CHAPTER ONE
INTRODUCTION
1.1 Background to the study
Due to the crucial roles that banks hold in the financial sector, this research evaluates the profitability  of  the  commercial  banks  in  Uganda.  The  performance  evaluation  of commercial  banks  is  especially  important  today  because  of  the  fierce  competition  and globalisation  of  world  economies.  Evaluation  of  banks’  performance  is  important  for: depositors,  shareholders,  investors,  bank  managers  and  regulators.  In  a  competitive financial  market,  bank  performance  provides  signals  to  depositors  and  investors  with regard  to  whether  to  invest  or  withdraw  funds  from  the  bank  (Abdus  &  Kabir  2000).
Similarly, it flashes direction to bank managers whether to improve its deposit service or loan  service  or  both,  to  improve  its  performance.  For  that  reason,  identifying  the  key success factors of commercial banks enables the design of policies that may improve the profitability of the banking industry (Buyinza, 2010).
The importance of bank profitability  can be  appraised  at  the micro  and macro  levels of the  economy.  At  the  micro  level,  profit  is  the  essential  prerequisite  of  a  competitive banking  institution  and  the  cheapest  source  of  funds.  Indeed,  without  profits,  any  firm cannot attract outside capital (Gitman, 2007). Thus, profits play a key role in persuading depositors  to  supply  their  funds on  advantageous  terms.  By  reducing  the probability  of financial  trouble,  impressive  profits  figures  also  help  reassure  a  bank’s  other stakeholders,  viz:  investors,  borrowers,  managers,  employees,  external  product  and service suppliers, and regulators (Anyanwaokoro, 1996). It is not merely a result, but also a  necessity  for  successful  banking  in  a  period  of  growing  competition  in  financial markets.  Hence,  the  basic  aim  of  a  bank’s  management  is  to  achieve  a  profit,  as  the essential requirement for conducting any business (Bobakova, 2003).  
In  Uganda,  after  a  long  period  of  economic,  financial  management  and  political instability, in 1987 the government adopted a rehabilitation and recovery programme to rebuild  the  economy  and  restore  macroeconomic  stability  under  the  auspices  of  the International  Monetary  Fund,  the  World  Bank  and  the  donor  community  at  large. Financial  sector  reforms  in  Uganda  were  implemented  as  part  of  the  stabilisation  and beginning  in  1990,  a  number  of  reforms  were  implemented  in  the  financial  sector  in order to achieve the main goals of increased efficiency and financial deepening. During this  period  however,  developments  in  the  financial  system  were  disappointing  and  in view of this, Nanyonjo (2001) argues that bank restructuring did not yield the expected results.  According  to  her,  despite  some  improvement,  the  quality  of  commercial  bank assets remained weak during the post reform period. By the end of June 1997, about 30 percent  of  all  commercial  bank  loans  in  Uganda  were  non-performing.  This  not  only reflected weak management and procedures, but also poor credit discipline. In addition, profitability  of  several  banks  deteriorated  during  the  same  period  which  Nanyonjo (2001)  attributes  to  the  presence  of  non-performing  loans  in  bank  portfolio.  This indicator showed some worrisome signs, and hinted a progressive deterioration of bank soundness.  As  a  result,  several  banks  indeed  experienced  solvency  and  liquidity problems  and  were  closed  down  during  the  1998/1999  financial  year.  Therefore, although  the  Government  of  Uganda  through  the  Central  Bank  has  often  sought  for permanent measures that would enhance the profitability and stability of banks operating
in the Uganda’s banking industry, if the historical antecedents of financial sector reforms are anything to go by; they have not completely succeeded in achieving this feat. Against this  backdrop,  the  broad  aim  of  this  study  was  to  identify,  on  the  basis  of  empirical evidence,  significant  determinants  of  bank  profitability  in  Uganda.  However,  its  scope was delimited  to volume of investment  loans  and treasury  bills, lending  rates  and  yield on treasury bills as determinants of bank profitability.
As  postulated  by  intermediation  theories,  Loans  are  the  traditional  business  of commercial banks. However,  in the case of  Uganda’s banking  industry, the experiences of the last two decades appear to have negatively impacted on this role. In the 1980s and 1990s, the  industry was  riddled with high  levels of  Non Performing Assets (NPA). The ratio  of  NPA  to  total  loans  fluctuated  between  26%  and  39%  between  1995  and  1999 (Bank of Uganda (BOU) Annual Supervision Report, 1999). As a result, many banks re-designed  their  investment  portfolio.  They  turned  to  other  safer  alternative  investments than lending, such as the Treasury Bills (TBs). As a result, commercial banks investment in TBs grew by 417% between 1995 and 1999 (BOU Annual Supervision Report, 1999), compared  to  growth  in  loans  of  40%  for  the same  period.  Financial sector  reforms  and aggressive  loan  recovery  efforts  resulted  into  substantial  reduction  of  the  NPAs  from 7.2%  in  2003  to  2.2%  in  2004  (BOU  Annual  Supervision  Report,  2004).  Nonetheless, commercial  banks’  balance  sheets  reflect  a  strong  preference  for  liquid  and  low-risk assets, which has implications for their soundness and overall profitability  (Tumusiime- Mutebile, 2005).