Why local banks fail!

OPINION

This is the question everyone who is following the banking industry in Uganda is asking, hope this article helps you in understanding the cause of failure of local banks.

You will need to have some basic knowledge of banking to appreciate this article but I will try my level best to explain how conventional banking works in a lay man's language.

In every society there are those who have more funds than they can put to use and there are those with great ideas but without enough funds to implement the ideas.

That's where bankers come in to act as intermediaries between these two parties.

However, this was not the original reason why banks where started in the first place. Originally before the invention of paper currency and now electronic money, people used gold, silver, and other precious metals as currency.

There was a limit to how much people would carry around and due to fear of theft, secure houses were created where people would store their gold and they would be issued with a deposit slip.

With time people started exchanging these deposit slips as a mode of payment since gold would be given to whoever presented the deposit slip and this is where paper money originated from.

On seeing this, bankers spotted an opportunity, they could create more deposit slips than the gold they received and since the deposit slips where as good as gold, they instantly became super rich.

On discovering that banks where creating bank notes that are not backed by gold, there was sudden loss of public confidence in banks which precipitated mass redemption of banknotes and result in bankruptcy.

Instead of punishing the banks for the robbery, the rush was blamed on "Gold" and gold was abolished as a form of currency, creation of bank notes from thin air was legalized and central bank was created to regulate on how much banks were supposed to create.

Forget want you learnt in O' level commerce, it's the commercial banks that create money not the central bank. The central bank's role is to regulate how the commercial banks create money.

Now let me answer your question, how do commercial banks create money?

Just like how it used to be with gold, it all starts with one customer depositing some money into the bank let's say Ugx one million (UGX1,000,000).

The central bank will put a minimum of how much each bank is supposed to keep for those customers who might need to withdraw some money, let us assume it is 10%, the bank will keep ugx100,000 and lend out ugx 900,000, the borrower will use these funds to pay his suppliers who will end up depositing it into the bank.

The bank will again remove 10% (90,000) and lend out UGX810,000… before we continue, can you see that what started as a deposit of UGX 1,000,000, the bank has so far lent out ugx1,710,000 (900K + 810,000).

This chain will continue until the bank has lent out UGX 9,000,000 from a deposit of ugx 1,000,000. Now you understand the purpose of those "Deposit and Win promotions". Money is created through creation of loans.

Having understood how banks work, let's try to answer our question, why do local banks fail?

Banking is the only industry where the majority shareholders don't vote on decisions of management. By majority shareholders I mean the major contributors of funds who happen to be the depositors.

As a result, Central bank is mandate to look out for the interests of these shareholders/depositors. The bank does this through setting minimum requirements and operational standards, so a country's banking industry is as good as its central bank management team.

One of the key ratios used by the central bank is the Capital adequacy Ratio which measures the available capital which can be used to protect depositors against financial risks.

This is the ratio that highlights to the central bank how much burden in terms of bank funding is being carried by shareholders and how much is carried by depositors. The lower the ratio, the more depositors are at risk of losing their deposits.

The central bank reserves the right to set the minimum capital adequacy ratio and they can change it depending on the financial circumstances prevailing in the economy.

The difference between local banks and foreign banks lies in the ability to mobilise funds in case the bank is falling short of the minimum required rate. While as foreign banks can easily call on their parent entities for recapitalization, local banks have to rely on local investors who would most likely also be affected in case of an economic depression.

If the central bank was to allow the commercial bank to go bankrupt, the minimum guaranteed reimbursement to shareholders for those holding more than UGX3million in deposits in UGX 3Million, meaning those whose deposits exceeded ugx 3million would most likely walk away with only ugx 3Million unlike in Islamic finance were non-investment depositors a guaranteed their full deposits.

One last question, do these failing banks deserve to be closed?

Well if you understood 80% of this article, you would say all conventional banks deserve to be closed unless you're are saying theft is okay as long as you follow the law, in that case those who fail to steal well deserve to be punished.

In the next article God willing I will explain to you the problems that have come as a result of allowing commercial banks to create money.

Yahya Kasujja FCCA

Certified Islamic Finance Professional

Master of Islamic Finance Practice (Malaysia)

MBA Edinburgh Business School UK