Moral hazard within the banking industry

By Thomas Lule Kaggwa

The last two years have been painful for many people with bank loans. This has been made worse by the high degree of financial illiteracy.

Banking brings about a fiduciary relationship between the bank and its customer. In a fi duciary relationship one person (for example a bank customer) in a position of vulnerability justifi ably vests confi dence, good faith, reliance and trust in
another (for example a bank) whose aid, advise and protection are sought in some matter.

In such a relationship, good conscience requires the fi duciary to act at all times for the sole benefit and interest of the one who entrusted it. 

A fiduciary duty is the highest standard of care at either equity of law. A fi duciary (a bank) is expected to be extremely loyal to the person to whom it owes the duty (the bank customer). It must not put its personal interests before the duty and must not profi t from its position as a fi duciary unless the principal (the bank customer) consents. This was a court decision held under the case of Bristol & West Building Society Vs Mothew (1998). 

When a customer opens a bank account or enters into a loan agreement with a bank, a fi duciary relationship is established. However, is it still a fiduciary relationship when a bank increases the interest rate for an existing customer, whether or not the customer consents to it!

In Uganda, many bank customers and the general public are financially illiterate and complacent about their rights as customers.

On one hand, we have banks that have more information and resources, thereby increasing interest rates for both existing and new borrowers based on the increased Central Bank Rate, but falling short of forecasting future interest rates based on the prevailing or expected economic conditions to adequately price the risk of their investments. 

Banks, like any other business, will make money and also lose some money. The Ugandan customer has no choice whether to borrow from the banks at a fi xed or fluctuating interest rate terms.

Should one borrow today with the expectation that interest rates will increase in the foreseeable future, or borrow in the future?
The result for the bank customer is the same because almost all commercial banks in Uganda have a clause in their loan agreements that state they reserve the right to alter the interest rate at their (the bank’s) discretion.

Over the past two years, we have seen various banks advertise increments in their loans to both the existing and new borrowers, arguing that the Central Bank rate had made funds in the fi nancial markets expensive.

This is interesting because over the last two years, I have not read a newspaper where a bank had advertised that it was increasing interest rates on savings and fi xed deposits for existing savers, but many are promising higher interest rates for new fi xed deposits and lottery cash prizes for those who save with them.

Aren’t these existing fixed deposit holders and savers with the banks lending to the banks? Aren’t they entitled to profi t from the gains?
If the manner in which the banks in Uganda have been behaving over the last two years does not fall under the defi nition of a fi duciary duty or relationship, then it probably falls under what is called moral hazard. A moral hazard may occur where
the actions of one party (for example a bank) may change to the detriment of another (for example a bank customer that borrowed) after a transaction has taken place.

Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its actions and, therefore, has a tendency to act less carefully than it would otherwise leaving the other party (the bank customer that borrowed) to hold responsibility for the consequences of those actions.

Slowly and steadily, the fiduciary duty of banks seems to be replaced with moral hazard. The results of moral hazard are quite evident today with many struggling borrowers having their properties advertised for auction, while the banks are announcing huge profits. 

Do not get me wrong, there are bad borrowers, but there is also a category of borrowers who are struggling to service their loans because they suddenly became too expensive yet the loans were acquired when the interest rates were relatively lower.

One thing is for sure; whilst many struggling borrowers will have their properties sold remember they bore the full risk, the commercial banks who gave them the loans will report good performance for this year. 

The writer is a senior creditanalyst at the Uganda Development Bank