How looming COVID-19 liquidity shock could collapse the local financial system

Bank Financial Risk Managers in the past 12 years have been the busiest bunch recovering from the aftermath of the financial crisis of 2007-2008. These particular effects have brought about the adoption of more robust and prudent credit risk models such as the prominent International Financial Reporting Standards 9 (IFRS9) that was fully adopted in Uganda in 2018. However, these models are not cover enough when the economy is threatened to collapse in the shortest time possible.

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While this lockdown has not restricted banks from carrying out their activities, there has been a significant decline in a number of transactions and business carried out at these intermediaries with most people looking to fast-move on most of the high-risk banks. But this only applies to rational clients who can tell what high risk and low risk is. Nevertheless, most of the high-risk banks have rational clients and these clients are there to leverage from the extra reward given to them for taking this risk. However, when the risk goes beyond a certain level of tolerance, we will soon be clattered with a host of bailout applications.

Like Bernanke stated during the aftermath of the financial crisis of 2008 before the Financial Crisis Inquiry Commission on 2^nd September 2010, “Should the safety of their investments come into question, it is easier and safer to withdraw funds than to invest time and resources to evaluate in detail whether their investment is, in fact, safe”, earmarking the run on banks.

For our case, we are going to assess Centenary bank, a commercial bank with a high loan to deposit ratio and one whose impact has not been globally diversified. Centenary Bank has for many years been the dominant local bank. However, Centenary is not listed. Financial analysts have put the price per share for its listing at highs of Ugx. 2,555 and lows of Ugx. 2,028 guaranteeing investors projected rates of return close to 100% over and above their cost of capital of just about 15.6%. This is the perfect case to assess as most banks have diversified into a number of different entities and have drifted away from traditional commercial banking. By the time this article is published, Centenary bank had not published its 2019 financial year report and so we shall project the financials for 2019. The financial information used in this case is published audited reports.

How the bank has performed over the past years.

Centenary’s deposit growth has averaged 18.4% from 2016 to 2018 growing from Ugx. 1.6 trillion to 2.82 trillion. We project further growth to not less than Ugx. 2.6 trillion in 2019 financials which we will confirm a few weeks from now. During the same period, the bank disbursed more than Ugx 140 billion in loans making a profit after tax of more than Ugx. 107 billion. But their performance is not our goal here. We want to look at the impact this lockdown would impose on Centenary Bank and how what risk Centenary Bank might be exposed to if this persists over a year.

First, let’s take the financial projections that would we not experienced this storm. The balance sheet below shows projected asset liability management in case there was no pandemic.

The bank’s assets would grow from Ugx. 3.67 billion to Ugx. 4.3 billion and attracting customer deposits of over Ugx. 3.2 billion due to the healthy condition the company would be in. This would lead to a growth in profit to Ugx. 149.6 billion on the high note, Ugx. 147.2 billion if the economy was to remain the same, and considering elections were around the corner, a more realistic bottom-line number would be the Ugx. 144.8 billion. Either way, the profit was growing to grow relative to 2019.

This would give Centenary a cushion to absorb high-risk assets, inform of default and still encourage business growth through extensive lending. Also, more interest would be recovered compared to the previous year. The bank is also projected to reduce the total number of write-offs with more efficient loan mechanisms supported by the adoption of IFRS 9 credit risk assessment models.

The Financial Tempest that is COVID-19

This, however, is not the case. 2020 can only be described as a financial tempest, a tempest because it has stormed many markets across the global economy including the real sector, where more than 90% of their customer deposits are from the real sector.

The panic that the pandemic lockdown brought to the economy triggered what we call fast movers, those clients who will want to withdraw their money early with looming risk of assets. The panic is projected to reduce customer deposits in banks as these monies are being withdrawn at voluminous rates for companies and individuals to prepare for the shortage. While inflation is rising at extensive rates, the high prices on essential products have also soared. This means clients will withdraw more than they normally do and considering the panic, most of them if not all will want to have their money at hand rather than in an institution as the opportunity cost might be extremely high.

Increasing counter-party risk will further reduce liquidity as inter-bank borrowings will be limited and at a high-interest rate. The following asset liability projection will be as a result of the looming financial crisis as a result of the global pandemic.

Commercial banks like Centenary Bank will experience a loss spiral, where a decline in the value of their assets will erode the bank’s enterprise value and push their share value on any exchange to lows of Ugx. 278.2 per share falling by more than 89.1% in net worth. Rates of return are also set to fall fro close to 100% to less than 6% way below the bank’s cost of capital.

While depositors will continue demanding their monies, they will leave the banks with no option than to sale their assets at lower amounts than their fair value in order to cover their obligations, which they might or might not cover.

A projected loss after tax of more than Ugx. 292 billion will leave the bank in the negative cash balance, which will require it to source at least Ugx. 381 billion from its stakeholders to continue operating and this is only if the pandemic lockdowns last not more than a year. A persistent lockdown will pose further harm.

A reduction in customer deposits, increasing default rates on financial assets, delayed payments from institutional and government investments and last but not least, a prudent interbank market will generate a never-ending spiral until a number of these financial institutions and intermediaries collapse if there is no clear intervention.

While IFRS9 called for prudence, there has been no financial institution of sorts especially these on Uganda that had projected a steep liquidity bubble.

How they can retaliate to these shocks

It’s time the banks accessed their capital reserves from the Central Bank

Banks have for many years-maintained capitals with Bank of Uganda with tier 1 required to have at least Ugx. 25 billion and tier 2 to have at least Ugx. 1 billion. These reserves should be accessed to boost liquidity in these trying times. However, this will only cover a little of their liquidity problems. Banks that will fall short of more than Ugx. 600 billion, the likes of Stanbic Bank Uganda might not have enough coverage in these times.

The Fed in the United States has already passed this and big banks have been able to access their reserves to cover for short term liquidity problems.

Bank of Uganda repurchase agreements should also include a cushion to protect current assets

There is a threat to these companies balance sheets as they will have credit-impaired assets of more than Ugx. 100 billion especially for those banks that have lent to individuals like Centenary. These assets are set to default on their payments as most businesses have closed. We expect this figure to soar even bigger on a bottom-up assessment of each facility.

Repos should also have extended periods. Bank of Uganda should give these banks at least 6-months to part with the liquidity they have borrowed for the short term. This will also prevent these banks from precautionary hoarding.

In case of the bailout, the Central Bank should issue a Wealth Fund in form of convertible debt

Banks that will struggle and fail to come out of this liquidity dump will ask for bailouts. Of course, the government has bailed out a number of firms but at what cost. Bailouts are good if the management teams learn from what happened. However, those firms that have been applying for persistent bailout might have to offer BoU equity holdings in exchange for financial aid.

Like a private equity firm, the government should aid these banks with what is known as convertible bonds. These bonds finance companies for a given period of time after which can be converted into equity which government can take over as stake or opt-out and sell them back to them. Once the COVID-19 is subdued and there are no more lockdowns, BoU can decide on which side to take, either to sell back the securities to the banks or take up a stake in these companies.

This fund will then be financed either by selling back that stake at an interest or maintaining their share positions. All the liquidity leveraged from each year will be reinvested in the wealth fund for future shocks. Reason being, to bail out these firms, we might need more than a trillion shillings. Let the central bank use this as an opportunity to prepare for other crises.

Bank of Uganda should increase the interest rates on treasuries to attract more liquidity to the financial markets

While the 10-year average treasury bill rate is just about 13%, BoU should further increase this rate to attract investors in purchasing these securities for short term liquidity problems. The rate should go up as high as 18%, which is the market risk premium for financial institutions in Uganda. This will also attract funding from global markets and although it will increase the level of nonsovereign debt, it will definitely boost the economy for short term liquidity problems. Uganda’s nonsovereign debt problems will worsen. External debt stood at US$ 292.3 million (More than a trillion Uganda shillings). We will do with any type of short-term liquidity for now. Otherwise, a number of top banks will sink.

These funds that BoU will source should, in turn, be used to buy-back the government securities issued in the previous term. In 2018 alone, Centenary Bank had bought government securities of more than Ugx. 900 billion. Of course, we do not mean buying back all these, but getting back what would be sufficient to help these institutions survive over at least a year.

Institutional M&A should be encouraged for banks on life support

There are banks which were already in the RedZone prior to this pandemic. The summit Bank analysis report highlighted some of these banks. These banks should look to making horizontal mergers in order to offset the risks they are exposed to especially those to do with liquidity.

Vertical mergers will also be encouraged for those top banks that are primarily focused on high-risk products during financial crises. Mortgage focused banks have been exposed to the highest risk yet again. The likes of Housing Finance Bank that have been with projected liquidity problems will continue to struggle in the coming months. This means they should restrict their lending away from Mortgages for the short term and refinance this product after the tempest has settled. These institutions should look to merge with smaller institutions like tier 2 or tier 3 deposit-taking institutions to diversify this liquidity risk exposure.

Most of these smaller players might not survive this storm. Although Bear Stearns was a significant global investment bank, it had to be sold to JPMorgan Chase in 2008, whose crisis was a prelude to the risk management meltdown of investment banking in the United States.

Issuing Fixed Income Securities at a cost though that can be recovered.

In a time of a crisis, fixed income securities could be a form of last resort as the markets lack liquidity. But issuing high yield debt securities like bonds will attract big investors who have ample liquidity and will be willing to invest. Selling bonds over and above the current risk-free rate of around 13-14% would give investors the opportunity to think. Going over and above the market risk premium for financial institutions (18%) will more than guarantee these inflows.

Need to reduce the dependence on brick and motor mechanisms

DFCU bank has recently left many of the buildings it took over in the acquisition of Crane Bank’s assets. This consequently boosted their profit after tax by 21% year on year. This should be the move most financial institutions that have a lot of fixed assets should do as they move to adopt digital means. Of course, not many people will love to hear this. While it threatens a number of jobs, it should also open up space for new careers in Cyber Security, Risk Management, Business Analytics and Intelligence. The cost on fixed assets remains the big hurdle for institutions big and small but can be offset with optimization. But that doesn’t mean closing every branch but optimizing business applications that when they are not functional could still yield leverage.

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