FINANCIAL SECTOR ASSESSMENT UPDATE UGANDA

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized 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 of Uganda s financial system in connection with the Financial Sector Assessment Program (FSAP) through one mission in November, The purpose of 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. The Ugandan economy has benefited from bold and comprehensive reforms following decades of civil war and economic mismanagement prior to 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. 2. The authorities have made good progress in implementing many of the 2001 FSAP recommendations. Key developments include: (i) the privatization of Uganda Commercial Bank Limited (UCBL) to a reputable bank; (ii) the clean up of some small weak banks from the banking system; (iii) substantial improvements to banking supervision with the introduction of a risk-based approach and passage of the new Financial Institutions Act (FIA); (iv) the preparation of AML/CFT legislation and of a credit framework for monitoring and enforcing it; and (v) the presence of banks that appear to be well capitalized, profitable, and resilient. Generally, progress in reforming the banking sector been faster than in the NBFI sector. I The mission comprised Messrs. Fuchs (Team Leader, World Bank), Teo (Deputy Team Leader, IMF); Hayward (Bank of England and IMF (retired)), Peiris, Yokobori (all IMF); Beck, Costain, Cuevas, Impavido, Vassilou, and Keppler (all World Bank). An AML/CFT mission visited Kampala from February 14-23,2005 in connection with this update.

2 3. The key finding of this FSAP Update is that the banking system is sound but continues to play a limited role in supporting economic development. Financial intermediation continues to be low in both relative and absolute terms. While the banking system is healthy, it is still small, faces relatively high costs, and offers a limited array of products most of which are limited to the short-end of 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 time for confidence to build and for intermediation to deepen. Many changes such as the privatization of UCBL are relatively recent, Given progress in liberalizing the sector, it would be counterproductive to reintroduce 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 of services to a larger segment of the population, and increase its role in supporting economic development. On outreach, the authorities are encouraged to focus their efforts on a smaller number of high performing entities and to minimize distortions introduced by government or political interference in microfinance. 5. There is also a need to increase domestic saving in order to support much needed 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 well as to reduce dependence on donors. Particularly important are steps to reform the pension system and deal with UDBL. 6. At the same time, the team supports continued efforts to improve prudential supervision and regulation as well as systemic liquidity management. Uganda has recently passed the new FIA and is moving toward risk-based supervision. The main challenge in this area is to fully implement these changes. The authorities will have to stay abreast of developments in the sector as competition increases and the market becomes more sophisticated. The transfer of project accounts to the central bank from commercial banks should also be done cautiously to avoid potential disruption in liquidity as well as to ensure these accounts are serviced in a cost efficient manner. 7. There is a real and current threat posed by both money laundering and terrorist financing. While there is 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. 8. Other key elements that are necessary for financial sector growth also need to be managed. One is the economy s dependence on agriculture that leaves Uganda vulnerable to external shocks. Another factor is the country s dependence on foreign donor inflows. Aid

3 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. Of 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 of the region can have an effect on confidence. Public confidence in medium- to longer-term prospects is 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 is growing but still small and underdeveloped, and it offers a limited array of products, mostly to the short end of the maturity curve. Financial intermediation is low, and dominated by commercial banks. Only 17 percent of total deposits are time deposits, and less than 0.4 percent of time deposits have a maturity of more than 12 months. Twelve percent of all loans and 35 percent of loan volume has an outstanding maturity of more than one year. While the share of long-term lending seems reasonably high by regional standards, it is mostly limited to on-lending of a European Investment Bank (EIB) Line of Credit, channeled through the Department of 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 of medium-to longterm funding sources. There is no factoring yet. 10. The banking system is sound but is 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 still faces inefficiencies that diminish the banking system s role in the economy. Net interest margin and overhead costs, both relative to total earning assets and calculated over a sample of 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 of higher operating costs, its small size, and/or low level of competition. Interest rate spreads are currently 20 percent and have not dropped below 16 percent over the last six years. Decomposition of spreads shows that operating costs constitute almost 50 percent of the spread (nine percentage points) with profits being the second largest component with 30 percent of the overall spread (six percentage points). 11, The high operating costs can be explained by the small size of 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 its low level of intermediation-larger degree of outreach and has recently invested heavily in physical infrastructure such as branches and ATMs. These higher costs might explain part of the extraordinarily high operational costs. High credit risk is also partly responsible for high interest spreads. The high overhead costs and the high profit margin can also be partly

4 -4- explained by high credit risk, as banks incur high evaluation, monitoring and enforcement costs. 12. Improvements that could be made in the legal and information environment and 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 of 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. 13. Financial institutions have improved access to financial services of its population and Tier 1 and 3 institutions are key players in the provision of services. Branches of financial institutions of Tiers 1 to 3 (see Annex I1 for an explanation of the terms used in the Ugandan classification of intermediaries) exist in 5 1 of the 55 districts in the country, and population per bank branch is in the order of 87 thousand people, when all three Tiers are considered, a substantial coverage by African standards. The total number of deposit accounts held in financial institutions is estimated to be just over 1.7 million, or about 35 percent of the total number of households. Depth of outreach is 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. 14. Gaps remain in the provision of deposit and payment services in rural areas, and in financing agriculture and rural enterprises. Although the coverage of deposit accounts as a proportion of the total number of households is relatively large, only about 11 percent of bank credit is reported as being allocated to agriculture. Notwithstanding the likely underestimation of this statistic, the contrast with the importance of agriculture to the economy is more acute than in most other countries. 15. The PostBank remains an important provider of 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, its intended targets for wholesale lending may require assessment skills 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 its role as a savings depository, it would always be a net creditor. 16. Financing of established small- and medium-scale enterprises (SMEs) is somewhat limited, while start-ups are primarily financed with their own funds. A recent assessment of the investment climate in Uganda reports that about one-fourth of established SMEs considered themselves credit constrained (40 percent among microenterprises), while the Uganda National Household Survey (UNHS) reports that less than 6 percent of enterprise start-ups are financed with borrowings. Uganda compares unfavorably with Kenya in terms of firms access to extemal sources of funds.

5 -5- B. Improving Financial System Efficiency and Outreach 17. The provision in the new FIA to allow for information sharing between financial institutions is a positive development that needs to be followed up by the speedy licensing and establishment of a Credit Bureau that allows for sharing of (negative and positive) information Accurate and reliable information about borrowers and their assets is difficult, if not impossible, to obtain because of deficiencies in the land and company registries thus increasing the cost of credit. The land registry is in a chaotic state, with files regularly lost or misplaced, and lengthy delays common. The creation, registration and enforcement of security rights in land is severely hampered by: (i) uncertainties in land title arising from the rights of non-owner occupiers of 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 of 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 regulation and administrations are costly, inefficient and subject to abuse. Excessive fees, which are normally calculated by reference to a percentage of recoveries, underscore the disposal culture in insolvency matters and the failure to engage in any sort of turnaround management. Only a limited number of accountants and lawyers understand insolvency issues, and auctioneers and court bailiffs are commonly appointed as receivers and managers3 The Official Receivers Department is inadequately resourced and subject to a high degree of political interference. The Commercial Court has improved the handling of commercial and insolvency cases but needs more resources, specialized judicial training and judges. 20. In September 2004 the Uganda Law Reform Commission issued a report with 35 proposals for a substantial overhaul of the country s formal insolvency system. Many of these proposals are commendable and should be implemented. It is strongly recommended the introduction of 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. The taxation system should be reviewed so as to facilitate the operation of corporate insolvency procedures and non performing 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 of credit reference bureaus. 3 The ULRC proposals for regulation stipulate that only accountants, auditor and lawyers may act as insolvency practitioners, which is 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 of 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.

6 -6- consequences of 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. Improved disclosure and transparency of interest and account-related charges would enhance competition. The BOU and banks may want to consider efforts in improving transparency of bank fees and charges, such as publication and comparison of fees by a consumer advocacy group, and more generally efforts to improve public understanding of banking services. BOU should also consider publishing effective lending rates and deposit interest rates and non-interest charges on its web-site to further foster competition and transparency. 23. Keeping the banking system contestable and reducing segmentation within the financial system can help increase competition in the financial system. In spite of the current moratorium on new bank licenses, the BOU is 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 of the financial system. More importantly, a complete integration of Tier 3 institutions in the financial system, including into the payment system and the intended credit bureau, is encouraged. 24. The legal reforms enacted in 2003 and the transformation of MFIs into Tier 3 institutions (MDIs) have been key elements of Uganda s sustainable outreach expansion and have placed Uganda at the forefront of microfinance development in the Africa region. The issuing of the MDI Act in 2003, the creation of 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 of the Uganda financial system. Once the current four applicants to Tier 3 status obtain their licenses, as seems likely, it is 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 of technical assistance including institutional strengthening. 25. While the MDI Act and its regulations follow international good practice and even add value to these standards, the licensing of the first four applicants currently in process will test the adequacy of 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 of this rule would require divestiture by these agencies so as to live up to the MDI Act s diversification requirements. 26. Concerns regarding the safety of small-balance deposits in unregulated institutions should be addressed through outreach expansion of regulated institutions into unserved areas, and a drastic restructuring of 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 of credit-only MFIs of sufficient

7 -7- scale should be increased through the Association of Microfinance Institutions in Uganda (AMFIU) non-prudential standards-setting and donor support of compliance therewith. 27. Expansion of branch networks and product innovation of regulated financial institutions and high-performing Tier 4 entities should be key priorities of government programs, at the expense of supporting new Tier 4 entrants. The Microfinance Outreach Plan (MOP) may risk fostering detrimental proliferation of small entities, thus compounding the severity of supervision constraints, and is likely to run into key capacity bottlenecks in terms of ownership and governance, management and marketing skills. Further, the reported emergence of briefcase MFIs or pseudo-saccos works against the general direction of financial sector development in Uganda. 28. Subsidized lending by the Microfinance Support Center Ltd. (MSCL) is likely to be introducing distortions and undermining the viability of MFIs and SACCOs by weakening credit culture. Aimed at rural microfinance, most of MSCL funds are allocated to on-lending through MFIs and SACCOs, whose track record and performance is not clearly known. It is suggested that MSCL management strictly adheres to its 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 is strongly recommended. Such a blend of MSCL support would be more in line with the main thrust of Uganda s commendable strategy to improve access to finance based on solid institutions. In addition, a careful analysis of the terms of on-lending may be warranted to develop guidelines for all government- and donor-funded lines of credit. 29. Private investment in marketing and processing, financing the marketing chain, warehouse receipts legislation, and market information systems are key elements for improving rural and agricultural finance, as they would have multiplier effects in facilitating the financing of 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 its part, the Plan for Modernization of 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. 30. While Uganda is, in broad terms, in line with its East African Community peers as regards adoption of a vision for the development of the payments system, use of electronic funds transfer is extremely limited. A Real Time Gross Settlement (RTGS) system for large value payments will be introduced by mid 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 of payment mechanisms will be available. However, there is still very little use being made of non-check instruments due to a distinct lack of interest in promoting these instruments by the banks The BOU and the banking industry recognize the need to make the payments system work for all segments of the population, but effective implementation of this agreed vision is 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,

8 -8- i.e., Tier 2 NBFIs and newly accredited MDIs. In this regard, a proactive educational and outreach program might be designed and executed by BOU 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. Given the progress that has been achieved in creating a sound financial system, the authorities are now focusing on issues related to longer-term finance that are facing the development of the financial sector. As the authorities proceed with this reform agenda, it is 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 of 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 of longer-term finance and economic growth. A. Pensions 33. Pension reform can have a significant positive impact both in providing protection to Ugandans in old age and in stimulating savings and the development of the market for longer-term finance. The Ministry of Finance is in the process of finalizing a cabinet paper relating to the reform of the Ugandan pension system. The general thrust of the vision under discussion is well conceived. Given the importance of NSSF as an investor and the recent suspension of its board, first priority should be given to the reform of NSSF. 34. A three-pronged approach to the restructuring of the NSSF is proposed: (i) contributors would be given the option to establish their own retirement benefit schemes in lieu of 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 of the governance of NSSF, steps should be taken to strengthen the investment process and ensure professional management of the NSSF s assets. 35. Priority should be given to the establishment of a new retirement benefit regulator and supervisor to oversee all retirement benefits schemes in Uganda (public and private). Given the small size of the insurance, pension and capital markets, a unified authority to supervise these three market segments would seem rational and appr~priate.~ This move would, however, require a substantial revision of the Capital Markets Authority Statute, not only to encompass the complexities of the pension business but also to accommodate the much increased dealings with the general public that would be required. 36. As a first step in reforming Public Sector Pension Fund (PSPF) it is necessary to verify the claims behind the identified arrears, improve on the arrears estimates, and budget for and make payments. The current PSPF has accumulated substantial arrears that are estimated around US$l SO-$200 million. It is Iikely that for some categories of arrears verification will be almost impossible. Given budget constraints it is unlikely that it will be As is the case in South Africa and Mauritius, for instance.

9 -9- possible to pay arrears in their entirety. A political solution needs to be reached between the government and individual or groups of claimants in respect of payment of arrears. 37. A second important step in reforming PSPF is to undertake an actuarial evaluation of the scheme, specifying the valuation bases, the economic and demographic assumptions and the reliability (or otherwise) of 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 is conducted, policy decisions can be taken on aspects of the scheme s design such as the benefit formula and the choice of financing mechanisms. 38. If the authorities adopt the recommendation that all pension funds in Uganda be established in the form of a trust, the PSPF bill may not be 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 civil servants. Should a separate PSPF Act be required, its drafting should await the outcome of actuarial evaluation of 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. B. Improving the Availability of Term Financing 39. The availability of term funds in Uganda is supported by several facilities administered by the DFD. Term facilities offered by the EIB at a concessional rate of 1 percent have been made available for general commercial purposes through DFD under four Apex loans. The total amount of DFD facilities (approximately U Sh 122 billion) is 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 credit support provision from donors, the guiding tenet of this support should be that credit is allocated by a qualified financial intermediary at market prices, with appropriate incentives, governance and controls to align interests with those of the government and supporting donor. Given the long term financing needs by clients of all sizes, a facility along the lines of 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 of 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. While the EIB facility has undoubtedly succeeded in its purpose of supporting investment in Uganda, its 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 it is noted that EIB funds are onlent to banks at the average of the 12 month deposit rate, the funds are for a significantly longer tenor (up to 15 years), the loan rate is the same for all banks, regardless of credit quality, and using the bank deposit rate for wholesale funds ignores the significant overhead expenses

10 - 10- 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 of long-term funding. C. Uganda Development Bank 42. The sale of a minority stake and management contract in UDBL merged with the DFD to a reputable finance institution should be expedited. Only by instituting strong internal management will it be possible for the restructured UDBL to avoid government directed lending and governance problems that had led to it is insolvency in the past. Moving DFD outside the BOU will also do away with any potential conflict of interest that might arise at the BOU. The key objective will be to allow UDBL to operate on commercial terms while still allowing for the fulfilment of a developmental role in recognition of 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 of subsidy are established. 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 of donor support for term financing needs. Reflow income generated from the repayment of existing DFD loans could also be allocated by the restructured UDBL. In line 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 of assets to local financial institutions. D. Uganda Stock Exchange 44. While the Uganda Stock Exchange (USE) has undoubtedly served as a useful pillar for the privatization strategy of 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 is sporadic and negligible measured both in real terms and relative to market capitalization. 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 of 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 is priced on the basis of EIB s international lending rates (ie., has no link to the Ugandan market). This need is recognized by the EIB and the next proposed tranche, Apex V, will not involve lending through the BOU, however, it will be two more years before the funds of 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 half the national average.

11 reliance on Collective Investment Schemes to reach the broader public. This approach could also be utilized to support greater trading of regional share issues targeting sophisticated and international investors. 46. The steps taken by the CMA to establish a market framework for Collective Investment Schemes are to be applauded. One well known international institutional asset manager is already undertaking investment of private pension assets and it is understood that others are in the process of entering this market, which will become dramatically more important with the reform of the NSSF now in train. One mutual fund is now in the final stages of 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 of borrowing. E. Housing Finance 47. While recognizing the limitations of the system and the considerable scope for further development, a broadly favorable outlook for the housing finance sector in Uganda was provided in an October 2004 in-depth stucty.' It is recommended that the major short-term priority be to speed up procedures in the land registry prior to the major upgrading of the system. The leading source of housing finance in Uganda is 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. It is a concern that NSSF has recently acquired a 70 percent stake in HFCU and also has a substantive role underpinning the market, through its 10 percent shareholding in DFCU as well as its substantial loans to both parties.' It is imperative that HFCU be passed to private sector control-not only does public ownership run the risk of distorting the market-but an investment of this type by NSSF is against the best principles of pension fund management as involvement in an operating company, with overhead, staff and liabilities is generally seen to be too demanding on the scarce management resources of an investment manager. F. Domestic Government Debt Markets 48. The successful introduction of treasury bonds is to be commended, as they have contributed to the establishment of a benchmark yield curve for issuers of mediumterm debt securities and represent a first step in extending the maturity structure of government securities. The BOU established a primary dealership in February 2003, which has facilitated secondary market trading of government securities with an increase in volumes traded, transactions of treasury bonds, and diversification of market participants. 49. However, the limited amount of term funding available in Uganda places constraints upon the government's capacity to issue long-term fixed-rate debt. More 'The study was prepared by a Work Bank Group Consultant. U Sh 10 billion to DFCU and U Sh 4 billion to HFCU.

12 - 12- generally, as the government moves to issue long-term debt instruments, further steps will need to be taken to strengthen its 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 of government debt risk properties and other key variables; (iii) policy on selling techniques, auction frequencies, and the desired range of debt instruments and; (iv) policy on market development FINANCIAL SECTOR SUPERVISION A. Supervision 50. The regulatory structure for banking supervision has been modernized and updated. The new FIA is comprehensive, clearly written, and provides a sound basis for the BOU s supervision. It is complemented by the MDI Act designed to extend the BOU s supervision to those micro-finance institutions willing and capable of assuming the obligations and responsibilities of taking deposits from the public. The process of drafting and making the consequential regulations is now well advanced, although not yet complete Although the process is just beginning, Uganda is already further down the road 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 of 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 of the risk-based supervisory regime. For this purpose BOU will need to spend a considerable amount of resources on training in order to maintain the intellectual capacity of the supervisory function as well as to ensure that it is adequately staffed. BOU will need to develop a flexible salary structure so it can retain the skills and, above all, the experience required. Efforts to improve off-site supervision, including regular stress testing are to be commended and should be continued. 52. In the insurance industry, some progress has been made in implementing the recommendations of the 2001 FSAP but investment regulations need to be issued as a matter of 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 of total assets. ~ 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 is not clear if there will be continued demand for such instruments, especially at the longer end. To date, the government has issued U Sh 335 billion in long-term bonds, the bulk of which have been taken up by the banking sector.

13 -13- B. Safety Net and Crisis Management 53. While coverage of the DIF is more than adequate, the governance structure is not incentive compatible. Coverage-currently U Sh 3 million-is seven times GDP per capita, significantly higher than in other countries. Ninety-six percent of all deposit accounts in Tier 1 and 2 financial institutions, but only 18 percent of total deposits are covered, which is 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 is also important that the guaranteed payout amounts not be exceeded. The absence of a separate legal and thus governance structure-dif is administered by BOU staff-and the lack of any involvement by the contributors (the financial institutions) could lead to conflicts of 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 BOU to minimize costs, duplication of supervisory work, and coordination problems. A board of directors should be established with adequate representation from financial institutions and with the authority over investment, coverage and premium decisions. 54. The investment policy of the DIF is in need of correction. Currently, the fund s liquid assets are held in unremunerated deposits with BOU, which deprives it of 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 of directors-under appropriate guidelines-and not subject to monetary policy considerations. Adequate representation of the financial institutions on the board of DIF should be guaranteed, and the board members should be submitted to a fit and proper test. 55. The new FIA contains the basis for effective bank failure resolution but only 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 BOU has not had cause to use them. IV. AML/CFT 56. There is 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 still is, the victim of domestic terrorism. The methods used by terrorist groups to move funds include: cross border cash couriering, the use of foreign exchange bureaus, which illegally offer remittance services, and other unlicensed remittance corridors. Finally, Uganda is 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. However, progress in enacting a legal framework for AML which was a main recommendation from the 2001 FSAP has been slow and inconsistent. Uganda has a draft AML bill, which is consistent with international standards and in some instances exceeds the Financial Action Task Force (FATF) Recommendations. The bill is close to being submitted to Parliament but the actual timeframe is uncertain. A comprehensive

14 - 14- implementation plan and cost assessment certificate need to be presented to Parliament with the bill. 58. Little progress has been made in putting in place a system for reporting and monitoring, AML/CFT violations (another main FSAP recommendation) in Ugandan banks. While there is 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 is 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 is to ensure that those who need to drive AML in terms of investigation, prosecution and intelligence are exposed to and adequately trained in relevant areas. The establishment of a FIU that is independent of political influence and has the resources to carry out its mandate is clearly a vital step forward.

15 ANNEX I Box 1. Summary of Key FSAP Update Recommendations ST - short-term, MT - medium to long term To improve financial system efficiency and outreach Accelerate licensing and establishment of a credit bureau (ST) Improve disclosure and transparency of interest and account related bank charges (ST) Accelerate rehabilitation of the land and companies registry (MT) Overhaul the corporate insolvency regime and supporting taxation framework, including the passage of a new insolvency legislation that gives creditors the right to commence bankruptcy procedures (MT) Strengthen institutional capacity of Commercial Court and of Official Receiver (MT) Focus government capacity building efforts on regulated institutions and high performing Tier 4 entities (MT) 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 MSCL adheres to its 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) To promote term financing and developing capital markets Restructure governance of NSSF, including the hiring of independent professional board members (ST) B Expeditious assignment of an incentive based management contract and partial sale of UDBL combined with the DFD of BOU (ST) B Increase private participation in HFCU, minimizing the involvement of government and NSSF (ST) B As soon as the regulatory authority for pensions is established and functional, rescind the monopoly status of the NSSF (MT) B Verify the arrears of the public service pensions scheme and undertake actuarial evaluation with a view to establishing a contributory trust fund (MT) B Provide future donor support to term financing, such as the EIB facility at market rates (MT) B Develop a comprehensive strategy for government debt management (MT) To enhance prudential sector stability and regulation B Issue investment regulations for insurance companies (ST) B Establish DIF as a separate legal entity without creating a separate institution outside BOU (MT) I Invest DIF assets in safe but high return securities, such as government paper (MT) I Continue to monitor and improve the risk based supervisory regime (Ongoing) To strengthen AMLKFT t Expeditiously enact AMLICFT legislation that meets FATF Recommendations (ST) 1 Take appropriate resource and assessment steps for a phased implementation of the AML legislation including resources to establish an FIU, enable BOU to carry out AML inspections, enable Director of Public Prosecutions, Law Enforcement, and Intelligence resources to meet responsibilities (MT)

16 - 16- Box 2. Possible Areas for Technical Assistance To improve financial system efficiency and outreach 0 Assist in the establishment of a credit reference bureau. 0 Assist in the rehabilitation of the land and companies registries. 0 Assist the Law Reform Commission and the First Parliamentary Counsel on the drafting of the new insolvency law. 0 Assist in establishing regulatory framework for insolvency practitioners. 0 Strengthen institutional capacity of the Commercial Court and of the Official Receiver. Assist with review of the taxation environment for NPL resolution. 0 Provide specialized assistance to the BOU in licensing and monitoring performance of MDIs. 0 Assistance to the MOF in re-focusing the Microfinance Outreach Plan. 0 Assist authorities in restructuring the SACCO sector. 0 Provide assistance to the top segment of the credit-only MFI. 0 Assist AMFIU on development of non-prudential regulations and standards for credit-only MFIs. 0 Assist commercial banks and Tier 2 and 3 entities for the development of microfinance and rural-finance products. 0 Assist BOU in promoting transparency, disclosure and consumer rights and education relating to financial service provision. Support the MOF/BOU in developing and implementing debt management and market strategy. B Assist BOU in establishing a regulatory framework for electronic and internet banking, and design of an East African cross-boarder payment system. To promote term financing and developing capital markets D Assist the design of the governance and investment process of NSSF. D Assist NSSF in the field of asset management in the form of a senior independent expert to provide advice juring the transition period. D Provide assistance on the establishment of the regulatory authority for pensions, including a combined :egulatory authority for pensions, insurance and the capital market. D Assist the PSPF to develop appropriate record-keeping procedures (including completion of the integrated 3ayroll system for the public service), investment policies and selection of asset managers. D Help build capacity in CMA in the field of Collective Investment Schemes, including taxation, accounting, licensing, supervision and enforcement. D Assist CMA and USE as to positioning the Ugandan capital markets for competitiveness in an East African ;ontext. To enhance prudential sector stability and regulation B Support the further institutional development of 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 its institutional capacity.

17 -17- 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 BOU supervises and regulates them. A commercial bank is defined as a company licensed to carry on financial business in Uganda and whose principal business consists mainly in (i) the acceptance of call, demand, saving and time deposits withdrawable by check or otherwise, in the capacity of a bank, (ii) provision of overdrafts and short to medium term loans; (iii) provision of foreign exchange, (iv) participation in inter-bank clearing systems, and (v) the provision and assumption of guarantees, bonds and other warranties on behalf of others. Tier 2 institutions: Credit institutions, licensed under the Financial Institutions Statute 1993, There are currently 7 credit institutions, and the BOU supervises and regulates them. A credit institution is defined as a company licensed to carry on financial business in Uganda whose principal business consists mainly in (i) the acceptance of call and time deposits repayable after a fixed period or after notice, and (ii) employment of such deposits wholly and partly by lending or any other means for the account and at risk of 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 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 of :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 of 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 will 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. 3ven the criteria that need to be fulfilled in order to qualify for an MDI-license, it is expected that mly a small number of the existing MFIs will be able to obtain such a license, and the majority of VIFIs (between 500 and 700) will remain in Tier 4.