FOR OFFICIAL USE ONLY

FINANCIAL SECTOR ASSESSMENT UPDATE UGANDA MAY 2005

FINANCIAL SECTOR VICE PRESIDENCY AFRICA REGION VICE PRESIDENCY

Based on the Joint IMF-World Bank FSAP Aide-MCmoire

A joint International Monetary Fund-World Bank team conducted an assessment update o f Uganda’s financial system in connection with the Financial Sector Assessment Program (FSAP) through one mission in November, 2004. The purpose o f the mission was to help the Ugandan authorities identify financial system strengths and weaknesses with a view to implementing an action plan to increase the system’s contribution to economic development.

OVERALL ASSESSMENT: PROGRESS SINCE 2001 FSAP AND POLICY AGENDA

1. following decades of civil war and economic mismanagement prior to 1987. Economic liberalization and prudent policies have resulted in generally high growth and low inflation. These achievements have led to strong support from the international community resulting in large donor inflows and substantial debt relief.

The Ugandan economy has benefited from bold and comprehensive reforms

2. FSAP recommendations. Key developments include: (i) the privatization o f Uganda Commercial Bank Limited (UCBL) to a reputable bank; (ii) the clean up o f some small weak banks from the banking system; (iii) substantial improvements to banking supervision with the introduction o f a risk-based approach and passage o f the new Financial Institutions Act (FIA); (iv) the preparation o f AML/CFT legislation and o f a credit framework for monitoring and enforcing it; and (v) the presence o f banks that appear to be well capitalized, profitable, and resilient. Generally, progress in reforming the banking sector been faster than in the NBFI sector.

The authorities have made good progress in implementing many of the 2001

I The mission comprised Messrs. Fuchs (Team Leader, World Bank), Teo (Deputy Team Leader, IMF); Hayward (Bank o f England and IMF (retired)), Peiris, Yokobori (all IMF); Beck, Costain, Cuevas, Impavido, Vassilou, and Keppler (all World Bank). An AML/CFT mission visited Kampala f rom February 14-23,2005 in connection with this update.

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3. The key finding of this FSAP Update is that the banking system i s sound but continues to play a limited role in supporting economic development. Financial intermediation continues to be l o w in both relative and absolute terms. Whi le the banking system is healthy, i t i s s t i l l small, faces relatively high costs, and offers a limited array o f products most o f which are l imi ted to the short-end o f the maturity curve. Institutions that could provide long-term savings and investment such as pension funds, insurance companies, and capital markets continue to face serious challenges.

4. The 2004 FSAP Update therefore focused on measures that could be taken to increase intermediation. However, it will take some t ime for confidence to build and for intermediation to deepen. Many changes such as the privatization o f U C B L are relatively recent, Given progress in liberalizing the sector, it would be counterproductive to re- introduce policies that attempt to induce greater intermediation through administrative means, in an attempt to speed up the process.

The FSAP 2004 recommends measures that will improve the reach and efficiency of the banking system, specifically, and the financial system more generally. These include measures to improve the environment to support lending and foster greater competition that would reduce costs faced by institutions and increase their efficiency, so that the sector would be able to provide a wider range o f services to a larger segment o f the population, and increase i t s role in supporting economic development. On outreach, the authorities are encouraged to focus their efforts o n a smaller number o f high performing entities and to minimize distortions introduced by government or pol i t ical interference in microfinance.

5. investment. Therefore steps are recommended to restructure the pension system, promote long-term financing, and develop capital markets. These reforms are necessary in order to provide markets and instruments for Ugandans to save and invest, to increase term financing necessary for growth, as we l l as to reduce dependence o n donors. Particularly important are steps to reform the pension system and deal with UDBL.

There i s also a need to increase domestic saving in order to support much needed

6. supervision and regulation as well as systemic liquidity management. Uganda has recently passed the new FIA and i s moving toward risk-based supervision. The main challenge in this area i s to fully implement these changes. The authorities will have to stay abreast o f developments in the sector as competition increases and the market becomes more sophisticated. The transfer o f project accounts to the central bank f r o m commercial banks should also be done cautiously to avoid potential disruption in liquidity as wel l as to ensure these accounts are serviced in a cost efficient manner.

At the same time, the team supports continued efforts to improve prudential

7. There i s a real and current threat posed by both money laundering and terrorist financing. While there i s a pol i t ical will to fight corruption the AML l a w has not been given a high enough pol i t ical pr ior i ty to get the draft legislation enacted in a t imely fashion.

8. Other key elements that are necessary for financial sector growth also need to be managed. One i s the economy’s dependence on agriculture that leaves Uganda vulnerable to external shocks. Another factor i s the country’s dependence o n foreign donor inflows. Aid

flows should help reduce poverty and increase investment, but their size complicates macroeconomic management. Increasing the economy’s absorptive capacity will reduce pressures on monetary and fiscal policies which currently bear the burden for sterilizing these large donor inflows. O f course, efforts to diversify the economy and increase absorptive capacity will take time. Finally, continued uncertainties over a return to a multi-party system and political succession as well as insurgencies in parts o f the region can have an effect on confidence. Public confidence in medium- to longer-term prospects i s necessary for intermediation to deepen and recommendations discussed in this update to be effective.

I. EFFICIENCY AND OUTREACH OF THE FINANCIAL SYSTEM

A. A Healthy But Underdeveloped Financial System

9. The Ugandan financial system i s growing but still small and underdeveloped, and it offers a limited array of products, mostly to the short end o f the maturity curve. Financial intermediation i s low, and dominated by commercial banks. Only 17 percent o f total deposits are time deposits, and less than 0.4 percent o f time deposits have a maturity o f more than 12 months. Twelve percent o f all loans and 35 percent o f loan volume has an outstanding maturity o f more than one year. While the share o f long-term lending seems reasonably high by regional standards, it i s mostly limited to on-lending o f a European Investment Bank (EIB) Line o f Credit, channeled through the Department o f Development Finance (DFD). Both the leasing and the mortgage markets are essentially limited to two providers each. Leasing and housing finance alike suffer from the lack o f medium-to long- term funding sources. There i s no factoring yet.

10. The banking system i s sound but i s not efficient as reflected in the high spreads paid by borrowers, which are strongly related to high operating costs. While significant achievements occurred since the 2001 FSAP, the system s t i l l faces inefficiencies that diminish the banking system’s role in the economy. N e t interest margin and overhead costs, both relative to total earning assets and calculated over a sample o f banks, are higher than in Tanzania and Kenya and above the averages for Sub-Saharan Africa and the low-income group. This suggests inefficiencies in the system that may arise out o f higher operating costs, i t s small size, and/or l ow level o f competition. Interest rate spreads are currently 20 percent and have not dropped below 16 percent over the last six years. Decomposition o f spreads shows that operating costs constitute almost 50 percent o f the spread (nine percentage points) with profits being the second largest component with 30 percent o f the overall spread (six percentage points).

11, The high operating costs can be explained by the small size o f the system, its recent efforts to increase outreach, and also by high credit risk. While the Kenyan and Ugandan banking markets share many characteristics, such as high costs for security and high salaries, the Ugandan banking system has attained a relatively-given i t s low level o f intermediation-larger degree o f outreach and has recently invested heavily in physical infrastructure such as branches and ATMs. These higher costs might explain part o f the extraordinarily high operational costs. High credit risk i s also partly responsible for high interest spreads. The high overhead costs and the high profit margin can also be partly

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explained by high credit risk, as banks incur high evaluation, monitoring and enforcement costs.

12. fostering competition offer the most promising areas to reduce overhead costs and interest spreads in the medium- to long-term. Establishing a credit reference bureau, improving the legal system, fostering competition by allowing innovative and professional entrants, improving the transparency o f banking costs, and broadening access to the payment system by bank-like institutions can help reduce overhead costs and interest spreads in the medium- to long-term.

Improvements that could be made in the legal and information environment and

13. and Tier 1 and 3 institutions are key players in the provision o f services. Branches o f financial institutions o f Tiers 1 to 3 (see Annex I1 for an explanation o f the terms used in the Ugandan classification o f intermediaries) exist in 5 1 o f the 55 districts in the country, and population per bank branch i s in the order o f 87 thousand people, when all three Tiers are considered, a substantial coverage by African standards. The total number o f deposit accounts held in financial institutions i s estimated to be just over 1.7 million, or about 35 percent o f the total number o f households. Depth o f outreach i s also noteworthy as loans and deposits are concentrated in relatively small amounts. Together these two Tiers combined- 15 banks and 4 Micro Deposit-Taking Institutions (MD1s)-dominate the markets for loans and deposits.

Financial institutions have improved access to financial services of its population

14. Gaps remain in the provision of deposit and payment services in rural areas, and in financing agriculture and rural enterprises. Although the coverage o f deposit accounts as a proportion o f the total number o f households i s relatively large, only about 11 percent o f bank credit i s reported as being allocated to agriculture. Notwithstanding the likely underestimation o f this statistic, the contrast with the importance o f agriculture to the economy i s more acute than in most other countries.

15. The PostBank remains an important provider o f deposit services, although its asset management continues to be an issue requiring attention. PostBank’s attempts to engage in wholesale and retail lending raises concerns. In particular, i t s intended targets for wholesale lending may require assessment sk i l ls which PostBank does not seem to have. A more immediate step (as recommended below) would be to grant PostBank access to the clearing house, where due to i t s role as a savings depository, i t would always be a net creditor.

16. Financing o f established small- and medium-scale enterprises (SMEs) i s somewhat limited, while start-ups are primarily financed with their own funds. A recent assessment o f the investment climate in Uganda reports that about one-fourth o f established SMEs considered themselves “credit constrained” (40 percent among microenterprises), while the Uganda National Household Survey (UNHS) reports that less than 6 percent o f enterprise start-ups are financed with borrowings. Uganda compares unfavorably with Kenya in terms o f firms’ access to extemal sources o f funds.

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B. I m p r o v i n g Financial System Eff ic iency and Outreach

17. T h e prov is ion in the new FIA to al low f o r i n fo rma t ion shar ing be tween f inancial inst i tut ions is a posit ive development tha t needs to be fol lowed up by the speedy licensing and establishment o f a Cred i t Bureau tha t allows f o r shar ing o f (negative and positive) information.2.

18. Accurate and rel iable in format ion about borrowers and the i r assets i s difficult, if n o t impossible, t o obta in because o f deficiencies in the l a n d and company registries thus increasing the cost o f credit. The land registry i s in a chaotic state, with f i les regularly lost or misplaced, and lengthy delays common. The creation, registration and enforcement o f security rights in land i s severely hampered by: (i) uncertainties in land t i t le arising from the rights o f non-owner occupiers o f the land; (ii) contests to enforcement actions by the legal owner’s spouse and dependants resident on the land; (iii) delays and costs associated with land registry searches and securing registration o f mortgages; (iv) deceptive practices by borrowers; and (v) the ease with which injunctions can be obtained and caveats lodged.

19. Company and insolvency laws are outmoded and insolvency regulat ion and administrat ions are costly, ineff icient and subject t o abuse. Excessive fees, which are normally calculated by reference to a percentage o f recoveries, underscore the disposal culture in insolvency matters and the failure to engage in any sort o f turnaround management. Only a limited number o f accountants and lawyers understand insolvency issues, and auctioneers and court bailiffs are commonly appointed as receivers and managers3 The Official Receivers Department i s inadequately resourced and subject to a high degree o f political interference. The Commercial Court has improved the handling o f commercial and insolvency cases but needs more resources, specialized judicial training and judges .

20. In September 2004 the Uganda L a w R e f o r m Commission issued a repo r t with 35 proposals f o r a substantial overhaul o f the country’s f o r m a l insolvency system. Many o f these proposals are commendable and should be implemented. It i s strongly recommended the introduction o f a new corporate rescue procedure known as provisional administration, under which the debtor’s board may appoint a provisional administrator to develop reorganization plans for approval by creditors with a moratorium or stay on creditor claims imposed during the provisional administration.

21. T h e taxat ion system should be reviewed so as to faci l i tate the operation o f corporate insolvency procedures and n o n pe r fo rm ing loans (NPL) resolution. Tax

* The BOU has issued the Credit Reference Bureau Regulations 2004, on February 5,2005, which specify the prudential requirements for licensing and supervising the operations o f credit reference bureaus.

The ULRC proposals for regulation stipulate that only accountants, auditor and lawyers may act as insolvency 3

practitioners, which i s commendable.

These include: purpose built premises, replacements for the two externally funded advisors assisting the court whose terms expire next year, access to international insolvency judgments, more judges, higher levels o f remuneration for judges to attract top legal talent, and exposure to case management procedures used by developed insolvency courts and registries in other jurisdiction, and specialized insolvency judicial training.

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consequences o f debt forgiveness should be addressed. Special exemptions or waivers might be made available to creditors or debtors in insolvency or restructuring scenarios. Some impediments should be removed, such as the taxation arrears liability in receiverships, as well as the clearance requirements by taxation authorities before assets can be sold.

22. would enhance competition. The B O U and banks may want to consider efforts in improving transparency o f bank fees and charges, such as publication and comparison o f fees by a consumer advocacy group, and more generally efforts to improve public understanding o f banking services. B O U should also consider publishing effective lending rates and deposit interest rates and non-interest charges on i t s web-site to further foster competition and transparency.

Improved disclosure and transparency o f interest and account-related charges

23. financial system can help increase competition in the financial system. In spite o f the current moratorium on new bank licenses, the B O U i s encouraged to carefully assess new applications for bank licenses, taking into account the positive effect that innovative and professional entrants could have on the competitiveness o f the financial system. More importantly, a complete integration o f Tier 3 institutions in the financial system, including into the payment system and the intended credit bureau, i s encouraged.

Keeping the banking system contestable and reducing segmentation wi th in the

24. institutions (MDIs) have been key elements o f Uganda’s sustainable outreach expansion and have placed Uganda at the forefront o f microfinance development in the Afr ica region. The issuing o f the MDI Act in 2003, the creation o f supervisory capacity at BOU, and the support programs to the top microfinance institutions to enable them to meet the MDI Act’s standards are major milestones in the development o f the Uganda financial system. Once the current four applicants to Tier 3 status obtain their licenses, as seems likely, i t i s foreseen that only three or four other NGO-MFIs would appear to be in a position to apply, assuming at least three or four additional years o f technical assistance including institutional strengthening.

The legal reforms enacted in 2003 and the transformation o f MFIs into Tier 3

25. even add value to these standards, the licensing o f the f i r s t four applicants currently in process will test the adequacy o f the law and regulations. In particular, the way in which the authorities apply the 30 percent limit on single shareholding may set important precedents for future entrants. As MFIs are normally financed by one or perhaps a few sponsoring agencies, application o f this ru le would require divestiture by these agencies so as to live up to the MDI Act’s diversification requirements.

While the MDI Ac t and i t s regulations follow international good practice and

26. Concerns regarding the safety o f small-balance deposits in unregulated institutions should b e addressed through outreach expansion o f regulated institutions into unserved areas, and a drastic restructuring o f the Savings and Credit Cooperatives (SACCOs) sub-sector. Basic mandatory prudential standards, governance and transparency requirements should be established and enforced for existing SACCOs, and technical assistance will help meet those standards within an established timeframe. In addition, transparency and consumer protection in the operations o f credit-only MFIs o f sufficient

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scale should be increased through the Association o f Microfinance Institutions in Uganda (AMFIU) non-prudential standards-setting and donor support o f compliance therewith.

27. inst i tut ions and h igh-per forming T i e r 4 ent i t ies should be key pr ior i t ies o f government programs, a t the expense o f support ing new Tier 4 entrants. The Microfinance Outreach Plan (MOP) may risk fostering detrimental proliferation o f small entities, thus compounding the severity o f supervision constraints, and i s likely to run into key capacity bottlenecks in terms o f ownership and governance, management and marketing ski l ls . Further, the reported emergence o f “briefcase” MFIs or pseudo-SACCOs works against the general direction o f financial sector development in Uganda.

Expansion o f b r a n c h networks and product innovat ion o f regulated f inancial

28. be in t roducing distort ions a n d underm in ing the v iab i l i ty o f MFIs and SACCOs by weakening credi t culture. Aimed at rural microfinance, most o f MSCL funds are allocated to on-lending through MFIs and SACCOs, whose track record and performance i s not clearly known. It i s suggested that MSCL management strictly adheres to i t s performance standards and excludes from further lending non-compliant MFIs and SACCOs. Partially re-allocating MSCL funds away from on-lending and into capacity building and innovation TA for program participants i s strongly recommended. Such a blend of MSCL support would be more in l ine with the main thrust o f Uganda’s commendable strategy to improve access to finance based on solid institutions. In addition, a careful analysis o f the terms o f on-lending may be warranted to develop guidelines for all government- and donor-funded lines o f credit.

Subsidized lending by the Microf inance Suppor t Center Ltd. (MSCL) is l ikely to

29. warehouse receipts legislation, and marke t i n fo rma t ion systems are k e y elements f o r improv ing rural a n d agr icu l tura l finance, as they would have multiplier effects in facilitating the financing o f marketing and farm production. Three-party contracting (bank, marketing/processing firm, producer) could be more broadly used, provided better and modern marketing and processing firms are put in place. For i t s part, the Plan for Modernization o f Agriculture (PMA) has prepared new legislation on warehouse receipts, expected to be considered by Parliament in March 2005, and has carried out a pilot initiative on market information (Foodnet) with seemingly promising results.

Pr ivate investment in marke t i ng and processing, f inanc ing the marke t i ng chain,

30. as regards adopt ion o f a v is ion f o r the development o f the payments system, use o f electronic funds transfer i s extremely l imited. A Real Time Gross Settlement (RTGS) system for large value payments will be introduced by mid-2005. There will then be an Automated Clearing House (ACH), an electronic low value system, and a special purpose large value system; thus a sufficient range o f payment mechanisms will be available. However, there i s s t i l l very l i t t le use being made o f non-check instruments due to a distinct lack o f interest in promoting these instruments by the banks.

W h i l e Uganda is, in b road terms, in l ine with i t s East A f r i c a n Commun i t y peers

3 1. system w o r k f o r a l l segments o f the populat ion, but effective implementat ion o f this agreed vision i s lagging. Specifically, and as a first-priority measure, access to the payment systems should be extended to institutions other than those categorized as commercial banks,

The BOU a n d t h e banking indus t r y recognize the need t o m a k e the payments

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i.e., Tier 2 NBFIs and newly accredited MDIs. In this regard, a proactive educational and outreach program might be designed and executed by B O U to sensitize the population as to the potential benefits available from using the now available electronic services.

11. PROMOTING TERM FINANCING AND DEVELOPING CAPITAL MARKETS

32. the authorit ies are n o w focusing o n issues related t o longer- term f inance that are facing the development o f t he f inancial sector. As the authorities proceed with this reform agenda, it i s recommended that priority be given to: (i) reforming the National Social Security Fund (NSSF) and the pension sector more generally, (ii) phasing out distortions in the provision o f term finance, (iii) moving expeditiously to deal with UDBL restructuring, and (iv) developing the domestic capital market. All are necessary in order to support the development o f longer-term finance and economic growth.

Given the progress that has been achieved in creat ing a sound f inancial system,

A. Pensions

33. Pension r e f o r m can have a significant positive impac t b o t h in p rov id ing protection to Ugandans in o l d age and in st imulat ing savings and the development o f the marke t f o r longer- term finance. The Ministry o f Finance i s in the process o f finalizing a cabinet paper relating to the reform o f the Ugandan pension system. The general thrust o f the vision under discussion i s well conceived. Given the importance o f NSSF as an investor and the recent suspension o f i t s board, first priority should be given to the reform o f NSSF.

34. A three-pronged approach t o the rest ructur ing o f the NSSF i s proposed: (i) contributors would be given the option to establish their own retirement benefit schemes in l ieu o f contributing to the NSSF once a regulatory and supervisory framework has been established; (ii) immediate steps should be taken to improve governance; and (iii) concurrent with the restructuring o f the governance o f NSSF, steps should be taken to strengthen the investment process and ensure professional management o f the NSSF’s assets.

35. P r i o r i t y should be given t o the establishment o f a new ret i rement benefi t regulator and supervisor to oversee al l ret i rement benefits schemes in Uganda (public and private). Given the small size o f the insurance, pension and capital markets, a unified authority to supervise these three market segments would seem rational and appr~pr ia te.~ This move would, however, require a substantial revision o f the Capital Markets Authority Statute, not only to encompass the complexities o f the pension business but also to accommodate the much increased dealings with the general public that would be required.

36. As a f i r s t step in re fo rm ing Publ ic Sector Pension Fund (PSPF) it i s necessary to ver i fy the claims beh ind the ident i f ied arrears, improve o n the arrears estimates, and budget f o r and m a k e payments. The current PSPF has accumulated substantial arrears that are estimated around U S $ l SO-$200 million. It i s Iikely that for some categories o f arrears verification will be almost impossible. Given budget constraints it i s unlikely that i t will be

’ As i s the case in South Afr ica and Mauritius, for instance.

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possible to pay arrears in their entirety. A political solution needs to be reached between the government and individual or groups o f claimants in respect o f payment o f arrears.

37. A second important step in reforming PSPF i s to undertake an actuarial evaluation o f t h e scheme, specifying the valuation bases, the economic and demographic assumptions and the reliability (or otherwise) o f the data. The review should define a baseline scenario for all sub-schemes in PSPF, and provide alternative simulation scenarios for reforming PSPF. After the actuarial evaluation i s conducted, policy decisions can be taken on aspects o f the scheme’s design such as the benefit formula and the choice o f financing mechanisms.

38. established in the fo rm o f a trust, the PSPF bill may not b e required. A simple deed of trust with scheme bylaws to be approved by the future pension regulator would suffice to establish a new occupational pension scheme for c iv i l servants. Should a separate PSPF Act be required, i t s drafting should await the outcome o f actuarial evaluation o f the current scheme and comply with governance and design standards contained in the law setting up the new regulatory authority. In addition, a simple tax-expenditure regime should apply to all pension funds in Uganda.

I f the authorities adopt the recommendation that a l l pension funds in Uganda be

B. Improv ing the Availabil ity o f Term Financing

39. The availability o f term funds in Uganda i s supported by several facilities administered by the DFD. Term facilities offered by the EIB at a concessional rate o f 1 percent have been made available for general commercial purposes through DFD under four Apex loans. The total amount o f DFD facilities (approximately U Sh 122 billion) i s quite substantial in comparison with the total loan financing made available by the commercial banking sector (U Sh 1,000 billion),

40. While the shortfall in available term finance would appear to justify additional credi t support provision f rom donors, the guiding tenet o f this support should be that credit i s allocated by a qualified financial intermediary at market prices, with appropriate incentives, governance and controls to align interests with those o f the government and supporting donor. Given the long term financing needs by clients o f all sizes, a facility along the lines o f the EIB Apex facility - but at market rates - could help provide credit support to financial intermediaries to lend to clients. However, considering the liquidity in the Ugandan market, it may be preferable that such credit support takes the form o f a refinancing facility which would undertake to purchase loans, including fixed rate loans, at face value from commercial banks after a stated period so long as they are performing.

41. investment in Uganda, i t s substantial scale and non-market terms do not contribute to developing sustainable local capacity.6 Future EIB loans and other donor credits should be

While the EIB facility has undoubtedly succeeded in i t s purpose o f supporting

While it i s noted that EIB funds are onlent to banks at the average o f the 12 month deposit rate, the funds are for a significantly longer tenor (up to 15 years), the loan rate i s the same for a l l banks, regardless o f credit quality, and using the bank deposit rate for wholesale funds ignores the significant overhead expenses

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provided to commercial banks at markets rates, reflecting risks so as to minimize distortions to the market, and in particular to retain an incentive for local intermediaries to develop altemative market-based sourced o f long-term funding.’

C. Uganda Development Bank

42. the DFD to a reputable finance institution should be expedited. Only by instituting strong internal management will i t be possible for the restructured UDBL to avoid government directed lending and governance problems that had led to it i s insolvency in the past. Moving DFD outside the B O U will also do away with any potential conflict o f interest that might arise at the BOU. The key objective will be to allow UDBL to operate on commercial terms while s t i l l allowing for the fulfilment o f a developmental role in recognition o f the existence of projects that are economically attractive but not commercially viable (i.e., those projects which provide strong extemalities that can not be recouped in user fees, such as rural electrification or urban water and sewerage). To meet these twin objectives it will be paramount to ensure that procedures that allow for transparent and fair allocation o f subsidy are established.

The sale of a minority stake and management contract in UDBL merged with

43. The restructured UDBL should retain the capacity to make direct loans to projects but would operate as a conduit fund rather than as a bank. A well structured institution with appropriate governance arrangements with 30 percent equity participation by a reputable financial institution could facilitate the provision o f donor support for te rm financing needs. Reflow income generated from the repayment o f existing DFD loans could also be allocated by the restructured UDBL. In l ine with the objective that the local financing capacity be developed to the greatest degree, the incentives under the management contract should also encourage sale or securitization o f assets to local financial institutions.

D. Uganda Stock Exchange

44. pillar for the privatization strategy o f the government, it was yet to fulfil the core functions of mobilizing equity finance for indigenous enterprises and providing a viable trading platform. Trading in the six listed issues i s sporadic and negligible measured both in real terms and relative to market capitalization.

While the Uganda Stock Exchange (USE) has undoubtedly served as a useful

45. The costs of issuance on the USE are too high given the extremely limited number of investors reached. At present, the Capital Markets Authority (CMA) does not make any distinction between types o f securities market investors. The USE might be more effective if it were to use a lower disclosure standard for new issues combined with a greater

associated with raising retail deposits. Foreign currency financing available under the program i s priced on the basis o f EIB’s international lending rates (ie., has no link to the Ugandan market).

’ This need i s recognized by the EIB and the next proposed tranche, Apex V, w i l l not involve lending through the BOU, however, it w i l l be two more years before the funds o f the current Apex IV are fully committed. The EIB program has also been successhl in promoting competition among banks. Lending spreads associated with the scheme are less than 5 percent, including SME loans, less than ha l f the national average.

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reliance on Collective Investment Schemes to reach the broader public. This approach could also be utilized to support greater trading o f regional share issues targeting sophisticated and international investors.

46. Investment Schemes a re to be applauded. One well known international institutional asset manager i s already undertaking investment o f private pension assets and it i s understood that others are in the process o f entering this market, which will become dramatically more important with the reform o f the NSSF now in train. One mutual fund i s now in the final stages o f preparation and will shortly be offered to retail investors in Uganda. This fknd will provide competition to commercial banks by offering retail savers shares in a money market fund invested in Treasury bills, serving to increase returns to savers and decrease the government cost o f borrowing.

The steps taken by the CMA to establish a market f r a m e w o r k f o r Collective

E. Housing Finance

47. f u r the r development, a b road ly favorable out look f o r the housing finance sector in Uganda was p rov ided in a n October 2004 in-depth stucty.' It i s recommended that the major short-term priority be to speed up procedures in the land registry prior to the major upgrading o f the system. The leading source o f housing finance in Uganda i s the Housing Finance Company (HFCU), while DFCU, a recently-listed development bank, has forcefully entered the market for mortgage lending. Other international banks are also now entering the market. I t i s a concern that NSSF has recently acquired a 70 percent stake in HFCU and also has a substantive role underpinning the market, through i ts 10 percent shareholding in DFCU as well as i ts substantial loans to both parties.' It i s imperative that HFCU be passed to private sector control-not only does public ownership run the risk o f distorting the market-but an investment o f this type by NSSF i s against the best principles o f pension fund management as involvement in an operating company, with overhead, staff and liabilities i s generally seen to be too demanding on the scarce management resources o f an investment manager.

W h i l e recognizing the l imi tat ions o f the system and t h e considerable scope f o r

F. Domestic Government D e b t M a r k e t s

48. contr ibuted to the establishment o f a benchmark y ie ld curve for issuers o f medium- term debt securities and represent a f i r s t step in extending the maturity structure o f government securities. The B O U established a primary dealership in February 2003, which has facilitated secondary market trading o f government securities with an increase in volumes traded, transactions o f treasury bonds, and diversification o f market participants.

T h e successful in t roduct ion o f treasury bonds is t o b e commended, as they have

49. constraints u p o n the government's capacity to issue long- term f ixed-rate debt. More

However, the limited amount o f term funding available in Uganda places

'The study was prepared by a Work Bank Group Consultant.

U Sh 10 billion to DFCU and U Sh 4 billion to HFCU.

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generally, as the government moves to issue long-term debt instruments, further steps will need to be taken to strengthen i ts debt management capacity and capability. Failure to establish a comprehensive debt management strategy would result in higher than necessary costs to the government and may increase risk in the system. lo Such a strategy would include among other things: (i) policy regarding the desired costhisk trade-off; (ii) analysis and projection o f government debt risk properties and other key variables; (iii) policy on selling techniques, auction frequencies, and the desired range o f debt instruments and; (iv) policy on market development.

111. FINANCIAL SECTOR SUPERVISION

A. Supervision

50. updated. The new FIA i s comprehensive, clearly written, and provides a sound basis for the BOU’s supervision. It i s complemented by the MDI Act designed to extend the BOU’s supervision to those micro-finance institutions willing and capable o f assuming the obligations and responsibilities o f taking deposits from the public. The process o f drafting and making the consequential regulations i s now well advanced, although not yet complete.

The regulatory structure for banking supervision has been modernized and

5 1. than most other African countries in shifting emphasis in the supervisory processes from compliance with regulation to identifying the risks faced by financial institutions and their capacity to manage those risks. Implementation o f the new approach requires both a change in supervisory culture within the BOU and a differing response from supervised institutions. As the system becomes more competitive, there will be a continuing need to monitor the effectiveness o f the risk-based supervisory regime. For this purpose BOU will need to spend a considerable amount o f resources on training in order to maintain the intellectual capacity o f the supervisory function as well as to ensure that i t i s adequately staffed. BOU will need to develop a flexible salary structure so it can retain the sk i l ls and, above all, the experience required. Efforts to improve off-site supervision, including regular stress testing are to be commended and should be continued.

Although the process i s just beginning, Uganda i s already further down the road

52. recommendations o f the 2001 FSAP but investment regulations need to be issued as a matter o f urgency with a view to ensuring greater diversity and liquidity in insurance portfolios. For instance, minimum capital requirement have been raised and actuarial reserves have been introduced to the life business. Next, regulation pertaining to investment need to be issued restricting real estate investment no more that 30 percent o f total assets.

I n the insurance industry, some progress has been made in implementing the

~ _ _ _ _

lo Certainly, there are institutions, such as NSSF, the private pension plans, and the insurance companies who should be prepared to pay an attractive price for fixed rate debt as they have a natural need for long-term assets. But it i s not clear if there wil l be continued demand for such instruments, especially at the longer end. To date, the government has issued U Sh 335 bi l l ion in long-term bonds, the bulk o f which have been taken up by the banking sector.

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B. Safety Net and Crisis Management

53. While coverage o f the DIF i s more than adequate, the governance structure i s not incentive compatible. Coverage-currently U Sh 3 million-is seven times GDP per capita, significantly higher than in other countries. Ninety-six percent o f all deposit accounts in Tier 1 and 2 financial institutions, but only 18 percent o f total deposits are covered, which i s at similar levels as in Kenya. The authorities’ plans for a significantly lower coverage limit for Tier 3 financial institutions have to be considered a positive effort. To reduce moral hazard risk, it i s also important that the guaranteed payout amounts not be exceeded. The absence o f a separate legal and thus governance structure-DIF i s administered by BOU staff-and the lack o f any involvement by the contributors (the financial institutions) could lead to conflicts o f interest. The authorities are urged to establish the DIF as a separate legal entity, but without creating a separate institutional entity. DIF should stay housed at the B O U to minimize costs, duplication o f supervisory work, and coordination problems. A board o f directors should be established with adequate representation from financial institutions and with the authority over investment, coverage and premium decisions.

54. The investment policy o f the DIF i s in need o f correction. Currently, the fund’s liquid assets are held in unremunerated deposits with BOU, which deprives it o f important revenues and internal growth opportunities. In the short run, these assets should be invested in safe, but higher-return assets, such as government debt. In the medium term, the investment policy should be determined by a board o f directors-under appropriate guidelines-and not subject to monetary policy considerations. Adequate representation o f the financial institutions on the board o f DIF should be guaranteed, and the board members should be submitted to a fit and proper test.

55. time and experience can demonstrate effective implementation. The new FIA contains all the necessary tools and instruments for efficiently intervening and resolving failing banks, but the B O U has not had cause to use them.

The new FIA contains the basis for effective bank failure resolution but only

IV. AML/CFT

56. There i s a real and current threat posed by both money laundering and terrorist financing. Corruption continues to be Uganda’s biggest problem, but other crimes have shown a sharp rise such as acquisitive crime, duty fraud and smuggling. In addition, Uganda has been, and s t i l l is, the victim o f domestic terrorism. The methods used by terrorist groups to move funds include: cross border cash couriering, the use o f foreign exchange bureaus, which illegally offer remittance services, and other unlicensed remittance corridors. Finally, Uganda i s also susceptible to being used as a transit point for fimds and resources that may be used to destabilize central African countries and to perpetuate war in these areas.

57. recommendation from the 2001 FSAP has been slow and inconsistent. Uganda has a draft AML bill, which i s consistent with international standards and in some instances exceeds the Financial Action Task Force (FATF) 40 + 9 Recommendations. The bi l l i s close to being submitted to Parliament but the actual timeframe i s uncertain. A comprehensive

However, progress in enacting a legal framework for AML which was a main

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implementation plan and cost assessment certificate need to be presented to Parliament with the bill.

58. monitoring, AML/CFT violations (another main FSAP recommendation) in Ugandan banks. While there i s a political will to fight corruption the AML law has not been given a high enough political priority to get the draft legislation enacted in a timely fashion. The new legislation i s necessary to give the police, prosecutor and intelligence agencies the legislative tools they need, as well as sufficient resources to effectively fight money laundering and terrorist financing. One critical aspect i s to ensure that those who need to drive AML in terms o f investigation, prosecution and intelligence are exposed to and adequately trained in relevant areas. The establishment o f a FIU that i s independent o f political influence and has the resources to carry out i t s mandate i s clearly a vital step forward.

Little progress has been made in putting in place a system for reporting and

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ANNEX I

Box 1. Summary o f Key FSAP Update Recommendations

ST - short-term, MT - medium to long term

To improve financial system efficiency and outreach Accelerate licensing and establishment o f a credit bureau (ST) Improve disclosure and transparency o f interest and account related bank charges (ST) Accelerate rehabilitation o f the land and companies registry (MT) Overhaul the corporate insolvency regime and supporting taxation framework, including the passage o f a new insolvency legislation that gives creditors the right to commence bankruptcy procedures (MT) Strengthen institutional capacity o f Commercial Court and o f Off icial Receiver (MT) Focus government capacity building efforts on regulated institutions and high performing Tier 4 entities

Expand access to the payment system to Tier 2 and 3 institutions (MT) License Tier 3 institutions in compliance with the principles set out in the MDI Act (Ongoing) Ensure M S C L adheres to i t s performance standards and excludes nonperforming MFIs/SACCOs (Ongoing) Be open to new Tier 1 entrants if they are professional and innovative (Ongoing) Focus PostBank as a narrow bank investing predominately in government securities (Ongoing)

(MT)

To promote term financing and developing capital markets

B

B

B

B

B

B

Restructure governance o f NSSF, including the hir ing o f independent professional board members (ST) Expeditious assignment o f an incentive based management contract and partial sale o f UDBL combined with the DFD o f BOU (ST) Increase private participation in HFCU, minimizing the involvement o f government and NSSF (ST) As soon as the regulatory authority for pensions i s established and functional, rescind the monopoly status o f the NSSF (MT) Verify the arrears o f the public service pensions scheme and undertake actuarial evaluation with a view to establishing a contributory t rus t fund (MT) Provide future donor support to term financing, such as the EIB facility at market rates (MT) Develop a comprehensive strategy for government debt management (MT)

To enhance prudential sector stability and regulation B

B

I

I

Issue investment regulations for insurance companies (ST) Establish DIF as a separate legal entity without creating a separate institution outside BOU (MT) Invest DIF assets in safe but high return securities, such as government paper (MT) Continue to monitor and improve the risk based supervisory regime (Ongoing)

To strengthen AMLKFT t

1

Expeditiously enact AMLICFT legislation that meets FATF 40 + 9 Recommendations (ST) Take appropriate resource and assessment steps for a phased implementation o f the AML legislation including resources to establish an FIU, enable BOU to carry out AML inspections, enable Director o f Public Prosecutions, Law Enforcement, and Intelligence resources to meet responsibilities (MT)

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Box 2. Possible Areas for Technical Assistance

To improve financial system efficiency and outreach 0

0

0

insolvency law. 0

0

0

0

0

0

0

0

products. 0

service provision.

B

East African cross-boarder payment system.

Assist in the establishment o f a credit reference bureau. Assist in the rehabilitation o f the land and companies registries. Assist the L a w Reform Commission and the First Parliamentary Counsel on the drafting o f the new

Assist in establishing regulatory framework for insolvency practitioners. Strengthen institutional capacity o f the Commercial Court and o f the Off icial Receiver. Assist wi th review o f the taxation environment for N P L resolution. Provide specialized assistance to the BOU in licensing and monitoring performance o f MDIs. Assistance to the MOF in re-focusing the Microfinance Outreach Plan. Assist authorities in restructuring the SACCO sector. Provide assistance to the top segment o f the credit-only MFI. Assist AMFIU on development o f non-prudential regulations and standards for credit-only MFIs. Assist commercial banks and Tier 2 and 3 entities for the development o f microfinance and rural-finance

Assist BOU in promoting transparency, disclosure and consumer rights and education relating to financial

Support the MOF/BOU in developing and implementing debt management and market strategy. Assist B O U in establishing a regulatory framework for electronic and internet banking, and design o f an

To promote term financing and developing capital markets D

D

jur ing the transition period. D

:egulatory authority for pensions, insurance and the capital market. D

3ayroll system for the public service), investment policies and selection o f asset managers. D

licensing, supervision and enforcement. D

;ontext.

Assist the design o f the governance and investment process o f NSSF. Assist NSSF in the field o f asset management in the form o f a senior independent expert to provide advice

Provide assistance on the establishment o f the regulatory authority for pensions, including a combined

Assist the PSPF to develop appropriate record-keeping procedures (including completion o f the integrated

Help build capacity in C M A in the field o f Collective Investment Schemes, including taxation, accounting,

Assist C M A and USE as to positioning the Ugandan capital markets for competitiveness in an East African

To enhance prudential sector stability and regulation B Support the further institutional development o f the BOU’s supervisory functions, as appropriate.

Assist the deposit insurance funding creating a separate legal entity, improved governance, etc. Assist the Uganda insurance commission to develop i t s institutional capacity.

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ANNEX I1

Box 3. Financial Institutions in Uganda

Tier 1 institutions: Commercial banks, licensed under the Financial Institutions Statute 1993 (recently amended to Financial Institutions Act 2004). Currently, there are 15 commercial banks and the B O U supervises and regulates them. A commercial bank i s defined as a company licensed to carry on financial business in Uganda and whose principal business consists mainly in (i) the acceptance o f call, demand, saving and time deposits withdrawable by check or otherwise, in the capacity o f a bank, (ii) provision o f overdrafts and short to medium term loans; (iii) provision o f foreign exchange, (iv) participation in inter-bank clearing systems, and (v) the provision and assumption o f guarantees, bonds and other warranties on behalf o f others.

Tier 2 institutions: Credit institutions, licensed under the Financial Institutions Statute 1993, There are currently 7 credit institutions, and the B O U supervises and regulates them. A credit institution i s defined as a company licensed to carry on financial business in Uganda whose principal business consists mainly in (i) the acceptance o f call and time deposits repayable after a fixed period or after notice, and (ii) employment o f such deposits wholly and partly by lending or any other means for the account and at risk o f the person accepting such deposits, and any other body specified by the BOU to be a credit institution.

Tier 3 institutions: Microfinance deposit taking institutions (MDIs), to be licensed under the Micro Deposit Taking Institutions Act 2003. BOU will supervise and regulate MDIs, under the MDI act. An MDI license allows the institutions to conduct the following microfinance business; (i) accept deposits from the public, (ii) use such deposits to make loans or extend credit, including short-term loans to small or micro enterprises and low-income households, usually characterized by the use o f :ollateral substitutes, such as group guarantees or compulsory savings, and (iii) transact such other ictivities as may be prescribed by the BOU. At the time o f the mission, there were four applications for MDI status being considered by BOU (FINCA, UMU, UMT, and PRIDE).

rier 4 institutions: Institutions involved in microfinance that do not qualify for Tier 1,2, and 3, e.g., smaller NGOs, membership-based savings and credit associations (such as SACCOs) and community Jased organizations. These organizations wil l not be regulated or supervised by the BOU. Tier 4 MFIs will only be allowed to accept compulsory savings from clients (loan insurance funds) and hose savings cannot be used for credit operations. Only those Tier 4 MFIs registered as co-operatives ire allowed to take in voluntary savings from members, and use them for on-lending to members. 3 v e n the criteria that need to be fulf i l led in order to qualify for an MDI-license, it i s expected that mly a small number o f the existing MFIs wil l be able to obtain such a license, and the majority o f VIFIs (between 500 and 700) will remain in Tier 4.