THE DETERMINANTS OF PROFITABILITY IN THE BANKING INDUSTRY

IN UGANDA (1999-2005)

BY
LUKWAGO STEPHEN

MSQE, (BSC) (MAK)

SEPTEMBER 2008

1
 Dedication

I dedicate this study to my late beloved father Mr. George William Jjumba for the love and support he showed

me throughout my career path. May his soul rest in peace.

2
 Acknowledgements

There are numerous people without whom this research wouldn’t have been possible but above all, I thank God

for his love.

I thank my supervisors; Dr. Tom Makumbi Nyanzi and Dr. Bruno Ocaya whose wide knowledge and patience

enabled me complete this study.

I thank my mother who pushed me on tirelessly more so when I lost my dad.

May God bless you all.

3
 Table of Contents
CONTENT Page
CHAPTER ONE: INTRODUCTION ................................................................................................................................. 1
1.1 Background .......................................................................................................................................................... 1
1.2 History of Banking in Uganda ................................................................................................................................ 1
1.3 Banking Crisis in Uganda ...................................................................................................................................... 2
1.4 Statement of the Problem ...................................................................................................................................... 3
1.5 Objectives ............................................................................................................................................................. 4
1.5.1 General Objective .......................................................................................................................................... 4
1.5.2 Specific Objectives ......................................................................................................................................... 4
1.6 Conceptual Framework ......................................................................................................................................... 5
1.7 Significance of the study ....................................................................................................................................... 6
1.8 Dissertation Layout ............................................................................................................................................... 6
CHAPTER TWO: LITERATURE REVIEW ....................................................................................................................... 7
2.1 Introduction ........................................................................................................................................................... 7
2.2 Financial System................................................................................................................................................... 7
2.3 Role of Banks in the Economy .............................................................................................................................. 7
2.4 Bank specific/Internal factors............................................................................................................................... 10
2.4.1 Size of Banks ............................................................................................................................................... 10
2.4.2 Capital Ratios .............................................................................................................................................. 11
2.4.3 Risk Acquired ............................................................................................................................................... 12
2.4.4 Bank Ownership........................................................................................................................................... 12
2.5 Macroeconomic/External Factors ........................................................................................................................ 12
2.5.1 Gross Domestic Product (GDP) .................................................................................................................... 12
2.5.2 Inflation ........................................................................................................................................................ 13
2.5.3 Interest Rate ................................................................................................................................................ 14
CHAPTER THREE: METHODOLOGY .......................................................................................................................... 16
3.1 Introduction ......................................................................................................................................................... 16
3.2 Data Source........................................................................................................................................................ 16
3.3 Sample Size........................................................................................................................................................ 16
3.4 Model specification ............................................................................................................................................. 17
3.4.1 Variable description and expected relationship ............................................................................................. 19
3.5 GDP Interpolation ............................................................................................................................................... 20
3.6 Econometric Modeling ......................................................................................................................................... 21
3.7 Fixed Vs Random Effects Model ......................................................................................................................... 23
3.8 Heteroskedasticity and Autocorrelation................................................................................................................ 24

4
 3.9 Stationarity Test .................................................................................................................................................. 27
CHAPTER FOUR:FINDINGS ........................................................................................................................................ 28
4.1 Introduction ......................................................................................................................................................... 28
4.2 Interpolation of quarterly GDP ............................................................................................................................. 28
4.3 Test for Autocorrelation ....................................................................................................................................... 28
4.4 Stationarity Test .................................................................................................................................................. 30
4.5 The Hausman Test ............................................................................................................................................. 30
4.6 Regression Results ............................................................................................................................................. 31
4.7 Discussion of Findings ........................................................................................................................................ 31
CHAPTER FIVE
SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS ................................................................... 35
5.1 Introduction ......................................................................................................................................................... 35
5.2 Conclusions ........................................................................................................................................................ 35
5.3 Recommendations .............................................................................................................................................. 36
References ................................................................................................................................................................... 38
APPENDIX ................................................................................................................................................................... 44
Appendix A. Stata output for the hausman test .......................................................................................................... 44
Appendix B. Stage 1 Random Effects Model Stata Output ......................................................................................... 45
Appendix C. Second Stage Random Effects model Stata Output............................................................................... 46
Appendix D. GLS model stata output ........................................................................................................................ 47
Appendix E. GLS second stage stata output ............................................................................................................. 48
Appendix F. Test for Autocorrelation ......................................................................................................................... 48

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 List of Tables
Page
Table 4.1: Quarterly GDP Interpolation .......................................................................................................... 29
Table 4.2: Stationarity Test Results ................................................................................................................. 30
Table 4.3: Determinants of Return on Assets .................................................................................................. 31

6
 Acronyms

ATM Automatic Teller Machine

ADF Augmented Dick Fuller

BOU Bank of Uganda

EADB East African Development Bank

EM Equity multiplier

GDP Gross Domestic Product

GLS Generalised Least Squares

GNP Gross National Product

IMF International Monetary Fund

IFS International Financial Statistics

LSDV Least Squares Dummy Variables

NIM Net Interest Margin

OBS Off-Balance Sheet

ROA Return on Assets

ROE Return on Equity

7
 Abstract

The research investigates the impact of bank’s characteristics and macroeconomic indicators on bank’s Return

on Assets in the Ugandan banking industry for the 1999-2005 period. The study analyzed and compared the

profitability of bank with both domestic and foreign centers of control operating in the Ugandan market.

Analysis was based on the panel data generalized least squares model which yielded the following results:

Higher Returns on Assets tend to be associated with small sized banks that have higher net interest margins and

therefore higher interest earning assets, and lower cost to income ratios. The size has negative and significant

coefficient on the Return on Assets reflecting scale inefficiencies. Secondly, the research finds that economic

growth is likely to improve all banks profitability but inflation has no impact on bank’s Return on Assets.

Thirdly, the research revealed that banks with domestic centers of control were more profitable than foreign

controlled banks. This may suggest that it is better for a multinational bank to acquire an existing bank than

establish a subsidiary in the Uganda.

Major recommendations drawn from the research are that BOU should enforce the core capital and total capital

requirements to boost capital levels in the industry, banks on their part should improve Board and senior

management involvement in daily operations, and foreign owned banks must be encouraged to have a strong

local representation on their Board of Directors. Banks should also be encouraged to maintain a high quality

asset portfolio particularly through improving the performance of the credit portfolios. Banks should put in

place effective risk management frameworks that identify, measure and control interest rate risk. The

government on its side should develop both the domestic and foreign financial markets and continue in its fight

towards achieving economic development.

8
 CHAPTER ONE
INTRODUCTION

1.1 Background

The Ugandan banking sector plays a very important role in the economy. A profitable banking industry

promotes financial stability and provides a cushion in times of macroeconomic shocks. Mature economies with

strong financial sectors have been successful in coping with shocks and avoiding the collapse in output that

developing countries often experience. Banks also play an important role in the transmission mechanism of

monetary policy and are also important indicators of the liquidity conditions of national economies. Therefore

understanding the performance and operations of banks is very important in stabilizing the monetary flow

throughout the economy. The linkage between bank operations and macroeconomic changes is very vital to the

financial regulators. The focus of the research is partly to determine whether macroeconomic factors affect

banks performance.

1.2 History of Banking in Uganda

Banking in Uganda has traditionally been dominated by government owned institutions.

In 1966 the Bank of Uganda, which controlled currency issue and managed foreign exchange reserves, became

the Central Bank. The Uganda Commercial Bank, which had fifty branches throughout the country, dominated

commercial banking and was wholly owned by the government. The Uganda Development Bank was a state-

owned development finance institution, which channelled loans from international sources into Ugandan

enterprises and administered most of the development loans made to Uganda. The East African Development

Bank, established in 1967 and jointly owned by Uganda, Kenya, and Tanzania, was also concerned with

development finance. It survived the break-up of the East African Community and received a new charter in

9
1980. Other commercial banks included local operations of Grindlays Bank, Bank of Baroda, Standard Bank,

and the Uganda Cooperative Bank.

During the 1970s and early 1980s, the number of commercial bank branches and services contracted

significantly. Whereas Uganda had 290 commercial bank branches in 1970, by 1987 there were only 84, of

which government owned banks operated 58 branches. [Rita M. Byrnes(1990)]. This number began to increase

slowly the following year, and in 1989 the gradual increase in banking activity signaled growing confidence in

Uganda's economic recovery.

1.3 Banking Crisis in Uganda

Uganda embarked on financial sector reform in the early 1990s as part of a broader economic reform program.

The main features of financial reform included the liberalization of interest rates and credit allocation,

introduction of new indirect monetary policy, strengthening prudential regulation, opening the financial sector

to foreign financial institutions to encourage competition in a sector previously dominated by government

owned banks and promotion of the equity market. All these developments would certainly have implications on

the interest margin and profitability of the Ugandan banking industry.

Between 1990-1995, 11 private banks were licensed resulting in a three-fold increase in the number of banks

relative to the pre-reform period. The reforms culminated in the passing of the Financial Institutions and Bank

of Uganda Statutes in 1993 that enhanced the regulatory authority of Bank of Uganda (BOU). Examples of

decisive intervention of the central bank include the closure of a local bank (Teefe Trust bank) in 1993 and the

sale of two local banks (Nile and Sembule) with solvency problems to strategic foreign investors in 1996. A

crucial outcome of the banking crisis was that it changed the market structure from one previously dominated

by domestic banks (local private or government) to one dominated by foreign banks. In addition to the loss of 3

10
indigenous banks, the largest bank Uganda Commercial Bank Ltd. (UCBL) was placed under statutory

management and operated under very narrow banking guidelines throughout the post crisis period.

Today, the entire banking sector comprises of commercial banks, deposit-taking institutions and micro-finance

institutions. However, this study considered a sample of commercial banks which have the largest share of

deposits as compared to deposit-taking institutions although deposits of other financial institutions are

increasing. The Ugandan banking system is very open to the entry of foreign banks and the acquisition of

domestic banks by foreign banks/investors is permitted. Currently, there are 15 banks operating in Uganda.

There are 12 foreign banks (80%) and 2 domestic banks (13.3%) with foreign control (i.e. majority foreign

ownership), which leaves only 6.7% of banks with domestic control (total or majority control) 1.

1.4 Statement of the Problem

In Uganda, foreign banks have taken over established domestic banks in order to expand their operations. This

has been encouraged by the liberalization of the international financial markets as quoted by Awdeh (2005).

However, the take-over of domestic banks by foreign banks raises two questions:

What is the effect of this takeover on the banking system in Uganda?

What are the inequalities and differences in the performance between the foreign and domestic banks?

It is therefore necessary to investigate whether the performance of banks in Uganda today is influenced by the

internal and/or external factors and if so whether there exists performance differences between the domestic and

foreign-owned banks. Empirical analysis of foreign and domestic bank performance is expected to reveal if the

two groups of banks perform differently and the reasons or factors behind the difference. By doing this,

necessary conditions for successful performance of banks in Uganda are identified.

1
All banks in Uganda are required to be incorporated in Uganda. Hence in the study bank ownership status was determined by the
location of shareholders and policy/decision makers.

11
The research therefore answers two questions; Why some commercial banks more successful than others? To

what extent discrepancies in bank’s profitability are due to variation in endogenous factors under the control of

bank management and to what extent external factors impact the financial performance of these banks?

Answers to the questions are helpful to identify the determinants of successful commercial banks in Uganda

which in turn leads to the formulation of policies for improved profitability of these institutions and perhaps

ease on the supervision role.

The research also opens a way for Bank of Uganda to supervise banks using established models which represent

risk weights attached to each risk area according to its likely effect on a bank’s profitability. With the factors

known, the Bank of Uganda can be able to know the direction of a commercial bank performance in time by

forecasting the closely related variables.

1.5 Objectives

1.5.1 General Objective

The research assesses the major determinants of profitability in the Ugandan banking sector.

1.5.2 Specific Objectives

 To analyze the disparity in the determinants of profitability across the different types of ownership.

 To determine the basic requirements for successful banks in Uganda during the period under review.

 To establish whether the economic situation in the country has a strong bearing in changes in the

banking profitability.

 To assist the Central Bank to come up with risk weights to each risk area as it affects the bank’s bottom

line.

12
1.6 Conceptual Framework

Commercial bank operations depend on both the macroeconomic factors and the internal factors. However, the

internal factors are also affected by the changes in the macroeconomic factors. Bank output also has a bearing

on the macroeconomic factors. A better banking environment will prosper the transmission mechanism which

will smooth GDP growth and also enable the Central bank to effectively control inflation. Figure 1.1 shows the

relationship between bank operations, macroeconomic factors and bank determined factors.

Figure 1.1: The interrelationships between internal and external determinants of bank operations.

Macroeconomic factors:
-GDP
-Inflation

Bank controllable factors:

Bank -Size
Operations -Total assets
-Deposits
-Net Interest Margin
-Cost to Income

1.7 Significance of the study

The research is pertinent to commercial banks, the central bank and the general public. Commercial banks can

use the results of this study to project and forecast future profitability using the determinants that will be proved

to affect profitability.

The Bank of Uganda, since shifting to a Risk-Based supervision of commercial banks will find this study useful

in assigning risk weights to suspect areas. Higher risks are expected in large profitable ventures. Therefore with

13
this study, Bank of Uganda can easily ascertain the problem areas in time before embarking on bank

inspections. Last but not least the general public can find great use for this research most especially in making

decisions on which bank to entrust their savings.

1.8 Dissertation Layout

The dissertation is apportioned into five chapters. Chapter one reviews the background to the study, develops

the research problem, and outlines the objectives and significance of the study. Chapter two presents, through

theoretical evidence, past studies that have been carried out in relation to the determinants of bank profitability.

The third Chapter presents the model framework developed from the Du Pont model through which profitability

determinants are analysed and identified. Chapter four outlines the results of the tests, estimations and findings

of the study. Finally, a summary of findings, conclusions and recommendations are presented in Chapter five.

14
 CHAPTER TWO
LITERATURE REVIEW

2.1 Introduction

The chapter discusses the existing literature which explains the possible determinants of commercial bank

profitability using empirical studies. The chapter discusses possible external and bank determined factors which

affects bank profitability.

2.2 Financial System

A good financial system is one that has a sound public finance and public debt management, stable monetary

arrangement, has a central bank to stabilize domestic finances, a well financing securities market and a variety

of banks (with domestic and international orientations or both). Such a financial system can mobilize capital

domestically and thereby promote a country’s economic development and growth. Rousseau and Sylla (2001)

found a robust correlation between financial factors and economic growth. Using a cross-country panel of

seventeen countries covering the period 1850-1997, they uncovered a robust correlation between financial

factors and economic growth that is consistent with a leading role for finance, and showed that these effects

were strongest over the 80 years preceding the Great Depression. Allen and Oura (2004) also argue that the

financial system plays a crucial role in understanding variations in economic growth.

2.3 Role of Banks in the Economy

Commercial banks play an important role in the financial system of the economy. As a key component of the

financial system, banks allocate funds from savers to borrowers in an efficient manner. They provide

specialized financial services, which reduce the cost of obtaining information about both savings and borrowing

15
opportunities. In a liberalized economy like Uganda, these financial services help to make the allocation of

resources in form of funds and information more efficient.

Banks operate by borrowing funds-usually by accepting deposits or by borrowing in the money markets. Banks

borrow from individuals, businesses, financial institutions, and governments with surplus funds (savings). They

then use those deposits and borrowed funds (liabilities of the bank) to make loans or to purchase securities

(assets of the bank). Banks offer these loans to businesses, other financial institutions, individuals, and

governments (that need the funds for investments or other purposes). Interest rates provide the price signals for

borrowers, lenders, and banks. Through the process of taking deposits, making loans, and responding to interest

rate signals, the banking system helps channel funds from savers to borrowers in an efficient manner. Savers

range from individuals to corporations with millions of shillings in temporary savings. Banks also service a

wide array of borrowers, from individuals to major corporations.

The entrance of foreign banks in the Uganda banking industry may improve the quality and availability of

financial services in the host market either through increasing competition, enabling a better application of

modern banking skills and technologies (ATM, Credit cards), or enhance a country’s access to international

capital markets. Claessens et al. (2001) argue that while foreign banks have lower overhead expenses,

profitability and interest margins than domestic banks in developed countries, the opposite is true in developing

ones. This is because in developing countries like Uganda, most of the foreign banks have not inherited

inefficient branch networks, obsolete IT systems, low-quality customers, inadequate management skills and

other problems that are prevalent in domestic banks.

16
Furthermore, they found that the increased presence of foreign banks is associated with reductions of

profitability, non-interest income and overall expenses of domestic banks and the competitive pressure from

foreign banks leads to positive efficiency effects at domestic banks. Lensink and Hermes (2004) also claim that

the entrance of foreign banks motivates domestic banks to enhance their efficiency and increase the diversity

and quality of financial services in order to retain their market share. Additionally, foreign bank entry is

associated with falling costs, profits and interest margins of domestic banks especially at higher economic

development.

Therefore it can be argued that the success of banks and financial institutions is very vital in smoothening the

economic sector. A sound banking sector will definitely lead to a stable financial sector.

The research investigates the effect of bank specific and macro economic determinants of bank profitability.

The bank specific factors include banks operating efficiency and financial risk. Size is included to capture the

effect of economies of scale. The macroeconomic determinants include cyclical output measured by GDP and

expected inflation. This research is based on past analyses of individual and cross countries banking operations.

These studies include Ali Awdeh (2005), Naceur(2003), Demerguç-Kunt and Huizingha (1999), Abreu and

Mendes (2002) and Guru et al (2002) among others.

Bank profitability is usually expressed as a function of factors which are internal and external to the bank. The

internal factors originate from the bank balance sheets and income statements. The external factors cannot be

controlled by the bank management but reflect the economic environment through which banks operate. A

number of variables were considered for the two sets of factors.

17
2.4 Bank specific/Internal factors

Studies using internal determinant draw on variables such as expense management, risk management, size for

economies of scale and capital. It is debatable whether the expansion of banks enables costs to be lowered. If

economies of scale exist, increased size will help to create systemic financial efficiency and shareholder value

to a bank. Economies of scale exist when the average cost decreases in scale over a relevant range as services

expand.

2.4.1 Size of Banks

Size may benefit the bank through customers’ preference of services from larger banks. Santomera and Eckles

(2000) stress that the real gain of multi-product distribution may not be in production efficiencies but in

customer service. A bank that produces various products and services usually reaps higher revenue and a better

return from any customer segment, if consumers of financial services find it more advantageous to purchase

multiple products from the same provider. Consequently, large banks can also increase their profits without any

significant enhancements in their operational efficiency. Akhavein et al (1997) and Smirlock(1985) found that

there exists a positive relationship between size and bank profitability.

Size may also result in instability of the institution. For example, a bad outcome in any one line of business may

have a magnified effect on all lines of business and on the core franchise itself, in this way increasing the

probability of loss making or the efficiency of a large financial institution may decrease if the consolidation

creates organizational diseconomies to operate a larger, more diverse enterprise, or makes it difficult to serve

some segments of the market.

Guru et al. (2002) in an attempt to identify the determinants of successful deposit found out that efficient

expenses management was one of the most significant in explaining high bank profitability.

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2.4.2 Capital Ratios

Capital adequacy and its availability to banks could be another factor that affects the earnings of banks. The

availability of capital shows how banks can absorb shocks to their financial statement. Capital reduces the risk

of failure by acting as a cushion against losses and by providing access to banks to their meet liquidity needs.

Lack of adequate capital may expose a bank to a high-risk exposure and possible capital adequacy problems.

Berger (1995) discovered that one of the most important factors influencing bank profits is capital. Using the

expected bankruptcy hypothesis, he states that increased capital leads to higher earnings due to reduced interest

rates on uninsured funds, especially for riskier banks whose probability of bankruptcy decreases.

Large banks tap the capital markets regularly but small banks must pay a stiff premium to obtain capital, if it is

available at all. Therefore, the size of banks affects their earnings through their access to capital. Naceur and

Goaied (2001) while investigating the determinants of the Tunisian bank’s performances during the period

1980-1995 found that the best performing banks are those with improved labor and capital productivity, high

level of deposit accounts relative to their assets and reinforced equity.

2.4.3 Risk Acquired

The Ugandan banking industry has adopted risk management while carrying out its operation. In the past, poor

asset quality and dismal levels of liquidity were the major causes of bank failures. Banks reduce their risk

through diversifying their portfolio. Risk can be either credit related or liquidity related. A significant negative

relationship between liquidity and profitability was found by Molyneux and Thorton (1992) among others.

Bourke (1989) reports a negative relationship between credit risk and profitability. Bank operations involve the

loaning out of depositors’ money in a bid to earn return which can pay interest to deposits and also earn a bank

profits. When the volume of unpaid loans accumulates therefore, the bank experiences lower returns.

19
2.4.4 Bank Ownership

One of the questions the research attempts to answer is whether the ownership of a bank can influence its

profitability. Little evidence is found to support this theory i.e. whether privately owned banks will return

relatively higher economic profits. Short (1979) established a negative relationship between government

ownership and bank profitability. Barth et al (2004) reports that government ownership is indeed negatively

correlated with bank efficiency. However, studies done by Bourke (1989) and Molyneux and Thornton (1992)

report that ownership status is irrelevant for explaining profitability.

2.5 Macroeconomic/External Factors

A number of studies have discovered that the macroeconomic environment has a direct effect on bank profits.

The macroeconomic variables commonly used are inflation, interest rate and GDP.

2.5.1 Gross Domestic Product (GDP)

Financial institutions’ earnings and lending are expected to drop when GDP takes a downturn. As a result, the

credit quality of the existing loans will be impaired and the demand for loans will fall as banks tighten their

credit. The final outcome will be a reduction in profits especially for banks that depend on earnings from debt

instruments.

Molyneux and Seth (1998) modelled the determinants of foreign bank profitability in the U.S. They found that

capital strength, assets composition, commercial and industrial loan growth, and U.S. GDP growth were

important factors in determining foreign banks’ ROA. Williams (1998) studied the determinants of profitability

of foreign banks operating in Australia. He found a positive effect of home GDP on foreign banks’ profitability.

Demirgc-Kunt and Huizinga (2000) used the annual growth rate of GDP and GNP per capita to present

evidence on the impact of financial development and structure on bank profitability. They found a positive

relationship between inflation and interest rate on one side and bank profitability on the other. Bikker and Hu

20
(2002) used GDP, unemployment rate and interest rate differential to identify possible cyclical movements in

bank profitability

2.5.2 Inflation

The other commonly used macroeconomic determinant of bank profitability is the inflation rate. Inflation is

associated with higher realized interest margin and greater profitability. Inflation fuels higher costs, more

transactions and thus more branch networks and probably more income.

Inflation can either be fully anticipated or unanticipated. A fully anticipated inflation is equal to the expected

inflation. In this case lending and borrowing contracts are adjusted to take into account the anticipated inflation

rate. People do not earn interest by holding money therefore an increase in anticipated inflation will induce the

people to shift from money into interesting earning assets like deposits. A question thus arises; will banks

benefit out of this phenomenon? With unanticipated inflation, there is a redistribution of income from creditors

(banks) to borrowers. There may also be cost implications on banks’ decisions as well.

Demirguc-Kunt and Huizinga (1998) found that bank income increases more with inflation than bank costs do.

Revell (1979) studies the relationship between inflation and profitability. He discovers that the effect of

inflation on bank profitability depends on whether banks’ wages and other operating expenses increase at a

faster rate than inflation. Banks are faced with a problem of estimating future operating costs; which can be

solved by accurately forecasting future inflation. Perry (1992) states that the extent to which inflation affects

bank profitability depend on whether inflation expectations are fully anticipated. Banks can adjust their interest

rates if they fully anticipate the inflation rate.

2.5.3 Interest Rate

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The interest rate is the yearly price charged by a lender to a borrower in order for the borrower to obtain a loan.

This is usually expressed as a percentage of the total amount loaned. Banks make money when interest rates

come down because the costs of the funds on deposit are reduced, whereas the earnings on their assets (loans)

remain high or fixed. Banks lose money when interest rates go up because the costs of their funds on deposit

increase whereas the earnings on their assets remain relatively low or fixed.

Sudden changes in the interest rates can affect banks in different ways;

An increase in rates means banks will begin earning more interest income on their assets and paying more

interest expense on their liabilities. However, because banks’ liabilities typically tend to roll over faster than

their assets, interest expense typically changes more than interest income in the short run, potentially squeezing

profits;

Or changes in interest rates directly alter the market value of interest-bearing assets and liabilities. When

interest rates rise, for example, the value of both assets and liabilities fall, but the effect is likely to be larger for

assets than for liabilities, leading to a decline in net value. Although these changes in value do not pass through

earnings, they do affect banks’ capital positions;

Or there might be a risk (known as “basis risk”) that not all interest rates will move together. The impact of rate

changes on capital and earnings will then depend upon what types of assets and liabilities a bank has on its

books and how the rates on these instruments change relative to one another.

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 CHAPTER THREE

METHODOLOGY

3.1 Introduction

The chapter introduces the problem to be solved using an approach developed from the traditional DuPont

model. The chapter further discusses the data sources, tests for suitability of the data used and finally the

method of regression analysis used.

3.2 Data Source

The data used was collected from the Central Bank, Commercial banks and the International Monetary Fund.

Quarterly data was collected from publicised financial reports of the banking industry and from the

International Financial Statistics (IFS) Online Services database.

The data is observed at quarterly intervals with the first quarter being Q1 of 1999 and the last being Q4 of 2005.

Using bank level data for Uganda between 1999-2005, statistics on size and decomposition of bank’s interest

margin and profitability are provided. Regression analysis (panel data with random effects) is used to find the

underlying determinants of Uganda’s banking industry performance. To this end, a set of internal characteristics

is included as determinants of bank’s profitability. Studying the impact of bank’s characteristics on their

performance calls for the inclusion of macroeconomic and financial structure indicators (bank and market size,

and concentration) to control for the effect of external factors.

3.3 Sample Size

The sample is very representative of banking in Uganda. There are 15 banks in Uganda from which 8 banks

were selected according to their percentage share of total assets. The sample represents 61.09% of total assets,

23
with the largest at 28.39% and lowest at 1.05%. The sampling frame consisted of three fields; large banks with

more than 9.99% share of assets, medium sized banks with the percentage share of assets between 3% and

9.99% inclusive and finally small-sized banks with lower than 3% share of assets.

3.4 Model specification

The most popular model for evaluating firm performance is the “return on equity model”. Return on equity

(ROE) is a measure of the rate or return flowing to the bank’s shareholders. It represents the net benefit the

shareholders receive from investing their capital in the bank, i.e. placing their funds at risk in the hope of

earning an appropriate profit. So ROE measures the profitability from the shareholders perspective, and it

measures bank accounting profits per dollar of book equity capital. ROE is defined here as net income divided

by average book value of equity. Return on assets (ROA) is an indicator of managerial efficiency and it shows

how the bank’s management converted the institution’s assets under their control into earnings. ROA is defined

here as net income divided by average book value of assets. ROE is linked to ROA by the equity multiplier

(EM), which is equal to total assets divided by total equity (the inverse of the equity-to-asset ratio), or average

assets divided by average equity. A bank’s equity multiplier compares assets with equity, where high EM ratio

indicates a large amount of debt relative to equity. ROE and ROA are linked by the following Du Pont Model

equation:

ROE = ROA x EM ………………………………………………………………………….(1)

The profitability determinants are basically divided into two main categories, namely the internal determinants

and the external determinants. The internal determinants include management controllable factors such as

liquidity, investment in securities, investment in subsidiaries, loans, non-performing loans, and overhead

expenditure. Other determinants such as savings, current account deposits, fixed deposits, total capital and

capital reserves, and money supply also play a major role in influencing the profitability. Similarly, external

24
determinants include those factors that are beyond the control of management of these institutions such as

interest rates, inflation rates, market growth and market share. In order to incorporate the internal and external

determinants into a single profitability model, dummy variables were used to take account of inter-firm and

inter temporal differences in the intercept.

The internal variables are related to the bank itself and they are planned according to the management decisions.

The external variables are an outcome of the environment where the bank is operating. The objective is to

separate these two effects and determine their degree of importance on foreign and domestic banks. I will

assume that the relationship between ROE and ROA and the variables that determine them can be described by

the following equation:

Y = Xα + Zβ + ε ………………………………………………………………………..….. (2)
where Y is the bank’s ROE/ROA,
X is a vector of internal variables
Z is a vector of external variables and
ε is the error term.

The variables affecting bank profitability and the equation relating ROE and ROA and their determinants as

tested in equation (2) are as following:

ROA = β0 + β1 FOREIGN + β2 SIZE + β3 OBS + β4 LOAN+ β5 TBILLS + β6 DEP + β7 CAP + β8 LIQ +

β9 CRDRISK + β10 NIM + β11 CA+ β12 CI +β13 GDP+ β14 RATE + β15 INFL +

ε………………………………………………………..…………….(3)

25
3.4.1 Variable description and expected relationship

The variables in the model are described as follows:

Firstly, relative size (SIZE) of a bank is utilized to control for scale and scope economies. The total assets of the

banks are used as a proxy for bank size. However, since total assets deflated the other dependent variables in the

models such as ROA it was appropriate to log total assets before it was included in the model.

Off-balance sheet activities as a proportion of total assets (OBS), private sector loans as proportion of total

assets (LOAN) and treasury bills as proportion of total assets (T-BILLS) are proxies for banks’ investment

opportunities/decisions.

Deposit growth (DEP) represents the growth opportunities/strategies. Capitalisation level (CAP) is the ratio of

equity capital to total assets is included to detect the effect of capital requirements on banks’ profitability.

Also the liquidity (LIQ) controls for the effect of reserve requirements on banks’ profitability. Liquidity is

calculated as the proportion of total assets that are liquid i.e. the liquid assets. CRDRISK will control for the

effect of credit risk on banks’ profitability and is calculated as the ratio of Non-performing loans/assets to total

assets.

The net interest margin (NIM) will control for the market power of banks. The NIM variable is defined as the

net interest income divided by average assets.

Cost-to-income ratio (CI) and cost-to-asset ratio (CA) control for the efficiency of bank management.

26
For foreign ownership, a bank is defined as “foreign” if it has more than 50% of its equity under foreign control.

Consequently, this will include domestic banks under foreign control and the subsidiaries of foreign banks. A

dummy variable (FOREIGN) is used where it takes the value of 1 if the bank is “foreign”, zero otherwise.

The real GDP growth rate (GDP), interest rates (RATE) at 91 day T-bills and the CPI inflation level (INFL) are

used to control the effect of the economic environment on bank’s profitability. Past studies have reported a

positive relationship between inflation and bank profitability. High inflation rates are generally associated with

high loan interest rates, and therefore, high incomes. I expect GDP growth rate to have a positive impact on

bank’s performance according to the well-documented literature on the association between economic growth

and financial sector performance.

3.5 GDP Interpolation

Uganda doesn’t report GDP at quarterly intervals. But the research is based on quarterly data points. In this

section, series for quarterly GDP were constructed using Denton 2001 method of Benchmarking.

Benchmarking combines a series of high frequency data with a series of less frequent data so as to combine the

relative strength of the low and high frequency data. Benchmarking generates quarterly data for the back series

from annual data and encompasses both interpolation and temporal distribution. Interpolation draws a line

between two points whereas Temporal distribution distributes annual flow data over quarters.

The general objective of the method is to preserve as much as possible the short term movements in the source

data under the restrictions provided by the annual data, and also to ensure, for forward series, that the sum of the

four quarters of the current year is as close as possible to the unknown future data.

27
The Denton 2001 method of Benchmarking was used in this research. Denton (2001) computes the proportional

Denton 2001 method of interpolation of an annual flow time series by use of an associated “indicator” series,

imposing the constraints that the interpolated series obeys the annual totals. The indicator series only contribute

to their pattern to the interpolation, thus it is quite feasible to use both quarterly and annual flow series

expressed at an annual rate. The interpolated series will however be at quarterly rate. The procedure is

especially applicable to flow variables like GDP in this case.

The Denton 2001 method is a least squares method in which the quarterly estimates to be derived are the

parameters and the sum of squares involved are the first differences of the ratio of interpolated series to the

indicator series. The indicator variable used in the research is Industrial Production which is both available at

monthly and quarterly rates.

3.6 Econometric Modeling

The data set used is a cross-section time series or panel data set. The banks sampled differ widely in terms of

ownership and centre of location. Therefore panel data analysis is used since the data is organized in both bank

and time dimensions. The error term likewise has two dimensions; one for the bank and the other for the time

period. The data set is a balanced panel since there are no missing values.

Two types of panel data analytic models were considered i.e. Fixed effects model and Random effects model.

The fixed effects model considers the bank specific effects on the regression estimates only, leaving out the

effect of time. The model examines group differences in intercepts with the same slopes and constant variance

across groups. Such models use least square dummy variables (LSDV), within and between effects estimation

methods.

28
Assume Yit = ά + Xitβ + έ……………………………………………………..…………….(4)

For a fixed effects model, Yit = (ά +µi) + Xitβ + έit where έit~iid (0,σ2)……….………..(5)

The dummy variable µi, is part of the intercept.

However, the banking sector in Uganda has undergone radical changes in form of structure of earnings,

technological changes, regulatory system change, etc. This means that we cannot totally ignore the time effect

across the banks hence the need for the random effects model.

Random effects are applied in cases where some variables may be constant over time but vary between groups,

and others may be fixed between groups but vary over time. The random effects model estimates the variance of

components for groups (banks) and error, assuming the same intercept and slopes. The difference between the

banks lies in the variance of the error term. The model is estimated by generalized least squares (GLS) method.

3.7 Fixed Vs Random Effects Model

In order to validate the results of the fixed effects model, the individual coefficients were tested to ascertain if

all were equal. This gave rise to a null hypothesis: Ho: ( ά +µ1) = (ά +µ2) =… = (ά +µN).The alternative

hypothesis was very helpful in differentiating the banks and confirming that existence of heterogeneity across

banks. This hypothesis was tested by the F test, which is based on loss of goodness-of-fit.

SSR0 SSR1
n 1 ~ Fn 1,nT
F n k …………………………………………………………….(6)
SSR1
nT n k

where SRR0 and SSR1 are the sum of residuals from the constrained and fixed effects models respectively.

Rejection of the null hypothesis implied that the fixed group effect model is better than the constrained model.

29
The one-way random effects model is formulated as

Yit = ά + Xitβ + µi + έit …………….............................................................................(7)

where

i= 1, 2, . . . T and t= 1, 2, . . . T

and µi ~iid (0, σ2u) and έit~iid (0, σ2έ). The µi are assumed to be independent of έit and Xit which are also

independent of each other for all i and t (Unlike in the fixed effects model). This model can be estimated using

the GLS method.

2
2
eit ei
…………………………………………………………………………(8)
nT n k
where eit are the residuals issued from the estimation of the fixed effects model and êi are the individual means

of these residuals over each time period relative to each bank.

σ2µ indicates the residuals issued from the estimation of the between effects model or the group mean

regression.

The Hausman test was used to determine whether to use fixed effects or random effects model. Statistically,

fixed models always give consistent results but they are not always the most efficient. Random effects models

however give better P-values because they are more efficient.

The Hausman’s test ensures that a more efficient model is tested against a less efficient but consistent model to

come up with a consistent more efficient model. In short, the test compares the fixed versus random effects

under the null hypothesis that the coefficients estimated by the efficient random effects estimator are the same

30
as the ones estimated by the consistent fixed effects estimator i.e. P-values of the test are insignificant (the

probability of Chi square are greater than 0.05. If they are, then the random effects model is the better model to

be used.

3.8 Heteroskedasticity and Autocorrelation

Volatilities of most high frequency economic and financial data are time varying. Conditional skewness and

kurtosis of asset returns have been found to be time varying in several studies e.g. Hansen (1994), Harvey and

Siddique (1999, 2000). In such cases, it’s inappropriate to assume i.i.d errors for each individual series έit. For

correct inference, an assumption that the differenced errors are homoskedastic and not serially correlated was

assumed. Thus the panel data used in the study was tested for autocorrelation and heteroskedasticity.

Heteroskedasticity problems arise from group wise differences, and often taking group means can remove the

problem. In general, generalized least square (GLS) method was employed to handle the problem.

The most straightforward way to handle heteroskedasticity in the fixed effects model was to begin by
2
calculating an estimate of σ έi using LSDV residuals.

Assume Yit = (ά +µi) + βXit + έit

T
2 1
i eit2 ………………………………………………………………….(9)
T t 1
Feasible GLS estimates are then calculated by the formula
1
FGLS X' 1
X X' 1
Y ………………….………………………………..………(10)

Where

31
 2
1 T I 0 . 0
2
0 2 T I . 0
. . . . ……………………………………...(11)
2
0 0 . n T I
In random effects model, a composite error term ( µi + έit) is considered. Although it makes sense to allow

E(µ2i) = σ2µi, one observation is made for each i on µi . Therefore, estimation of σ2µi would have to be µ2i,

which is probably not desirable. LSDV residuals can be used to estimate σ2έi . And the group specific variance

can be estimated by

n
2 1 2 2
u OLS , i t ………………………………………………..(12)
n i 1

To deal with Autocorrelation in the FE models, care was taken to ensure that the data was stacked in the correct

manner. Using AR (1) errors it i i ,t 1 it , the coefficients can be estimated with LSDV residuals, the

data pseudo-differenced, and feasible GLS applied.

In the RE model there was always going to be autocorrelation in the composite error term (µi + έit) because µi

does not vary over time. Therefore, it only made sense to specify autocorrelation in έit . The LSDV residuals

could be used to get an estimate of ρ.

32
Heteroskedasticity in the data set was tested using the LR test since iterated GLS with only heteroskedasticity

produces maximum-likelihood parameter estimates. However, iterated GLS with autocorrelation does not

produce the maximum likehood estimates, so the likelihood-ratio test procedure could not be used as with

heteroskedasticity. However, Wooldridge (2002, 282–283) derives a simple test for autocorrelation in panel-

data models. Drukker (2003) provides simulation results showing that the test has good size and power

properties in reasonably sized samples. The data was subjected to a user-written program, called xtserial,

written by David Drukker to perform the autocorrelation test in Stata. A significant test statistic indicates the

presence of serial correlation whereas an insignificant test indicates absence of autocorrelation.

3.9 Stationarity Test

The levinlin method of panel unit root test developed by Levin, Lin and Chu (2002) was used to test for

stationarity of the variables. The test assumes that each individual unit in the panel shares the same AR(1)

coefficient, but allows for individual effects, time effects and possibly a time trend. The test usually viewed as a

pooled Dickey-Fuller test, or an Augmented Dickey-Fuller (ADF) test when lags are included, with the null

hypothesis of non-stationarity. After transformation, the t-star statistic is distributed standard normal under the

null hypothesis of non-stationarity.

33
 CHAPTER FOUR
DISCUSSION OF FINDINGS
4.1 Introduction
This chapter presents and empirically analyses the regression results of the determinants of bank return on

assets (ROA) or profitability in the Ugandan Banking industry. The data from a sample of 8 banks is pooled

together for the period 1999 to 2005. The banks used in the research are; Barclays bank, Centenary Rural

Development bank, Crane bank, DFCU, Diamond Trust bank, Orient bank, Stanbic bank and Allied bank (Bank

of Africa).

4.2 Interpolation of quarterly GDP

Table 4.1 shows quarterly GDP figures obtained from stata 8.0 using the Denton 2001 method with industrial

production as the indicator variable.

4.3 Test for Autocorrelation

The Wooldridge test for autocorrelation in the data set used revealed the following results;

With the null hypothesis H0: no first-order autocorrelation,

F( 1, 7) = 0.084

Prob > F = 0.7802

The F-statistic fails to reject the null hypotheses and hence there is no evidence to prove that the data used is

serially correlated.

Table 4.1: Quarterly GDP Interpolation

Time Time IP GDP Qgdp
1999 q1 128.767 1.181
q2 114.867 1.051

34
 q3 120.700 1.099
q4 129.067 4.5 1.168
2000 q1 125.800 1.128
q2 123.133 1.083
q3 130.433 1.115
q4 130.600 4.4 1.074
2001 q1 140.067 1.093
q2 135.233 1.013
q3 147.400 1.071
q4 143.000 4.2 1.023
2002 q1 140.800 1.006
q2 143.800 1.021
q3 154.233 1.083
q4 143.167 4.1 0.990
2003 q1 158.500 1.074
q2 143.933 0.950
q3 146.367 0.934
q4 153.667 3.9 0.942
2004 q1 170.067 0.994
q2 161.467 0.910
q3 172.967 0.954
q4 172.200 3.8 0.943
2005 q1 176.400 0.974
q2 173.500 0.964
q3 175.967 0.982
q4 175.367 0.980
Source: Bank of Uganda (2006)

4.4 Stationarity Test

Table 4.2 shows results of the levinlin test for stationarity. Apart from the loan variable (loan) which is

significant at 10%, all the variables are stationary at 1% based on the significance of the t-star statistic.

35
Table 4.2: Stationarity Test Results

Variable coefficient t-value t-star P>t

Roa -0.71398 -11.9530 -8.87706 0.0000
Asset -0.16969 -5.0350 -2.48666 0.0064
Loan -0.16492 -4.6410 -1.24844 0.1059
Tbill -0.23692 -6.1590 -2.74324 0.0030
Dep -0.36695 -6.8440 -4.21860 0.0000
Cap -0.22152 -5.4960 -2.86409 0.0021
Nim -0.56648 -11.4750 -8.24751 0.0000
Ci -0.50287 -8.7340 -5.90919 0.0000
Cap -0.5464 -8.9670 -6.31101 0.0000
Liq -0.32732 -6.9010 -3.72802 0.0001
Obs -0.43347 -7.6140 -4.28982 0.0000
crdsk -0.40146 -8.3080 -5.03397 0.0000

4.5 The Hausman Test

When the data set was subjected to the Hausman’s test, a random effects model was preferred basing on the P-

value which was greater than 0.05 as shown below.

b = consistent under Ho and Ha; obtained from xtreg

B = inconsistent under Ha, efficient under Ho; obtained from xtreg
Test: Ho: difference in coefficients not systematic
2
chi (14) = (b-B)'[(V_b-V_B)^(-1)](b-B)
= 20.31
Prob>chi2 = 0.1208
4.6 Regression Results

As discussed in the previous chapter, the estimation technique used is panel data method. Table 4.3 summarizes

the results of the regression. The empirical analysis finds that both individual bank characteristics and

macroeconomic factors are important determinants of bank profitability in Uganda.

Table 4.3: Determinants of Return on Assets

36
4.7 Discussion of Findings

High interest rates are associated with higher returns on assets or profitability. This is in line with the fact that

demand deposits frequently pay zero or below market interest rates. Hence the higher the interest rates, the

bigger the margin banks make over the demand deposits.

Determinants of Return on Assets Sample period: 1999-2005

Variables Description Model 1 Model 2
ASSET Natural Log of assets -0.004 (-2.55)** -0.004 (-2.59)***
LOAN Loans Over total assets -0.011 (-0.61)
TBILL Treasury bills over total assets 0.027 (1.88)* 0.027 (2.55)**
DEP Total deposits over total assets -0.030 (-1.47)
CAP Equity Capital over total assets -0.034 (-1.14) -0.044 (-1.68)*
NIM Net interest margin 0.167 (6.78)*** 0.168 (8.43)***
CI Cost to income ratio -0.139 (-14.1)*** -0.139 (-20.51)***
CA Cost to assets ratio -0.048 (-0.25)
LIQ Proportion of total assets that are liquid -0.012 (-0.94)
OBS Off balance sheet items over total assets -0.005 (-0.34)
CRDSK Non-performing assets over total assets 0.008 (0.37)
INFLATION Inflation rate 0.045 (0.98)
GDP GDP growth rate 0.080 (4.69)*** 0.078 (5.02)***
INTEREST Interest rate 0.001 (3.00)*** 0.001 (3.2)***
LOCAL Bank with local centre of control 0.008 (3.16)*** 0.008 (3.31)***
Number of banks 8 8
Number of observations 216 216
Log likelihood 614.024 612.914
Wald Chi2(15) 633.49 624.81
p> chi2 0.000 0.000

Z values are in parentheses, *,** and *** indicate that variables are significant at 10%, 5% and 1% levels respectively

The Net Interest Margin (NIM) which is also the bank’s (in)efficiency is highly associated to Return on Assets

(ROA). This explains why loans and Deposits are not significant. The ROA does not automatically depend on

how many loans bank give or how much deposits banks collect but rather on how banks utilize the two to

achieve maximum returns simultaneously.

37
Surprisingly, the analysis shows that banks with a local centre of control are significantly more efficient than

banks with foreign centers of control. This is explained by the disadvantage foreign banks face in terms of input

efficiency driven by excess expenditures on purchased funds [ De Young and Nolle,1996] and overuse of inputs

in order to out compete local banks. Furthermore, reliance on parent banks is another reason why foreign banks

in Uganda are less efficient than banks with local centre of control. Unlike local banks, foreign banks in Uganda

depend on a variety of funds including lines from their parent companies and hence their profitability may not

be dependent on how they utilize or convert their deposit into interest earning assets. But local banks go an

extra mile in utilizing deposits and in the end achieve higher profits than foreign banks.

The coefficient of the size of the bank represented as the natural log of assets is negative and significant on the

Return on Assets. This is explained by the proportion of the total assets held as loans and advances. In Uganda,

most specifically in the sample used, total loans and advances make up the most representation on the balance

sheet. Between 1999 to 2005, the banking industry in Uganda was experienced a high ratio of non performing

loans and advances to total assets meaning that a greater percentage of the balance sheet was non performing.

Therefore in conclusion, the higher the total assets, the higher the proportion of the assets that are non-

performing, the less the interest earned on the loans and advances and finally the less the return on assets.

Another reason as to why size is negatively related to profitability is that the larger a bank becomes the lower its

efficiency arising out of scale inefficiencies. In other words little cost saving can be achieved by increasing the

size of the bank as noted by Berger, 1987. This may also be evidence that the inter-bank market in Uganda is

competitive and efficient since banks with a large asset base or deposit-taking network do not gain a cost

advantage against other banks after taking into account the expenses associated with attracting deposits.

38
Treasury bills have a positive relationship with banks’ Return on Assets. The more the proportion of assets held

as treasury bills, the more likely a bank will improve its profits. This is explained by the fact that unlike loans,

treasury bills are safer to invest in, competitive, secure and transferable with predictable rates of return. The risk

of losing on a treasury bill investment is zero.

The cost to income ratio is significant and negatively related to return on assets (ROA). Higher cost to income

ratio implies either higher costs of production or reduction in income. Hence the higher the costs of production

and/or the lower the income, the lower the return on assets. Higher cost to income ratio also implies

management inefficiencies. Hence the lower the inefficiency of management, the lower the profits of a bank.

Higher GDP growth improves banks’ profitability as indicated by the positive significant relationship between

GDP at factor cost and Return on Assets. The demand for loans is likely to rise in a period of boom thus giving

banks more pricing power in lending. As investment levels rise, demand for investment funds also raises which

results in more willingness to go in credit.

Though the level of capitalization shows a weak relationship, banks that are well capitalized have higher profit

margins and hence are more profitable. Banks with higher capital ratios have lower cost of funding.

Loans, Liquidity, credit risk, cost to asset ratio, inflation, OBS activities, and deposit growth do not have a

significant impact on banks’ ROA.

39
 CHAPTER FIVE
SUMMARY OF FINDINGS, CONCLUSIONS AND RECOMMENDATIONS

5.1 Introduction

The chapter summarises the main findings of the study and derives policy recommendations from the

conclusions based on the established significant relationships.

5.2 Conclusions

The research investigates the impact of bank’s specific and external factors on banks’ return on assets or

profitability in the Ugandan banking industry from 1999 to 2005.

Both internal and external factors explain a substantial part of the variation in bank ROA. High profitability is

associated with banks with higher interest assets, higher net interest margins, lower cost to income ratios, with

their centre of control located in Uganda. These banks’ profitability is also likely to increase when there is

economic growth. Other important factors are the size of the banks which has a negative relationship with

profitability reflecting scale inefficiencies and the capitalization level with a positive relationship.

Secondly the research finds that inflation has no impact on bank’s interest margins and profitability as earlier

thought. This is simply explainable because during inflationary periods, depositors demand for money will rise

resulting into a rundown of the deposits. However the bank counteracts this action by increasing the interest

rates charged on loans.

5.3 Recommendations

Therefore with the above conclusions, the central bank, government and financial institutions need to consider

the following recommendations when drawing policies:

40
Bank of Uganda in its capacity as the regulator must continue to enforce its supervisory role in boosting capital

levels of the industry since capital is the primary source for back up in cases of losses. Bank of Uganda, through

The Financial Institutions Act 2004, requires commercial banks’ to maintain their core capital and total capital

to risk weighted assets above 8% and 12% respectively. This is in line with the Basel Core principle 6 of capital

which stipulates that regulators or supervisors should set prudent and appropriate minimum capital adequacy

requirements which reflect the risks that banks undertake and should define the components of capital bearing

in mind its ability to absorb losses.

The central bank should ensure that banks improve Board and senior management oversight in the operations of

the banks in order to improve efficiency at all levels. Board oversight has been proven crucial in identifying,

evaluating, monitoring and mitigating all material risks that would otherwise be detrimental to profitability. The

level of involvement of Board and senior management should be commensurate with the size and complexity of

the bank.

With regard to the positive relationship between banks with local centres of control and profitability, the

government through Bank of Uganda should ensure that subsidiaries of international banks are stand alone

registered banks with local representation on the Board of Directors. Board oversight is very effective if and

when board members reside within the environment in which their banks operate.

In order to control the effect of size in terms of total assets on profitability, Banks should aim to improve their

credit risk management in order to improve the quality of their credit portfolios that make up most of their total

assets. Banks should set up credible credit policies and credit management information systems that clearly help

41
in the timely identification of bad loans and advances. Furthermore, banks should be very stringent on writing

off of loans and advances that have gone bad so that the quality of total assets is not weighed down.

With a strong and significant relationship with interest rates, banks should have effective systems in place that

identify, monitor and control interest rate risk in their banking books. On the side of government, both domestic

and foreign financial markets should be developed to boost banks’ profitability.

Government should continue the fight towards economic development and also improve the general welfare of

the population so as to boost their credit worthiness. Banks focused their investment in treasury bills which are

risk free unlike loans and advances which were always subject to credit worthiness of clients. Furthermore,

Bank of Uganda should guarantee a strong and stable financial sector to strengthen the public’s confidence in

banks.

42
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 APPENDIX

Appendix A. Stata output for the hausman test

. quietly xtreg roa asset loan tbill dep cap nim ci ca liq obs crdsk gdp inflation interest,fe

. estimates store fixed_group

. quietly xtreg roa asset loan tbill dep cap nim ci ca liq obs crdsk gdp inflation interest,re

. hausman fixed_group

---- Coefficients ----

| (b) (B) (b-B) sqrt(diag(V_b-V_B))
| fixed_group . Difference S.E.
-------------+----------------------------------------------------------------
asset | -.0145771 -.0042991 -.010278 .0034817
loan | .0150788 .0027943 .0122845 .0087949
tbill | .0395743 .0252229 .0143513 .0029846
dep | -.0424893 -.0260917 -.0163977 .0051574
cap | -.0245111 -.0382393 .0137282 .0159566
nim | .215585 .1710626 .0445224 .0118502
ci | -.1251122 -.1411414 .0160292 .0043172
ca | -.3268486 .103312 -.4301606 .0593833
liq | -.0094099 -.0084255 -.0009844 .004443
obs | -.0268257 -.009344 -.0174817 .008724
crdsk | .0021055 .0160345 -.013929 .0087578
gdp | .0374997 .0751503 -.0376506 .0149363
inflation | .0447653 .0362551 .0085102 .
interest | .0009227 .0007147 .000208 .
------------------------------------------------------------------------------
b = consistent under Ho and Ha; obtained from xtreg
B = inconsistent under Ha, efficient under Ho; obtained from xtreg

Test: Ho: difference in coefficients not systematic

chi2(14) = (b-B)'[(V_b-V_B)^(-1)](b-B)
= 20.31
Prob>chi2 = 0.1208*

*Given a P-value greater than 0.05, a random effects model was preferred to a random effects model.

46
Appendix B. Stage 1 Random Effects Model Stata Output

. xtreg roa asset loan tbill dep cap nim ci ca liq obs crdsk gdp inflation inte
> rest local

Random-effects GLS regression Number of obs = 216

Group variable (i): institution2 Number of groups = 8

R-sq: within = 0.6951 Obs per group: min = 27

between = 0.9329 avg = 27.0
overall = 0.7457 max = 27

Random effects u_i ~ Gaussian Wald chi2(15) = 586.57

corr(u_i, X) = 0 (assumed) Prob > chi2 = 0.0000

------------------------------------------------------------------------------
roa | Coef. Std. Err. z P>|z| [95% Conf. Interval]
-------------+----------------------------------------------------------------
asset | -.0044278 .0018023 -2.46 0.014 -.0079603 -.0008953
loan | -.0113438 .0193905 -0.59 0.559 -.0493485 .0266609
tbill | .0271285 .0149774 1.81 0.070 -.0022267 .0564837
dep | -.0298974 .0212048 -1.41 0.159 -.0714581 .0116633
cap | -.0339235 .0308329 -1.10 0.271 -.0943548 .0265079
nim | .1671453 .0256051 6.53 0.000 .1169603 .2173303
ci | -.1391251 .0102556 -13.57 0.000 -.1592256 -.1190246
ca | -.0477845 .1996143 -0.24 0.811 -.4390212 .3434523
liq | -.012224 .0134666 -0.91 0.364 -.0386181 .0141701
obs | -.004717 .0146197 -0.32 0.747 -.0333711 .023937
crdsk | .0076502 .0216686 0.35 0.724 -.0348194 .0501198
gdp | .0804012 .0178186 4.51 0.000 .0454773 .115325
inflation | .044899 .0475676 0.94 0.345 -.0483318 .1381297
interest | .000715 .0002475 2.89 0.004 .0002299 .0012
local | .0081327 .0026763 3.04 0.002 .0028873 .0133781
_cons | .1346526 .0433519 3.11 0.002 .0496845 .2196207
-------------+----------------------------------------------------------------
sigma_u | 0
sigma_e | .01405524
rho | 0 (fraction of variance due to u_i)
------------------------------------------------------------------------------

47
Appendix C. Second Stage Random Effects model Stata Output

. xtreg roa asset tbill dep cap nim ci gdp interest local

Random-effects GLS regression Number of obs = 216

Group variable (i): institution2 Number of groups = 8

R-sq: within = 0.6894 Obs per group: min = 27

between = 0.9399 avg = 27.0
overall = 0.7431 max = 27

Random effects u_i ~ Gaussian Wald chi2(9) = 595.88

corr(u_i, X) = 0 (assumed) Prob > chi2 = 0.0000

------------------------------------------------------------------------------
roa | Coef. Std. Err. z P>|z| [95% Conf. Interval]
-------------+----------------------------------------------------------------
asset | -.0042652 .0016848 -2.53 0.011 -.0075673 -.0009631
tbill | .0267108 .01073 2.49 0.013 .0056804 .0477412
dep | -.0377664 .0187097 -2.02 0.044 -.0744368 -.001096
cap | -.0432796 .0264407 -1.64 0.102 -.0951024 .0085432
nim | .1678939 .0203966 8.23 0.000 .1279173 .2078706
ci | -.1387823 .0069281 -20.03 0.000 -.152361 -.1252035
gdp | .0783997 .0159836 4.91 0.000 .0470724 .109727
interest | .000713 .0002285 3.12 0.002 .0002652 .0011608
local | .0077608 .0024006 3.23 0.001 .0030557 .0124659
_cons | .128839 .0416389 3.09 0.002 .0472283 .2104497
-------------+----------------------------------------------------------------
sigma_u | 0
sigma_e | .01408942
rho | 0 (fraction of variance due to u_i)
------------------------------------------------------------------------------

48
Appendix D. GLS model stata output

. xtgls roa asset loan tbill dep cap nim ci ca liq obs crdsk gdp inflation inte
> rest local

Cross-sectional time-series FGLS regression

Coefficients: generalized least squares

Panels: homoskedastic
Correlation: no autocorrelation

Estimated covariances = 1 Number of obs = 216

Estimated autocorrelations = 0 Number of groups = 8
Estimated coefficients = 16 Time periods = 27
Wald chi2(15) = 633.49
Log likelihood = 614.0239 Prob > chi2 = 0.0000

------------------------------------------------------------------------------
roa | Coef. Std. Err. z P>|z| [95% Conf. Interval]
-------------+----------------------------------------------------------------
asset | -.0044278 .0017343 -2.55 0.011 -.0078269 -.0010286
loan | -.0113438 .0186585 -0.61 0.543 -.0479138 .0252262
tbill | .0271285 .014412 1.88 0.060 -.0011186 .0553756
dep | -.0298974 .0204043 -1.47 0.143 -.0698892 .0100944
cap | -.0339235 .029669 -1.14 0.253 -.0920736 .0242266
nim | .1671453 .0246385 6.78 0.000 .1188548 .2154359
ci | -.1391251 .0098684 -14.10 0.000 -.1584668 -.1197833
ca | -.0477845 .1920789 -0.25 0.804 -.4242522 .3286832
liq | -.012224 .0129583 -0.94 0.346 -.0376217 .0131738
obs | -.004717 .0140678 -0.34 0.737 -.0322894 .0228553
crdsk | .0076502 .0208506 0.37 0.714 -.0332162 .0485165
gdp | .0804012 .017146 4.69 0.000 .0467957 .1140066
inflation | .044899 .0457719 0.98 0.327 -.0448124 .1346103
interest | .000715 .0002381 3.00 0.003 .0002482 .0011817
local | .0081327 .0025752 3.16 0.002 .0030853 .0131801
_cons | .1346526 .0417153 3.23 0.001 .052892 .2164132
------------------------------------------------------------------------------

49
Appendix E. GLS second stage stata output

. xtgls roa asset tbill dep cap nim ci gdp interest local

Cross-sectional time-series FGLS regression

Coefficients: generalized least squares

Panels: homoskedastic
Correlation: no autocorrelation

Estimated covariances = 1 Number of obs = 216

Estimated autocorrelations = 0 Number of groups = 8
Estimated coefficients = 10 Time periods = 27
Wald chi2(9) = 624.81
Log likelihood = 612.9141 Prob > chi2 = 0.0000

------------------------------------------------------------------------------
roa | Coef. Std. Err. z P>|z| [95% Conf. Interval]
-------------+----------------------------------------------------------------
asset | -.0042652 .0016453 -2.59 0.010 -.0074899 -.0010404
tbill | .0267108 .0104787 2.55 0.011 .006173 .0472486
dep | -.0377664 .0182715 -2.07 0.039 -.0735779 -.0019549
cap | -.0432796 .0258214 -1.68 0.094 -.0938886 .0073294
nim | .1678939 .0199189 8.43 0.000 .1288537 .2069342
ci | -.1387823 .0067658 -20.51 0.000 -.152043 -.1255216
gdp | .0783997 .0156092 5.02 0.000 .0478061 .1089932
interest | .000713 .0002231 3.20 0.001 .0002757 .0011503
local | .0077608 .0023444 3.31 0.001 .0031659 .0123557
_cons | .128839 .0406636 3.17 0.002 .0491398 .2085382
------------------------------------------------------------------------------

Appendix F. Test for Autocorrelation

. xtserial roa asset tbill dep cap nim ci gdp interest local

Wooldridge test for autocorrelation in panel data

H0: no first-order autocorrelation
F( 1, 7) = 0.084
Prob > F = 0.7802

50