads in their current state. The bank of Uganda officials have on many occasions argued that lack
of competition and the concentration of banks in urban areas is to blame for the current state of
spreads. Mugume and Ojwiya (2009) postulate that high interest rate spreads in Uganda have been
empirically explained by high operating costs faced by the banks, high liquidity in commercial
banks, discount rates, inflation, volatile exchange rates and financial liberalization. Mlachila and
Chirwa (2002) have found robust relationship between non financial costs, high reserve requirement,
inflation, financial liberation and interest rate spreads in their study they did in Malawi.


18

While all the views contain merit, one may continue to question why the interest spreads have
remained high even when the country is experiencing relative macroeconomic stability, with more
banks entering the sector, and with a stronger regulator in place?. Given that credit risk as a
probable cause has not been given the attention it deserves in partly explaining this state of affairs,
this research undertook to establish the determinants of interest rate spreads in Uganda with a view
to establish the extent to which credit risk can explain the current spreads state in the banking
industry of Uganda.
2.5 Credit Risk and Interest rate Spreads

The theoretical model of Ho and Saunders (1981) expanded by Angbazo (1997) and Maudos and
Guevara (2004) indicate that there is a positive correlation between credit risk or loan quality and
interest rate spreads. The model argues in part that when banks are faced by deterioration in loan
quality (credit risk), they hedge against the impending loss by transferring a portion or all of it to
their customers (either borrowers or depositors). This is done by increasing the lending rate and or
lowering the deposit rate.

In Uganda, the uncertainty created by the existence of a weak legal regime especially in contract
enforcement coupled with the inadequate borrower information has aggravated credit risk and
probably the interest rate spreads. This is so because the inefficient legal systems and information
inadequacies do not only cause interest rates to be high but also crowd out borrowers who would
have obtained credit in an environment without information asymmetries. Moreover in such a case,

19

lenders would require a risk premium in form of higher lending rates and or lower deposit rates to
compensate for the likely event that some of its borrowers may default (Mugume and Ojwiya 2009).

Some empirical studies have found robust relationship between credit risk and interest rate spreads.
Mugume and Ojwiya (2009) using data from Ugandan banks found a positive relationship between
credit risk and interest rate spreads. Moreover this is reinforced by similar findings from studies by
Mlachila and Chirwa (2002) in Malawi. Others include Randall (1998), Barajas, Roberto et al.
(1998), Brock and Rojas-Suarez (2000), Gelos (2006), Crowley (2007), Arano and Emily (2008),
and Calcagnini et al, (2009). This implies that banks use the spread between the deposit rate and
lending rate as a buffer to any loss arising out of adverse selection. Nonetheless, some of these
studies used data over quite a short time, moreover with different measures of credit risk from that of
the current study.

On the contrary, Nannyonjo (2002), Samuel and Valderrama (2006) established a negative
correlation between credit risk and interest rate spreads in Uganda and Barbados respectively.
Similarly, the efficiency hypothesis supporters like Saunders and Schumacher (2000), Craigwell and
Moore (2002) instead view wider spreads as a function of market structure and bank specific factors.
To this end they postulate that size of a bank, its market power, and bank concentration have a
higher explanatory power for intermediation spreads. Therefore they conclude by indicating that
smaller banks, a market with a few banks but with a higher market power and hence with high
concentration are likely to lead to wider interest rate spreads. Nonetheless, in contrast to some of the

20

preceding assertions are Panzar and Rosse (1987), and the IDB (2005) which disregard purported
relationship between bank concentration and spreads.

Institutional constraints related to financial regulations including liquidity requirements, statutory
government securities holding requirement, capital controls, and tax have been found to have a
positive correlation with Intermediation Spreads. In their studies, Barajas, Roberto et al. (1998),
Saunders and Schumacher (2000), Gelos (2006), Nannyonjo (2002), Hesse and Beck (2006) came up
with empirical evidence to the fact that financial regulation is costly to banks which makes them
pass on all of the resultant costs to the customer by hiking the lending rates and or reducing deposit
rates.

Reviewing literature on credit risk and interest rate spread reveals the following gaps:
- Though a lot has been researched on credit risk, intermediation ipreads; not much has been
researched in detail on the relationship between the two
- Most of the studies available relate to the Latin America, Asia, USA but not Africa and
Uganda in particular and the few that relate to Uganda have examined data over a very short
span.
- A lot of emphasis has been placed on the other factors that cause higher Intermediation
Spreads other than credit risk.
To this end therefore there is still valid reason for one to specifically investigate the direct
relationship between credit risk and interest spreads especially in the Ugandan banking system. But

21

as hinted by Arano and Emily (2008), Mugume and Ojwiya (2009), Mlachila and Chirwa (2002) and
others, credit risk on its own may not suffice to explain intermediation spreads. Consequently, as an
auxiliary intent for this study, macroeconomic factors and client-bank relationship have been studied
to supplement the explanatory power of credit risk for the current state of interest rate spreads in
Uganda.
2.6 Client-Bank relationship and Interest rate spreads


It has been well documented that the relationship between the bank and its client is an important
aspect of obtaining favorable credit terms. The finding of more favorable rates provided by firms
with stronger relationships reinforces the significant attention that banking institutions have
accorded to relationship banking of recent. Moreover, relationship banking has never been important
than during this error of economic slowdown partly blamed on weak client-bank relationships.
According to Arano and Emily (2008), the greater the duration and scope of the relationship between
the borrower and the lending institution, the more soft information becomes available, and the
more efficient the pricing of the loan due to a reduction in the asymmetric information problem
which aggregates to lower credit risk and hence lower bank spreads. Degryse and Cayseele (2000)
using ordinary least squares regression on a sample small business loans in Belgium found spreads
decrease with the scope of the relationship. Further, this argument is reinforced by the findings from
studies carried out by Diamond (1984), Ramakrishnan and Thakor (1984), Fama (1985), Sharpe
(1990), Diamond (1991) and Boot (2000) who postulate that the greater the duration and scope of
the relationship between the client and the financial institution, with this relationship providing both

22

public and the more important private information, the more information becomes available, and the
more efficient the pricing of the loans and deposits due to a reduction in the asymmetric information
problem and hence lower spreads.

Nonetheless, the fact that very few banks especially in developing countries have built capacity to
effectively capture and process soft information for informed decision making casts doubt on
whether spreads could be impacted by the relationship between the bank and its client. Petersen and
Rajan (1994), Berger and Udell (1995) analyzed relationship lending on various loan types of the
most recent approved loan, but were not able to find an association between the strength of the bank-
client relationship and the interest rate charged on the loan. Instead, they were able to find an
increase in the availability of credit based upon a stronger relationship between the bank and its
client. Further, Harhoff and Korting (1998) using ordinary least squares regression on the actual
rates charged on lines of credit against the premium paid obtained from a survey of small and
medium-sized German firms find the interest rate spread not impacted by the relationship between
client and the bank.

2.7 Macroeconomic environment and interest rate spreads

The macroeconomic environment (Inflation, Liquidity, 91day T-bill rate) predominantly affects a
countrys spreads through its impact on credit risk and therefore the quality of loans. An unstable
and weak macroeconomic environment creates uncertainty about future economic growth and

23

returns on investments, making defaults on loans more likely. In response to this increased credit
risk, banks will raise the premium on loans thus increasing the Spreads (Central Bank of Solomon
Islands, 2007; Mugume and Ojwiya, 2009). However, this has been contested by the findings of
Seetanah et al, (2009). In their study, macroeconomic environment was not a significant variable in
explaining interest spreads as the case was for the bank specific characteristics.

High and volatile inflation and the uncertainty this creates seems to lead to an increase in interest
rate spreads. This is so because price swings always compromise borrowers ability to meet their
loan obligations, and the quality of collateral is also likely to weaken which could increase the bank
costs in loan recovery and default cases. Again, this will make banks hedge against the likelihood of
default arising from the high and variable inflation by using higher spreads. MLachila and Chirwa
(2002), Brock and Rojas-Suarez (2000), Demirguc-Kunt and Huizinga (1999), Mugume and Ojwiya
(2009),Tennant and Folawewo (2009), Crowley (2007), Nannyonjo (2002) and Seetanah et al,
(2009) all found a positive relationship between price instability represented by high and variable
inflation and interest rate spreads. However, this is still contested by Samuel and Valderrama, (2006)
whose study in the Barbados established a negative relationship between inflation and interest
spreads. The possible explanation for the negative relationship would be that higher inflation
indicates faster credit expansion at possibly lower lending rates and therefore lower spreads.

Liquidity also appears to be an influential factor in determining the Spreads. In countries where
excess liquidity is very high (and banks have surplus funds), the marginal cost of deposit

24

mobilization is high and the marginal benefits are likely to be very low. In this scenario, interest
rates on deposits will be low, tending to increase the Spreads. Relatedly, it is believed that high
liquidity in the banking system will exert upward pressure on inflation with all its effects on credit
risk which will in turn lead to banks hedging against such effects by increasing the spreads.
Conversely, Seetanah et al, (2009) have found that higher liquidity in the financial system can lead
to low interest spreads in that whenever banks are liquid, their perceived liquidity exposure is low
which translates into lower premiums on both loans and deposits and hence narrow spreads. This is
also consistent with the findings of Dermirguc-kunt et al, (2004).

The 91-day T-bill rate has also been found to influence interest rate spread. In most of the countries,
banks use this as their reference rate for pricing their loans and deposits. Moreover this is reinforced
by the findings from the studies of Samuel and Valderrama (2006), Nannyonjo (2002), Tennant and
Folawewo (2009) that indicate a positive correlation between the T-bill rate and Interest rate spreads.
Though the former two studies coefficients are significant, the latter manifested a weak linkage
between the two. A positive relationship between the T-bill rate and interest rate spreads indicates
that the higher the bill rate the higher the spreads and vice versa. This is so because the 91 days bill
is used as the mirror for the risk return continuum of any financial system. To this end a higher bill
rate would indicate the same risk profile for the sector which would make banks mark-up their credit
facilities to compensate for perceived risk. However, this may not be always the case in undeveloped
financial systems where information inadequacies constrain effective loan and deposit pricing.


25

CHAPTER THREE
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 was a quantitative research based on secondary time series data from the Central Bank and the
IMF statistical year books. Further, it was a relationship study that aimed at establishing the
association between interest rate spreads (response variable) and credit risk, macroeconomic
variables and client bank relationship (explanatory variables) based on inferential statistics.
3.3. Model Specification

The model used was inspired by the bank dealership model of Ho and Saunders (1981) with
extensions from later studies incorporating different factors to explain the Interest rate spreads
(Angbanzo, 1997; Maudos and Guevara, 2004; Carbo and Rodriguez, 2007).

The model bases on the hypothesis that Credit risk is the cause of the persistently wider
intermediation spreads in Uganda. Credit risk has been proxied by Non Performing loans (NPLs) to
total loans advanced (Beck and Hesse, 2006; Calcagnini et al, 2009). Moreover, the model

26

incorporates the other determinants of interest rate spreadsClient-Bank relationship and the
macroeconomic environment proxied by inflation, liquidity, and the 91-day T-bill rate.

Barajas et al, (1998), Bazibu (2005), Ho and Saunders (1981), Zarruck (1988), and Wong (1997) all
argue that when Banks are faced with clients with high probability of default (Credit risk), they
hedge against the impending loss by increasing the lending rates and or lowering the deposit rates
(widening the spreads). Therefore according to this model, it is expected that banks with high
exposure to risky loans exhibit wider interest rate spreads.

However as highlighted by Arano and Emily (2008), Demirguc-Kunt and Huizinga (2000),
Robinson (2002), Nannyonjo (2002), Beck and Hesse (2006) and Bandyopadhyay (2007) credit risk
alone may not suffice to explain the intermediation spreads. To this end, it has been hinted that the
relationship a bank has with a particular client and the macroeconomic environment in which
financial institutions operate have the ability to affect the intermediation spreads.

The modified version of the model predicts that interest rate spreads are as a result of credit risk and;
inflation, liquidity, T-bill rate, and client-bank relationship. The proposed methodology therefore
analyses interest rate spreads by investigating the significance of credit risk, macroeconomic
environment, and client-bank relationship variables in a spread determination function. Put
symbolically,
IRS=
( ) CB T L Inf CR f , , , ,
. (2)

27

For estimation purposes, equation (2) will be transformed as below
IRSt t t t t t t
D CB T L Inf CR c | | | | | | | + + + + + + + =
6 5 4 3 2 1 0 ... (3)

Where:
IRSt - is interest rate spread over time,
CRt -is credit risk over time,
Inf t - is the inflation rate over time,
Lt - is Liquidity in the market over time,
Tt - is the 91day Treasury Bill rate over time,
CBt - is the Client-bank relationship proxied by average life time of loans dispensed to clients by
banks at a given time,
D - is a dummy variable that captures the impact of the financial reforms on the IRS; and
t
c
~i.i.d (0,
2
o ), is a serially uncorrelated error term.
From equation (3), it is hypothesized that variables--
4 3 2 1
, , | | | | and are positive while 5
|
and 6
|

are negative.




28

3.4 Variable Definitions, Measurement and Data Source

Interest rate spread (IRS)
Interest rate spread is the difference between the weighted average lending rate (WALR) and the
weighted average deposit Rate (WADR) (Barajas et al, 1998; Beck and Hesse, 2006; Central Bank
of Solomon Islands, 2007; Crowley, 2007; Vera and Andreas, 2007). In the current study, the
interest rate spread was captured over two sub-periods; the pre-sector reform and reform periods.
The financial sector reforms adopted towards the end of the 80s (1987) were aimed at among other
things causing financial intermediation efficiency proxied by narrow interest rate spreads. Data on
interest rate spreads included the WALR and WADR from the research department of the central
bank.

Credit Risk (CR)
Guided by the previous empirical studies by Calcagnini et al, (2009), Fungov and Poghosyan
(2008), Beck and Hesse (2006), credit risk was proxied by the ratio of Nonperforming Loans (NPLs)
to the total loans advanced by the banks in the same period. In banking, NPLs loss provisions arise
out of probable defaults that banks envisage of borrowers that turn risky which makes it the closest
measure of credit risk. This study pre-supposes that banks with higher NPLs (Credit risk) exhibit
wider interest rate spreads and vice versa. Data on the non performing loans was sought from the
financial statements of all the commercial banks that are published in the Bank of Uganda annual
supervision reports and IMF statistical year books.

29


Inflation (Inf)
This is the rate of change in the general price levels of consumer goods and services captured
annually within the country. Inflation was measured by the annual changes in the consumer price
index (CPI). High and volatile inflation and the uncertainty it creates seem to lead to an increase in
interest rate spreads. Similarly, in a weak macroeconomic environment, and in developing countries
in particular, the quality of collateral is likely to be weak which increases the costs to banks in their
effort to recover loans. Moreover, this will tend to increase the amount of Non Performing loans
provisioning and lead to higher spreads. Data on inflation rates was sought from the CPI office at the
Uganda Bureau of Statistics.
Liquidity in the market (L)
Liquidity in the market was taken as liquid assets that are held by banks over time. Excess liquidity
also appears to be an influential factor in determining the spreads. In countries where excess
liquidity is very high (and banks have surplus funds), the marginal cost of deposit mobilization is
high and the marginal benefits are likely to be very low. In this scenario, interest rates on deposits
will be low, tending to increase the Spreads. Data on market liquidity was sought from the financial
statements that commercial banks submit to the central bank and published in the annual supervision
reports.
Treasury bill rate (T)
This is interest rate on the 91-day government debt instrument. The 91-day Bill rate in most of the
countries is taken as the benchmark for any credit pricing (Nannyonjo, 2002; Samuel and

30

Valderrama, 2006; Tennant and Folawewo, 2009). In Uganda, the bank rate, lending rate and
deposit rate are in most cases referenced to this rate. This study presupposes that any increase in the
91-day T-bill rate leads to wider spreads as it will raise the cost of finance and of doing business
which finally interfere with the borrowers ability to pay. Data on Treasury bill rate was accessed
from the financial markets time series of annualized T-bill yields at the Central bank.

Client-Bank Relationship (CB)
This was taken as the average time a customer has banked with a particular financial institution. This
was proxied by the average loan life Time of the loans dispensed by the banks at a given time
(Calcagnini et al, 2009) which was estimated from the simple interest model; Time=
te incipalxRa
Interest
Pr

where Time is the average loan life time, Principal is the total amount of loans expended by banks at
a given time, while Rate is the weighted average lending rate at a given time. This study
hypothesizes that the greater the duration and scope of the relationship between the borrower and the
lending institution, the more soft information becomes available, and the more efficient the pricing
of the loan due to a reduction in the asymmetric information problem which aggregates to lower
credit risk and hence lower bank spreads (Diamond, 1984; Ramakrishnan and Thakor, 1984; Fama,
1985; Sharpe, 1990; Boot and Thakor, 1994; Berger and Udell, 1995; Scott, 1999; Boot, 2000;
Degryse and Cayseele, 2000; Arano and Emily, 2008). Data for Client-Bank relationship was sought
from the financial statements submitted to the central bank at the end of each financial year.

31

3.5 Data Estimation and Testing Procedures

Quarterly time series data on commercial bank financials and Ugandan macroeconomic variables for
the period 1981: I-2008: IV was used. The data was taken from the Publications of Bank of Uganda,
IMF Statistical year books, Uganda Bureau of Statistics and Ministry of Finance, Planning and
Economic Development of the republic of Uganda.

Ordinary Least squares (OLS) estimation was used in the estimation of equation (3). 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 non-stationary. This
implies that, the variables may have a mean, variance, and co-variance not equal to zero. Working
with such variables in their levels will present a high likelihood of spurious regression results. To
this end, the researcher performed stationarity 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 cointegrated, that is, if there exists a set of
linear combination of variables that are stationary (Engle and Granger, 1987). Accordingly, the
cointegration technique developed in Johansen (1988) and applied in Johansen and Juselius (1990)
was employed in this study and two cointegrating equations were established. We normalized for the
interest rate spreads and thereafter proceeded to estimate a long run Interest rate spread model. It

32

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).

3.6 Limitation

Results of this research should be taken with caution as some of the time series were not readily
available on a quarterly basis. This made the researcher to transform the existing macroeconomic
data into quarterly data (see Appendix I) using the computer method of direct linear interpolation
which imposes a linear trend on the data. This may imply that part of the findings are based on
interpolated data which could lead to the findings herein to differ in some way from those of the
prior empirical studies. Nonetheless, the author made sure that this limitation is counteracted by the
rigorous model and residual assumption tests.















33

CHAPTER FOUR
PRESENTATION, ANALYSIS AND INTERPRETATIONOF FINDINGS
4.1 I ntroduction

This chapter presents findings in orientation to the conceptualizations from the annual time series
data. The bondage between the variables in the study was estimated by the Ordinary Least Squares
(OLS) method of analysis. The findings abridged from secondary data, are interpreted in relation to
the research objectives.
4.2 Objective 1: To analyze the trend of credit risk in Ugandas banking system

Between 19872000, Ugandan policy makers embarked on an ambitious and far reaching Financial
sector reform programme marked by the reforming of the legal and institutional frame work,
restructuring of state-owned financial institutions, lifting of entry barriers to private sector operators
in the financial sector, and the deregulation of interest rates from the government controls; with hope
that interest rate spreads among other things would narrow (Bank of Uganda, 2005). Sequentially,
the Credit Reference Bureau is another vehicle that was instituted by Bank of Uganda on the
rationale that timely and accurate information on borrowers debt profiles and repayment history
would reduce information asymmetry between borrowers and lenders. This was expected to enable
banks to among other things lower credit risk and possibly interest rate spreads and hence contribute
to financial stability in the economy.


34

Figure1: Credit Risk trend in Uganda

Source: Authors computation using data from Bank of Uganda and IMF statistical year books
As seen from figure 1, prior to the 1987 Economic Sector Adjustment Programme (ESAP), Credit
risk proxied by the ratio of Non Performing Loans (NPLs) to Total loans advanced was on a rising
trend mainly on account of economic and political distortions that engulfed the nation between 1981
and 1986 thereby causing a lot of uncertainty in the financial sector. The year 1987 was marked by
currency reform in Uganda in a bid to revive confidence in the financial sector and this caused a
transitory reduction in credit risk from 33.3% to 30% in 1986 and 1988 respectively. Credit risk took
a significant nosedive in the early 90s on account of the implementation of the Industrial
Development Agencys funded Economic Recovery Programme (ERP) and the passage of the
Financial Institutions Statute of 1993 which raised the minimum capital requirements for
commercial banks from less than a Billion shillings to now four Billion shillings and increased on
site inspection. However, after 1993/94, Credit risk significantly edged up to the highest ever rate of

35

61 percent in 1999 mainly on account of the deteriorating asset quality in the gigantic Uganda
Commercial Bank that was then bloated with 80% of her total assets as non performing. Also, this
trend was escalated by the insolvency of the four local banksGreenland Bank, Cooperative Bank,
International Credit Bank and Trust Bank.

Available theory can also be used to explain this credit risk trend. Nannyonjo (2002), Diaz-
Alejandro (1985), Burkett and Dutt (1991), Gibson and Tsakalotos(1994), Arestis and Demetriades
(1997), Chang and Velasco (1998),Demirguc-Kunt and Huizinga (1999) in their studies indicate
that financial sector liberalization in particular has been at the root of many recent cases of financial
and banking crises, even though this contradicts the ever revered Mckinnon (1973) and Shaw (1973)
financial repression hypothesis which contends otherwise. In this line therefore one can conclude
that the significant surge in credit risk that proceeded 1994 was sparked by the sector adjustments
that the country was undertaking.

Since the year 2000, credit risk has been on a declining trend though punctuated by some upsurges.
This indicates that the Bank of Ugandas strengthening of banking supervision and its move towards
a risk based approach of banking supervision have yielded positive results. However though, these
results may also be indicative of the deficiencies in assessing credit risk in banks or of the fact that
banks have become more risk averse as reflected in the surging demand for government securities
that has crowded-out private sector credit. Moreover this trend may also be as a result of the closure

36

of the insolvent banks and the transfer of the Non Performing Loans of the UCB to the Non
Performing Assets Recovery Trust (NPART) coupled with a reduction in its branch network.
4.3 Objective 2: To portray the state of interest rate spreads in the Ugandan banking system

Uganda, just like any other developing country, persistent high interest rate spreads have been of
particular concern to the business fraternity and policy makers (Nannyonjo, 2002; Cihak and
Podpiera, 2005; Tumusiime, 2005; Beck and Hesse, 2006; Ministry of Finance Planning and
Economic Development, 2008). Lending rates continue to ride high while lower rates are being
offered on deposits.
Figure 2: Interest Rate spreads trend in Ugandas banking system

WADRWeighted Average Deposit Rate; WALRWeighted Average Lending Rate
0
5
10
15
20
25
30
35
40
45
1
9
8
1
1
9
8
2
1
9
8
3
1
9
8
4
1
9
8
5
1
9
8
6
1
9
8
7
1
9
8
8
1
9
8
9
1
9
9
0
1
9
9
1
1
9
9
2
1
9
9
3
1
9
9
4
1
9
9
5
1
9
9
6
1
9
9
7
1
9
9
8
1
9
9
9
2
0
0
0
2
0
0
1
2
0
0
2
2
0
0
3
2
0
0
4
2
0
0
5
2
0
0
6
2
0
0
7
2
0
0
8
Interes t rate s pread(%) WADR WAL R L inear (Interes t rate s pread(%))

37

Source: Authors computation using data from Bank of Uganda and IMF statistical year books
From Figure 2, the line of best fit (Linear trend) indicates a steadily rising trend for interest rate
spreads though at different rates of change. Going by the graph (curvature), the early 80s were
marked by low interest rate spreads in the region of 3 and 8 percent. This is on account of the higher
deposit rates that reigned by then that narrowed the gap between the lending rate. Spreads ebbed to
their lowest in 1992 after which they significantly edged up to their highest in the recent history at
26% in 1993 at a time when Commercial banks, for the first time, were formally allowed by Bank of
Uganda (BoU) to set their own interest rates based on their own analysis of market conditions in a
bid to create more competition in the sector. Currently, Ugandas spreads range between 14 and 17
percent which is still significantly high compared to 7.4% on average in the sub-Saharan African
region, 6.3% on the average in low-income countries, and 5% in the world, and moreover, higher in
comparison to neighboring Kenya and Tanzania (see Beck and Hesse, 2006).

Various views have been expressed as to why high interest spreads have persisted in Uganda. Beck
and Hesse (2006) postulate that the small financial system, the high level of risk, the market
structure and the instability of macroeconomic variables have played a bigger role in buoying the
spreads in their current state. The bank of Uganda officials have on many occasions argued that lack
of competition and the concentration in banking is to blame for the current state of spreads.

38

4.4: Objective 3: To establish the relationship between Credit Risk and I nterest rate spreads
Objective 4: To establish the relationship between Macroeconomic factors (I nflation, Liquidity, T-
bill rate) and interest rate spreads.
Objective 5: To establish the relationship between client-bank relationship and interest rate
spread.

4.4.1Time Series properties
To fulfill the fundamental statistical requirements for the empirical model, data transformation was
carried out to establish the normality and stationarity of the data prior to empirical estimation of the
model in investigating the determinants of Interest rate spread (IRS) in Uganda (1981-2008).
Descriptive statistics for the data were undertaken for variables in levels to describe the basic
features of data used in the study. Table 4.1 summarizes the descriptive statistics for the series in
levels. The results illustrate that most of the variables satisfy the normality test. The low Jarque-Bera
probability values for some of the series can be ascribed partly to structural change in the data and
partly to the weaknesses of the direct linear interpolation method used in the generation of quarterly
data. The method imposes a linear trend on the data. Accordingly, undertaking descriptive statistics
for variables in the two sub periods (Pre-ESAP and ESAP) separately and use of annual data could
probably generate better Jarque-Bera probability values.





39


Table4.1: Descriptive Statistics

CB CR INF IRS L T
Mean 0.797302 20.26979 42.33221 11.86737 590.9880 17.91817
Median 0.815000 18.50000 9.029167 13.13798 274.7500 11.76000
Maximum 0.998199 60.59226 699.7500 26.00000 2258.000 43.00000
Minimum 0.394077 0.180080 2.307804 3.500000 1.155000 5.850000
Std. Dev. 0.164037 16.40371 108.0276 4.525424 659.1260 11.33447
Skewness -0.495100 0.495100 4.331423 0.312090 0.791376 0.905351
Kurtosis 2.320728 2.320728 22.16449 3.105313 2.073714 2.282759

Jarque-Bera 6.548663 6.548663 20.08882 1.819804 15.27412 17.22689
Probability 0.37842 0.37842 0.000000 0.402564 0.0482 0.0182

Observations 109 109 109 109 109 109
Source: Authors computations using financial statements of all the commercial banks that are
published in the Bank of Uganda annual supervision reports and IMF statistical year books for
years 19812008.
Table 4.2: Correlation Analysis
CB CR INF IRS L T
CB 1 -1 -0.0636107 0.11376 0.523770 -0.128460
CR -1 1 0.0636107 -0.11376 -0.523770 0.1284604
INF -0.0636107 0.0636107 1 -0.296578 -0.267028 0.145386
IRS 0.11376282 -0.1137628 -0.296578 1 0.445018 -0.49664
L 0.52377026 -0.5237702 -0.267028 0.445018 1 -0.590898
T -0.128460 0.1284604 0.145386 -0.49664 -0.590898 1

Source: Authors computations using financial statements of all the commercial banks that are
published in the Bank of Uganda annual supervision reports and IMF statistical year books for
years 19812008.

During the preliminary analysis, it was discovered that variables CB and CR were perfectly
correlated (negatively) and that exclusion of one led to virtually no statistical difference in the results
obtained. Moreover this was reinforced by the stepwise regression analysis which also proved the
same. Table 4.2 justifies why variable CB had to be dropped from the model being estimated after
which the researcher proceeded to test for stationarity of data.

40

4.4.2 Unit root tests
By means of conventional testing procedures of Augmented Dickey-Fuller (ADF) the order of
integration of the variables (and the degree of differencing required in order to induce stationarity)
was determined. Integrated variables have a mean that changes over time and a non-constant
variance. This implies that working with such variables in their levels gives a high likelihood of
spurious regression results which makes deduction untenable since the standard statistical tests like
the F distribution and the students t distribution are invalid. The unit root test results are
presented in table 4.3 and 4.4. Unit root test results for the variables in levels indicate that all the
variables are non-stationary at all levels of significance (see Tables 4.3)
Table 4.3: Results of Unit Root Tests for Variables in Levels


Variable
ADF Order of Integration
LCR -2.740780 I(1)
LINF -3.460659* I(1)
LRS -2.303598 I(1)
LL -2.691016 I(1)
LT -2.557701 I(1)

Notes: (i) L is logarithm and ADF is Augmented Dickey Fuller.
(ii) Asterisk *, ** and *** indicate significance at the 1%, 5% and 10% significance levels respectively.
(iii) MacKinnon (1980) critical values are used for rejection of hypothesis of a unit root.
(iv) Critical values for ADF statistics are -4.0485, -3.4531, and -3.1519 at 1%, 5% and 10% respectively.

Source: Authors computations using EVIEWS 3.0 based on the information from financial
statements of all the commercial banks that are published in the Bank of Uganda annual supervision
reports and IMF statistical year books for years 19812008.


41

Using the ADF unit root testing procedure, the first differences of the log of the non-stationary series
were subjected to the unit root tests which confirmed the results in table 4.3 above and reveal that
the series are integrated of order zero in their first differences.
. The summary of the results are presented in table 4.4
Table 4.4: Results of Unit Root Tests for Variables in First Difference
Variable
ADF Order of Integration
LCR -5.957670 I(0)
LINF -5.433128 I(0)
LRS -5.365922 I(0)
LL -5.115730 I(0)
LT -4.766369 I(0)

Notes:
(i) L is logarithm, D is the first difference and ADF is Augmented Dickey Fuller.
(ii) Asterisk *, ** and *** indicate significance at the 1%, 5% and 10% significance levels respectively.
(iii) Mackinnon (1980) critical values are used for rejection of hypothesis of a unit root.
(iv) Critical values for ADF Statistics are -4.0468, -3.4523, and -3.1514 at 1%, 5% and 10% respectively.

Source: Authors computations using EVIEWS 3.0

4.4.3 Cointegration tests
As pointed out by Engle and Granger (1987), even though individual time series are nonstationary
(with trend), their linear combinations can be, since equilibrium forces tend to keep such series
together in the long run. When this happens, the variables are said to be cointegrated and error-
correction terms exist to account for short-term deviations from the long-run equilibrium relationship
implied by the cointegration. Moreover, over differencing of nonstationary variables to achieve
stationarity leads to loss of long run properties which can be restored by the error correction term. To

42

test for cointegration among these five non-stationary variables, a procedure developed in Johansen
(1988) and applied in Johansen and Juselius (1990) is applied.

To apply the Johansen procedure (see Johansen, 1988; and Johansen and Juselius, 1990) for
cointegration analysis, the maximum likelihood procedure developed in Johansen (1988) and applied
in Johansen and Juselius (1990) is adopted. Results from the cointegration test are presented in table
4.5 in which the maximal eigenvalue statistics are reported. The cumulative form of the eigenvalue
statistic and/or the trace statistic is not reported. This was because of the advantage of the
econometric package (Eviews 3.0) used in the analysis, which computes the trace statistic
automatically and only reports the number of cointegrating equations.
The eigenvalue statistics reject the null hypothesis that there are zero cointegrating vectors or five
common trends. The test suggests that there are two long-run relationships (see Table 4.5) among the
five variables (CR, INF, IRS, L, and T). However, as shown in table 4.6 only one long run IRS
function has been specified. The normalization process was guided by economic theory, according to
which, IRS is the regressand.
Table 4.5: J ohansen Cointegration Test
Eigenvalue Likelihood
Ratio
5 Percent
Critical Value
1 Percent
Critical Value
Hypothesized
No. of CE(s)
0.492541 146.0758 87.31 96.58 None **
0.320620 75.52846 62.99 70.05 At most 1 **
0.167607 35.32471 42.44 48.45 At most 2
0.114408 16.24583 25.32 30.45 At most 3
0.034115 3.609929 12.25 16.26 At most 4
*(**) denotes rejection of the hypothesis at 5%(1%) significance level

43

L.R. test indicates 2 cointegrating equation(s) at 5% significance level

Source: Authors computations using EVIEWS 3.0

Table 4.6: The Long-Run I RS Function
Normalized Cointegrating Coefficients: 1 Cointegrating Equation(s)
LIRS LCR LINF LL LT @TREND(81:2) C
1.000000 0.132279 0.579640 0.059386 0.365932 0.010196 -6.100510
(0.03724) (0.07741) (0.04449) (0.12000) (0.00290)

Log likelihood 199.2698
In parentheses are t-statistic values and before the parentheses are parameter coefficients.

Source: Authors computations using EVIEWS 3.0


Following the results in table 4.5 cointegration is accepted and therefore the residual generated from
the long run IRS function tabulated in table 4.6 if lagged once (ECT_1) can be used as an error
correction term in the dynamic model.
4.4.4 Estimation of the error correction model
Following Engle-Granger (1987) representation theorem, the third step involved an estimation of the
error correction of the relationship and testing the adequacy of the estimated equation. At this stage,
an error correction specifications of the form
t
k
i
k
i
i t i i t i t
ECT LIRS LZ LIRS c o o o + + A + A + = A

= =

1
1
0 1
0 ,

44

was formulated. Where t
Z
, a vector of cointegrated variables as is defined before and ECT_1

is the
error correction term lagged one period with 1

as a measure of the adjustment mechanism.

The equation above represents the initial overparametized error correction model. At this stage, the
overparametization of the model makes it difficult to be interpreted in any meaningful way.
Accordingly, using Hendrys (1985) general-to-specific approach, one proceeds through a
simplification process to make the model more interpretable and a certainly more prudent
classification of the data. The simplification process, guided by statistical rather than economic
reasons, proceeds principally by setting certain parameters starting with those with t values
between less than one and zero in absolute terms to zero.

The overall validity of the reduction sequence is the need to maximize the goodness of fit of the
model with the minimum number of variables. The model is also to be assessed in terms of the
diagnostic tests such as residual autocorrelation, normality and heteroskedasticity, in addition to
information criterion. The object purpose is to ensure data admissibility and then consider whether
the dynamic responses of the variables conform to theory.
4.4.5 Empirical Results
This section reports the econometric results on the determinants of Interest Rate Spreads in Uganda
during the study period (1981-2008). Using the general-to-specific modeling procedure (as presented
in the preceding section), the analysis began with two lags for each variable, the dummy variable and
the error correction term, ECT_1

(see Table 4.7). The optimal lag length of two (2) was one at which

45

increasing the order of the model by one lag could not be rejected using Akaike Information criterion
test. The results for the overparametized model are presented in table 4.8.
Table 4.7 General model results: Estimation of the I RS Equation
Dependent Variable: DLIRS
Method: Least Squares
Sample(adjusted): 1981:4 2008:1
Included observations: 106 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic
C -0.002397 0.022711 -0.105550
DLIRS_1 0.561228 0.102004 5.502023
DLIRS_2 0.098750 0.110545 0.893294
DLCR -0.035460 0.020701 -1.712936
DLCR_1 0.027274 0.021628 1.261054
DLCR_2 0.015596 0.020788 0.750235
DLINF 0.021927 0.034580 0.634096
DLINF_1 -0.012914 0.036635 -0.352499
DLINF_2 0.030387 0.032998 0.920897
DLL -0.105499 0.038515 -2.739156
DLL_1 0.027159 0.044506 0.610239
DLL_2 -0.038474 0.041928 -0.917628
DLT -0.365279 0.132543 -2.755926
DLT_1 0.171079 0.162488 1.052875
DLT_2 -0.007956 0.137302 -0.057944
D87 0.013707 0.026663 0.514090
ECT_1 -0.161170 0.051019 -3.159023
R-squared 0.469687 Akaike info criterion -1.739156
Adjusted R-squared 0.374350 Prob(F-statistic) 0.000000
S.E. of regression 0.094279 Durbin-Watson stat 2.044888
F-statistic 4.926586

Hendrys (1985) general-to-specific approach was then used to eliminate lags with insignificant
parameter estimates. Accordingly, the overparametized model was reduced until a parsimonious one
was obtained. The estimation results of the parsimonious model are presented in table 4.8.



46

Table 4.8: Preferred/specific Model: Estimation of the Interest Rate spread Model
Dependent Variable: DLIRS
Method: Least Squares
Date: 08/12/09 Time: 15:29
Sample(adjusted): 1981:3 2008:1
Included observations: 107 after adjusting endpoints
Variable Coefficient Std. Error t-Statistic
C 0.000211 0.020732 0.010179
DLIRS_1 0.585723 0.086474 6.773377*
DLCR -0.033503 0.019149 -1.749547***
DLCR_1 0.026409 0.019653 1.343764
DLL -0.090172 0.030185 -2.987291**
DLT -0.364842 0.126418 -2.886004**
DLT_1 0.161197 0.128585 1.253622
D87 0.08382 0.024005 2.349191***
ECT_1 -0.144140 0.037302 -3.864158*
R-squared 0.448796 Akaike info criterion -1.86235
Adjusted R-squared 0.403800 Prob(F-statistic) 0.000000
S.E. of regression 0.091603 Durbin-Watson stat 2.114522
F-statistic 9.974067

*, **, *** indicates significance at 1%, 5% and 10% respectively
4.4.6 Diagnostic tests
Evaluating the general and the preferred model (see Tables4.7 and 4.8 respectively) results, one can
see that the reduction process has eliminated most of the insignificant variables without losing
valuable information. The whole information criterion shows improvement of the results of the
preferred model over the general model. Specifically, the Akaike information criterion (AIC)
declined from -1.739 in the general model to 1.862 in the preferred model (see Tables 4.7 and 4.8
respectively). Furthermore, as the results in tables 4.7 and 4.8 show, the standard error of the model
declined from 0.094 in the general model to 0.092 in the reduced model.

Regression results in table 4.8 show that the goodness of fit (Adj. R-squared) is 0.40, implying that
the regressors in the model explain about 40 percent of the variations in IRS during the 1981-2008

47

period. Thus, about 60 percent of IRS remains unexplained. The F-statistic of 9.974, with probability
value of 0.0000 indicates that the overall model is highly significant. This implies a rejection of the
null hypothesis that all the right hand variables except the constant have zero parameter coefficients.

The Durbin-Watson statistics (DW) does not point to autocorrelation problem. The Jarque-Bera
statistic for testing for normality of the residual for the estimated model is 127.96, with probability
value of 0.016. Therefore, the normality assumption is not rejected. The Auto Regressive
Conditional Heteroskedasticity (ARCH) for stability of the residuals yields an F-statistic of
0.140694, with a probability value of 0.708. This is quite satisfactory in terms of explaining the
coefficient stability of the model. Besides, the residuals are white noise as per the correlogram plot
(not reported herein) of the residuals.

In addition, the Ramsey RESET test for specification error yields F-statistic of 0.000106, with a
probability value of 0.9918. This suggests that the model is not misspecified. Also, the test for serial
correlation among variables in the model using Breusch-Godfrey Serial Correlation LM test was
carried out. The result was an F-statistic of 0.5116, with a probability value of 0.601. This reveals
that there is no serial correlation among variables.

The results of the model evaluation reveal that no weakness has been found. The fundamental
statistical requirements have been adequately met, thus it can be inferred that the empirical results of

48

the model are indeed reliable. The next section discusses the economic interpretation of the
empirical results.
4.5 Key Findings
4.5.1 Interpretation of Empirical results in relation to:
Objective 3: To establish the relationship between credit risk and interest rate spreads
Objective 4: To establish the relationship between credit risk, Macroeconomic factors (Inflation,
Liquidity, and T-bill rate), and Interest rate spread
Objective 5: To establish the relationship between Client-Bank relationship and interest rate spreads

At 1 percent level of significance, the coefficient of the first lags of Interest Rate Spreads (IRS) and
the Error Correction Term (ECT_1) are significantly different from zero. The coefficients of the first
differences of liquidity (L) and T-Bill rate (T) are significantly different from zero at the 5 percent
level. However, coefficients of the first differences of liquidity (L) and the T-bill rate (T) are not
correctly signed as expected. The coefficient of the first difference of Credit Risk (CR) is wrongly
signed but significant at 10 percent level while the coefficients of the first lags for Credit Risk
(CR_1), and t-bill rate (T_1) are insignificant though correctly signed as expected. The coefficient of
the Dummy (D
87
) is wrongly signed from the earlier hypothesized and significant at 10 percent level.

The positive influence of the first lag of the Interest Rate Spreads implies that Banks rely mainly on
the past Interest rates (lending and deposit) to price the current spread and that the higher the lagged
spreads, the higher the current Interest Rate Spreads. In the Ugandan context this could be explained

49

by the fact that in pricing their loans and deposits, Ugandan commercial banks use the magnitude of
the previous spread as a determinant of the current spread probably with little or no consideration of
the fundamentals that determine the spread. One can therefore conclude that in Uganda, current
interest rate spreads (IRS) depend mainly on the magnitude of the previous spreads.

The Error Correction Term (ECT_1) in the model is correctly signed and is significant at 1 percent
level. This confirms the earlier results presented in Table 4.5 that Interest rate Spreads (IRS), Credit
Risk (CR), Inflation (INF), Liquidity (L) and the T-bill rate (T) are cointegrated. The ECT_1
coefficient of -0.144 implies that in each period, the level of Interest Rate Spreads (IRS) adjust by
about 14.4 percent of the gap between the current level and the long run equilibrium level.

The coefficient of the first difference of the variable capturing Liquidity (L) carries a negative sign
and is significant at 5 percent level. This is an indication of the short term negative correlation
between liquidity and Interest rate spreads. This therefore means that where there is low liquidity in
the banks, the interest rate spreads will be higher and vice versa. This is in contradiction with the
earlier hypothesis that assumed a positive relationship between liquidity and interest rate spreads. In
the Ugandan context, this implies that whenever commercial banks are faced with low liquidity
levels, they tend to hike the lending rates for the little liquid assets available. Similarly, where banks
have higher liquidity, ceteris paribus, they are likely to lower the spread due to downward pressure
from the supply side. However, the coefficient of the first lag although insignificant is correctly
signed as predicted. This is an indication that in the long run, liquidity in banks is positively

50

correlated with interest rates spreads. Moreover, some theory points to the fact that high liquidity
increases the marginal cost of deposit mobilization which lowers the likely marginal benefits which
finally makes banks to offer very low deposit rates, tending to increase the spreads (Central Bank of
Solomon Islands, 2007).

The coefficient of the first difference of the T-bill rate (T) has a significant but negative impact on
the interest rate spreads (IRS) at 5percent level. The negative correlation between the T-bill rate (T)
could probably indicate that the deposit rate is more reactive to the T-bill rate than the lending rate
such that the lower the T-bill rate the higher will be the spread and the reverse could also be true. It
could also imply that whenever T-bill rates are lower, Banks compensate for the loss of income from
government papers by exerting an upward pressure on lending rates. However, the first lag of the
same variable (T_1), though correctly signed (positive) is insignificant. This therefore is implicit of
the fact that though in the long run, T-bill Rate has a positive relationship, its insignificance rules out
its predictive power of current interest rate spreads.

The coefficient of the first difference of the variable capturing Credit Risk (CR) is significant at the
10 percent level and negatively signed. The negative relationship between Credit Risk and Interest
rate spreads rejects the earlier hypothesis that credit risk explains the current interest rates spreads in
Uganda and therefore suggests that banks did not attach high enough premium to the lending rates.
In addition, this may be an effect created by smaller banks in Uganda that make riskier or more
diversified loans but also face more competition for deposits which exerts pressure on deposit rates

51

hence narrowing the deposit and lending spreads. Even in the long run (see CR_1) though correctly
signed, the coefficient is completely insignificant. This indicates that in the long run, Credit risk
could probably have an indirect relationship with the interest rate spreads may be via increased cost
of doing business in banks as they spend more on borrower screening and loan recovery efforts or
for being risk averse.

The dummy (D
87
), a variable representing the impact of financial liberalization on Interest rate
Spreads (IRS) has a significant coefficient though wrongly signed at 10 percent level of confidence.
This suggests that the Economic Sector Adjustment Programme (ESAP) instead led to an increase in
the spreads contrary to the earlier hypothesis. Moreover this finding is reinforced by theory as
presented by Nannyonjo(2002), Diaz-Alejandro(1985),Burkett and Dutt(1991), Gibson and
Tsakalotos(1994), Arestis and Demetriades(1997), Chang (1998),Demirguc-Kunt and Huizinga
(1999) in which Financial sector liberalization in particular has been at the root of many recent cases
of high interest rate spreads, bankruptcy of financial institutions and lack of monetary control.
However this contradicts the ever revered McKinnon (1973) and Shaw (1973) financial repression
hypothesis which contend otherwise.
4.5.2 Comparison of Empirical studies on Interest rate spreads with the current study

The current study confirms and at the same time differs with some earlier studies. This is majorly as
a result of inclusion of variables never modeled together before and the differences in the
methodology and specifications used in the various preceding empirical studies. For comparison

52

purposes, table 4.9 provides a summary of empirical findings relating to the study variables from
selected studies both in Uganda and other developing countries.
Table 4.9: Comparison of results of current study with those of others
Variable Current
study
Other studies
Nannyonjo
2002
(Uganda)
Samuel
and
Valderrama
2006
(Barbados)
Crowley
2007(English
speaking
African
Countries
including
Uganda)
Tennant
&Folawewo
2009(Low
&middle income
countries
including
Uganda)
Dabla-
Norris&
Floer
Kemeier
2007
(Armeni
a)
Mlachila &
Chirwa 2002
(Malawi).

Mugume
& Ajwiya
2009
(Uganda)
Lagged
IRS
+ve N.A N.A N.A N.A N.A N/A N/A
Credit Risk -ve -ve -ve N.A N.A N.A +ve +ve
Inflation +ve +ve -ve +ve +ve +ve +ve +ve
Liquidity -ve -ve N.A N.A N.A -ve N/A N/A
T-bill rate -ve +ve +ve N.A +ve N.A N/A +ve
Notes: implies not significant and N.A implies not included in the model
Source: Own compilation

From table 4.9, the current study coefficient of the variable capturing credit risk bears consistency
with results obtained by Nannyonjo (2002) and Samuel and Valderrama (2006) on Ugandan and
Barbados data respectively. Moreover, as indicated by the positive coefficients of inflation variable
by studies of Nannyonjo (2002),Crowley (2007), Tennant and Folawewo (2009), Dabla-Norris and
Floerkemeier (2007), Mlachila and Chirwa (2002), Mugume and Ajwiya (2009) so is the finding of
the current study. Similarly, the coefficient for liquidity is negatively signed which is reinforced by
the empirical results from Nannyonjos (2002), and Dabla-Norris and Kemeier(2007).

The current study however, differs a bit from earlier studies in that it includes other variables not
modeled in other selected studies. For comparative purposes, table 4.9 provides a summary of

53

empirical findings for selected studies both in Uganda and other developing countries. First, whereas
the econometric results of the T-bill rate bear positive influence on Interest Rate Spread in most of
the selected empirical studies, the variable bears negative coefficient in the current study. This could
be attributed to the utilization of interpolated data by quarters and relatively long sample period.
Additionally, data in the current study is not inflation adjusted as it is the case with some empirical
studies.












54

CHAPTER FIVE
CONCLUSION AND POLICY IMPLICATIONS
5.1 Summary
This study investigated the determinants of interest rate spreads in Uganda with a view to identifying
the role of credit risk in explaining the current state of interest rate spreads. The variables used for
the study were: Credit Risk (CR), Inflation (INF), Liquidity (L), T-bill rate (T) and client Bank
relationship (CB). A dummy variable (D
87
) was included as one of the regressors in order to test the
view that financial liberalization policies help to narrow the interest rate spreads. Time series data
was employed and its properties explored. Stationarity tests were carried out using the ADF unit root
testing procedure followed by cointegration analysis developed in Johansen and Juselius (1990). The
study employed econometric analysis in which the Error Correction Term method of modeling was
adopted and applied to restore the lost long term data properties due to differencing while creating a
link between the long run variables and short-run disequilibrium. This was followed by the findings.
The findings bear consistency with the previous studies in Uganda and other country and cross-
country studies in developing countries. However, some of the findings of this study reflect
deviations from the previous empirical studies which could be attributed to the use of different
variable measurements. The next chapter provides the conclusion of this study and policy
implications drawn from the empirical findings


55

5.2 Conclusions
The econometric results reveal that 40 percent of the interest rate spreads can be explained by the
variables under the study. Further, the results indicate that the major determinants of interest rate
spreads in Uganda include; the 91-days Treasury bill rate, Liquidity, and the lagged interest rate
spreads.

Credit risk (CR) was found to be weak in explaining the currently wider interest rate spreads in
Uganda. This is illustrated by the small value of its coefficient with its significance level at 10%.
Moreover financial sector liberalization was found to have a slightly significant effect on the interest
rate spreads but with a wrongly signed coefficient. This was accomplished by the use of a dummy
variable (D
87)
to capture the impact of the Economic Sector Adjustment Programme with effect from
1987. Besides, Inflation rate, and Client Bank relationship were seen to be insignificant in explaining
the interest rate spreads in Uganda.
5.3 Policy Recommendations
The trend of credit risk in Ugandas banking system
The 90s were marked by the worst experience in the countrys banking history when Non
Performing Loans (NPLs) reached unbearable levels. Since then, credit risk as proxied by the NPLs
to total loans advanced has been on a declining trend though punctuated by some upsurges. This
indicates that the Bank of Ugandas strengthening of banking supervisory and its move towards a
risk based approach of banking supervision have yielded positive results. However though, these
results may also be indicative of the deficiencies in assessing credit risk in banks or of the fact that

56

banks have become more risk averse as reflected in the surging demand for government securities
that has crowded-out private sector credit.

It is therefore recommended that commercial banks move from their traditional mechanisms used to
control credit risk, to loan portfolio restructuring. Other options that could be tried for dealing with
credit risk include loan sales and debt-equity swaps but all of which require developed capital
markets.
The state of intermediation spreads in Uganda.
In the last 30 years or so, interest rate spreads in Uganda have more than doubled. This is a worrying
fact given the adversity of high interest rate spreads on growth and macroeconomic equilibrium. The
five variables under study account for 40 percent of the current Interest rate spread state. This
implies that more investment in policy research on the other likely explanatory variables to the
current state of intermediation spreads is required to supplement the current study.

The relationship between credit risk and Interest rate spread.
Empirical results reveal a negative relationship between credit risk and interest rate spreads at 10
percent level of significance. This implies that credit risk is not form the basis for banks decision to
charge higher spreads. Nevertheless, this may reflect deficiencies in assessing of credit risk due to
lack of capacity in the local banks. This therefore implies the need for capacity building within the
individual banks human and technology resources for better credit risk assessment and
management.

57

The relationship between credit risk, Macroeconomic factors (Inflation, Liquidity, and T-bill rate),
Client-Bank relationship; and interest rate spreads.
The empirical results reveal the fact that many of the factors commonly believed to be salient
determinants of interest rate spreads may not be as vital as earlier perceived. Those that have been
revealed to have a significant impact at the different levels of significance are wrongly signed from
the expected. It is therefore recommended that a multidimensional approach to policy directed to
narrowing interest rate spreads (IRS) be adopted.
5.4 Possible Areas for further research
In examining the factors that determine the interest rate spreads in Uganda from 1981 to 2008, the
study limited itself to five variables; that is, Credit risk, Inflation, Liquidity, T-bill rate and Client-
bank relationship. The fact that these variables explain 40 percent of the current status of the interest
rate spreads in Uganda suggests that there are variables that can complement this study in explaining
IRS that deserve a scholarly investigation. To this end therefore, this study could be complimented if
more research is carried out on the quality of credit risk management systems and interest rate
spreads in Ugandas Banking system.






58



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APPENDIX 1
Quarterly data used in the analysis.
Years IRS CR INF L T CB D87
1981 I 7 14.5 56.76667 13.624 7 0.855 0
II 7.125 15.5 65.3375 12.663 8 0.845 0
III 7.25 16.5 73.90833 11.702 9 0.835 0
IV 7.375 17.5 82.47917 10.741 10 0.825 0
1982 I 7.5 18.5 91.05 9.78 11 0.815 0
II 7.0075 18.05 74.3125 23.0225 11.5 0.8195 0
III 6.515 17.6 57.575 36.265 12 0.824 0
IV 6.0225 17.15 40.8375 49.5075 12.5 0.8285 0
1983 I 5.53 16.7 24.1 62.75 13 0.833 0
II 5.0225 18.025 27.4 80.4525 14.5825 0.81975 0
III 4.515 19.35 30.7 98.155 16.165 0.8065 0
IV 4.0075 20.675 34 115.8575 17.7475 0.79325 0
1984 I 3.5 22 37.3 133.56 19.33 0.78 0
II 4.7 22.5 202.9125 117.0094 19.9975 0.775 0
III 5.9 23 368.525 100.4588 20.665 0.77 0
IV 7.1 23.5 534.1375 83.90813 21.3325 0.765 0
1985 I 8.3 24 699.75 67.3575 22 0.76 0
II 9.375 26.325 527.7932 50.80688 24.175 0.73675 0
III 10.45 28.65 355.8364 34.25625 26.35 0.7135 0
IV 11.525 30.975 183.8795 17.70563 28.525 0.69025 0
1986 I 12.6 33.3 11.92273 1.155 30.7 0.667 0
II 11.7625 32.975 11.19934 1.254 31.025 0.67025 0
III 10.925 32.65 10.47595 1.353 31.35 0.6735 0
IV 10.0875 32.325 9.752557 1.452 31.675 0.67675 0
1987 I 9.25 32 9.029167 1.551 32 0.68 0
II 8.6575 31.5 9.300625 2.19425 32.25 0.685 1
III 8.065 31 9.572083 2.8375 32.5 0.69 1
IV 7.4725 30.5 9.843542 3.48075 32.75 0.695 1
1988 I 6.88 30 10.115 4.124 33 0.7 1
II 6.66 32.5 19.24425 4.163 35.5 0.675 1
III 6.44 35 28.37351 4.202 38 0.65 1
IV 6.22 37.5 37.50276 4.241 40.5 0.625 1
1989 I 6 40 46.63201 4.28 43 0.6 1
II 6 39.5 39.93293 9.315 42.5 0.605 1
III 6 39 33.23385 14.35 42 0.61 1
IV 6 38.5 26.53478 19.385 41.5 0.615 1
1990 I 6 38 19.8357 24.42 41 0.62 1
II 7.0625 28.645 22.03394 30.915 39.25 0.71355 1
III 8.125 19.28999 24.23217 37.41 37.5 0.8071 1

71

IV 9.1875 9.934991 26.43041 43.905 35.75 0.90065 1
1991 I 10.25 0.579988 28.62865 50.4 34 0.9942 1
II 8.9425 0.574422 31.18374 78.67 35 0.994256 1
III 7.635 0.568856 33.73883 106.94 36 0.994311 1
IV 6.3275 0.56329 36.29392 135.21 37 0.994367 1
1992 I 5.02 0.557724 38.84901 163.48 38 0.994423 1
II 10.265 0.463313 30.18856 172.76 33.75 0.995367 1
III 15.51 0.368902 21.5281 182.04 29.5 0.996311 1
IV 20.755 0.274491 12.86765 191.32 25.25 0.997255 1
1993 I 26 0.18008 4.20719 200.6 21 0.998199 1
II 24.3225 6.83256 4.867588 243 18.875 0.931674 1
III 22.645 13.48504 5.527985 285.4 16.75 0.86515 1
IV 20.9675 20.13752 6.188383 327.8 14.625 0.798625 1
1994 I 19.29 26.79 6.848781 370.2 12.5 0.7321 1
II 18.1693 29.99349 7.474618 337.9 11.575 0.700065 1
III 17.0485 33.19698 8.100455 305.6 10.65 0.66803 1
IV 15.9278 36.40047 8.726293 273.3 9.725 0.635995 1
1995 I 14.8071 39.60396 9.35213 241 8.8 0.60396 1
II 14.2636 39.26369 8.246653 252.25 9.525 0.607363 1
III 13.72 38.92343 7.141175 263.5 10.25 0.610766 1
IV 13.1765 38.58316 6.035698 274.75 10.975 0.614168 1
1996 I 12.633 38.24289 4.930221 286 11.7 0.617571 1
II 12.9504 35.19813 6.058824 296.75 11.425 0.648019 1
III 13.2679 32.15336 7.187426 307.5 11.15 0.678466 1
IV 13.5854 29.1086 8.316029 318.25 10.875 0.708914 1
1997 13.9029 26.06383 9.444631 329 10.6 0.739362 1
II 13.8605 33.71266 7.660425 344.75 9.8375 0.662873 1
III 13.8181 41.36149 5.876218 360.5 9.075 0.586385 1
IV 13.7757 49.01031 4.092011 376.25 8.3125 0.509897 1
1998 I 13.7333 56.65914 2.307804 392 7.55 0.433409 1
II 14.5202 57.64242 3.777756 489.75 7.5225 0.423576 1
III 15.307 58.6257 5.247708 587.5 7.495 0.413743 1
IV 16.0939 59.60898 6.717659 685.25 7.4675 0.40391 1
1999 I 16.8808 60.59226 8.187611 783 7.44 0.394077 1
II 16.4036 47.92038 7.21004 863.75 8.88 0.520796 1
III 15.9264 35.24851 6.232469 944.5 10.32 0.647515 1
IV 15.4492 22.57664 5.254899 1025.25 11.76 0.774234 1
2000 I 14.9721 9.904762 4.277328 1106 13.2 0.900952 1
II 15.1399 9.060049 4.332523 1152.5 12.65 0.9094 1
III 15.3078 8.215337 4.387718 1199 12.1 0.917847 1
IV 15.4757 7.370624 4.442913 1245.5 11.55 0.926294 1
2001 I 15.6435 6.525912 4.498108 1292 11 0.934741 1
II 15.2535 5.650863 4.779358 1360 9.7125 0.943491 1

72

III 14.8634 4.775815 5.060609 1428 8.425 0.952242 1
IV 14.4733 3.900767 5.341859 1496 7.1375 0.960992 1
2002 I 14.0832 3.025719 5.62311 1564 5.85 0.969743 1
II 13.6182 4.069761 5.665472 1501.5 8.6125 0.959302 1
III 13.1532 5.113804 5.707833 1439 11.375 0.948862 1
IV 12.6882 6.157846 5.750195 1376.5 14.1375 0.938422 1
2003 I 12.2231 7.201889 5.792556 1314 16.9 0.927981 1
II 13.1658 5.938776 6.296407 1370 14.925 0.940612 1
III 14.1085 4.675663 6.800258 1426 12.95 0.953243 1
IV 15.0512 3.41255 7.304108 1482 10.975 0.965874 1
2004 I 15.9939 2.149437 7.807959 1538 9 0.978506 1
II 15.1848 2.188389 6.784517 1543 8.875 0.978116 1
III 14.3757 2.227342 5.761076 1548 8.75 0.977727 1
IV 13.5667 2.266294 4.737634 1553 8.625 0.977337 1
2005 I 12.7576 2.305246 3.714192 1558 8.5 0.976948 1
II 12.8527 2.462934 5.381338 1543.5 8.4 0.975371 1
III 12.9478 2.620621 7.048484 1529 8.3 0.973794 1
IV 13.0429 2.778308 8.71563 1514.5 8.2 0.972217 1
2006 I 13.138 2.935995 10.38278 1500 8.1 0.97064 1
II 13.2509 3.225456 9.061124 1547 8.35 0.967745 1
III 13.3639 3.514916 7.739471 1594 8.6 0.964851 1
IV 13.4768 3.804376 6.417819 1641 8.85 0.961956 1
2007 I 13.5898 4.093836 5.096167 1688 9.1 0.959062 1
II 13.6054 3.621038 7.178436 1830.5 9.075 0.96379 1
III 13.621 3.14824 9.260704 1973 9.05 0.968518 1
IV 13.6366 2.675441 11.34297 2115.5 9.025 0.973246 1
2008 I 13.6522 2.202643 13.42524 2258 9 0.977974 1