On 11 March 2020, the World Health Organisation declared the COVID–19 a pandemic. The impact of the Coronavirus / COVID-19 outbreak is significant, unprecedented and fast developing resulting in significant business disruption. In Uganda, the sectors most likely to be impacted are manufacturing (where the option is to suspend operations or set up ways for their employees to camp at factory premises during the lockdown period), real estate, trade (because of significant dependence on imports from countries facing considerable COVID-19 related disruptions like China) tourism and transportation. Yet, these are the sectors that most financial institutions are exposed to significantly through lending.
The COVID-19 situation raises a range of issues which financial institutions are managing and will continue managing over the coming months. Business continuity plans have already been activated by financial service providers and clients alike. The Government of Uganda has also put in place several preventative measures including a lockdown that will most certainly test business continuity plans of financial services providers and their operational and financial resilience over the next several months.
Access to credit by businesses and the continued operation of financial institutions is essential. As such, banking services have been classified as essential services.
Bank of Uganda in its Monetary Policy Statement for April 2020 noted a deterioration in macroeconomic conditions and adopted measures that are aimed at ensuring continued access to credit. The measures include a reduction in the Central Bank Rate (CBR) by 1 percentage point (to 8%) and provision of liquidity assistance for financial institutions that need it.
However, with significant restrictions on business activities and transportation, the extent to which customers can access financial services and the relevance of some financial products and services is limited. This commentary evaluates key issues that the financial services sector is likely to encounter as it strives to remain open for business and support customers during these unprecedented times. The level of impact of the key issues analysed will depend on the duration and severity of the COVID-19 measures which will be influenced by global trends in containment of the pandemic.
Key issues for consideration
What are the implications of limiting operations?
The Central Bank, in response to a request from the Uganda Bankers Association, provided a “no objection” to supervised financial institutions to adjust branch operating hours to 9.00 a.m. to 3.00 p.m. on weekdays and complete closure on weekends. In response, financial institutions have implemented reduced working hours coupled with suspension of branches in certain locations. In the event the pandemic persists beyond the second half of the year resulting in significant negative economic effects, financial institutions will have to further re-evaluate operations and focus on trimming non-essential spending on low-impact and low performing operations.
Considering that the banker-customer relationship is one of creditor and debtor, customers expect to receive money deposited with financial institutions on demand. Financial service providers are therefore required to exhibit operational and liquidity resilience through their alternative service platforms. Providing regularly updated information about the operating status of the bank and its branches, remote access facilities, and mobile and online services as conditions evolve is essential.
Digital and information security risk:
With a view to curb the spread of the virus, cashless transactions are being encouraged and digital transactions have increased. ATMs and other self-service banking channels should be available both day and night except where the customers have been informed of temporary inaccessibility as required by the consumer protection guidelines. The increased use of self-service banking channels invariably heightens risks associated with the use of digital channels.
- Transaction risks: Financial institutions should have IT and process capabilities that will quickly address transaction and operational risks arising from enhanced usage of self-service banking channels. This should include IT surveillance to detect any anomalies in system operations, testing, detection, analysis and elimination of vulnerabilities and threats. It is also essential that audit trails for all transactions are retrievable and communication of security measures to customers is intensified.
- Information security risks: Maintaining data privacy and minimising the risk of data loss is required during this period. Similarly, adequacy of the frameworks and capabilities to manage data security for third party service providers should be regularly audited and reviewed.
2. Loan obligations
The economic impact of the COVID-19 pandemic will trickle down to existing loan arrangements. Financial institutions have to examine existing commitments and either renegotiate terms or cancel undrawn commitments. The approach taken by a financial institution should be preceded by confirmation that such action is supported by the loan agreement(s) in place.
Compliance with loan commitments especially to businesses in sectors that have been hit hard by the COVID-19 economic effects
Financial institutions may have loan arrangements in place that require continued accommodation to customers whose ability to service the loan has been curtailed by the economic realities and market uncertainties resulting from the COVID-19 crisis.
Advancing funds and fulfilling loan commitments
Financial institutions that have not yet signed loan agreements should establish whether the documentation that has been shared with the customer so far creates a contractually binding agreement. They may only be able to “freeze” a pending transaction where the customer requests for such action or the transaction is at preliminary stages with only non-binding documents shared with the customer. Importantly, financial institutions should re-evaluate the merits of the proposed lending considering the change in circumstances.
Contractually binding loan agreements may only be circumvented where under the terms of that agreement the lender has grounds to refuse to advance the funds. A change in circumstances regarding the borrower's prospects or market conditions, between the date of the contract and the date of a utilisation request may entitle the financial institution to decline to fund a utilisation request.
- Material Adverse Change (MAC): The Material Adverse Change (MAC) clause authorises the lender to declare an event of default and/or impose a draw-stop for undrawn commitments. This clause is usually widely couched such that it may be invoked based on the lender’s opinion that there is a material adverse change in the borrower’s financial condition and operational circumstances. In practice, however, COVID-19 being a global issue beyond the customer’s control and in most cases occasioned by government “lockdown” arrangements, relying on the MAC clause as the only ground for triggering an event of default may have an adverse impact on the financial institutions reputation in the market. However, it may be utilised as leverage in negotiations with the borrower including to support requests for additional security and cancellation or postponement of unutilised commitments.
- Events of default: Various events of default are likely to be triggered by the COVID-19 pandemic which may give the lender the right to cancel its commitment to fund utilisation requests or recall the loan. These include: non-payment, cross-default, suspension of payment or compromise with creditors by the borrower, suspension or cessation of business, breach of financial covenants, breach of information undertakings regarding financial statements/reports and the existence of a MAC. Financial institutions are entitled to cancel an undrawn commitment and call the loan if any of these events of default exist.
Can a borrower defer payments as a result of economic difficulties that arise from COVID-19?
Loan arrangements between the financial institution and a borrower are primarily governed by the loan agreement. Payment by the borrower may therefore be deferred to the extent of grace periods provided in the loan agreement. These grace periods are usually short, apply to specified circumstances and typically, to principal payments. In some agreements, the parties provide for re-negotiation of terms where there is a market disruption. Whether COVID-19 related events fall within the definition of market disruption to trigger re-negotiation of terms will depend on the definition of the term in the specific loan agreement.
Force majeure protections will only operate if the loan agreement has a specific contractual provision on force majeure. Contractual remedies for force majeure include extension of time to perform obligations, suspension of contractual performance during a force majeure event and termination in cases where the event continues for a prolonged period. Typically, most loan agreements do not contain force majeure clauses and as such borrowers may not have this as an option to defer or decline to make payments.
A contract may be discharged on the ground of frustration when something occurs after the formation of the contract which renders it commercially impossible to fulfil the contract. It is doubtful whether a borrower can successfully argue frustration to terminate the loan arrangements where loan repayments may be delayed or restructured but are not commercially impossible. A secured lender may also argue that there is an alternative way the loan may be repaid, i.e. through sale of the security by the lender or even with participation of the borrower.
3. Non-performing loans
According to a statement by the Minister of Finance, Planning and Economic Development to parliament dated March 2020, the coronavirus will affect the banking sector by resulting into non-performing loans (NPLs), affecting sectors like trade, tourism, transportation and construction. The Minister of Finance projects that if NPLs in these sectors increase by 50% due to fallout from the COVID-19 outbreak, the ratio of non-performing loans to total loans would worsen from 4.7% to 5.9%
Protections a borrower may seek against action by its lender
The legal provisions that provide protections to the borrower against action by lenders are usually limited to breach of contract by the lender, illegality, fraud and unconscionable bargains. It is unlikely that COVID-19 effects would form grounds for a court to protect a borrower against action by its lender. Even then, it is expected that many borrowers will seek court protection as a way of delaying their loan obligations.
The President of the Republic of Uganda in his address to the nation on 31 March 2020 stated that there should be no seizing of properties on account of unpaid loans. Amidst other practical limitations, it is likely that there will be Police intervention to prevent sale of mortgaged property during the lockdown period and likely beyond.
Can a lender take action against a borrower for non-performance by commencement of distress proceedings?
Unless the loan agreement contains an enforceable force majeure clause, the lender may take action against a borrower provided there is an enabling provision in the loan agreement. However, the lender’s action is likely to be limited by the following practical considerations:
- Absence of electronic default notice flexibilities in the loan agreements;
- Suspension of Court operations;
- Reputational considerations;
- Presidential directives on seizure of properties;
- Practicalities of an electronic/remote sale of property transactions;
- The impact of the COVID-19 crisis on property values and thus the value of security held; and
- Likely low- appetite of potential purchasers of collateral given the high likelihood of legal challenge.
Impact of non-performing loans on provisioning
Financial institutions are required to classify facilities which are 90+ days in arrears as non-performing loans. Provisioning for COVID-19 affected facilities together with likely enhanced deposit withdrawal following the lifting of the lock-down are likely to result in liquidity pressure on financial institutions. The Central Bank has indicated that lines of credit may be available to assist financial institutions that may require liquidity assistance. Financial institutions should consider engaging the Uganda Bankers Association to seek approval of the Central Bank for:
- authorisation to curve out COVID-19 related restructures from the ambit of Regulation 13 of the Financial Institutions (Credit Classification and Provisioning) Regulations, 2005 such they do not count as one of the two restructure opportunities per borrower; and
- relaxation of the provisioning requirements that would otherwise be applicable to COVID-19 related non-performing loans.
4. Restructuring of loans
Bank of Uganda, by its communication dated 20 March 2020, undertook to waive limitations imposed by the Financial Institutions (Credit Classification and Provisioning) Regulations, 2005 on restructuring of credit facilities that may be at risk of going into distress.
Bank of Uganda has also indicated that it will grant exceptional permission to supervised financial institutions to restructure loans of corporate and individual customers, including a moratorium on loan repayments for borrowers that have been affected by the pandemic on a case-by-case basis at the discretion of the supervised financial institution. This exceptional waiver period will last for 12 months with effect from 1 April 2020.
Banks should quickly identify the most affected sectors and their customers in those sectors to understand how they can be supported e.g. through relaxed payment schedules, availability of credit to relieve financial stress. This will require proactively engaging with customers to understand their unique circumstances.
To further mitigate the risk of loan losses and potential liquidity issues, financial institutions may have to consider freezing of lending for particular categories of businesses, industries or geographical locations on the basis of the severity of COVID-19 effects on such businesses. They should also consider whether they should take on new customers. Financial institutions should also consider borrowers who can only resume their businesses with financial support and whether lending will stimulate the business and ensure the bank gets paid.
In determining the approach to new lending, the following practicalities will need to be considered:
Standard template loan agreements are likely to be revised or negotiated to accommodate market uncertainties. Financial covenants ordinarily acceptable to the institution may be unachievable, representations and undertakings may have to be qualified and longer moratoria may be required. If an institution decides to lend, the loan agreement should be carefully reviewed and adjusted to conform to the present realities.
Availability of digital engagements
Considering the social distancing and partial lockdown arrangements, financial institutions should deploy mechanisms that support digital customer engagement, disbursements and collections. These mechanisms should be able to support the retrieval of an audit trail should it be required. Relatedly, compliance with the requirements of the Electronic Transactions Act, 2011 should be a primary consideration.
Audits and valuations
The requirement for social distancing and the lockdown invariably affects the ability to conduct valuations on potential security for credit facilities. Additionally, any desktop valuations should consider the asset depreciation concerns resulting from the impact of COVID-19 on the real estate sector. The financial institution would therefore have to consider whether loan to value ratios should be revised as a precautionary measure or on a case by case basis.
Limitations on perfection of securities
The Registry of Lands and Uganda Registration Services Bureau were not listed as essential services providers. Consequently, Lands Registry staff have been unable to report to work as a result of transport restrictions. Additionally, lawyers who provide support in perfection of securities are also affected by the lockdown. Lenders are currently unable to register legal interests as mortgagee.
Similarly, the Uganda Registration Services Bureau communicated a service suspension during the lockdown period. Should the lockdown period be extended, statutory time limits imposed by the Companies Act, 2012 may be flouted. COVID-19 interruptions should form a valid basis for extension of time. However, extension of time should be sought timely to ensure competing creditors do not register their interests first and attain priority. Engagement of the Uganda Registration Services Bureau to provide a general waiver on penalties for late registration should be considered.
6. Continuing data protection compliance with remote working
Financial institutions should ensure that the legal requirements on customer confidentiality and data protection and privacy and other information security measures are effective even with the remote working arrangements. The obligation to keep customer information confidential continues despite the remote working arrangements or the channels used to provide services to customers.
7. Capital and liquidity
The impact of COVID-19 on financial institutions operations is likely to affect capital adequacy buffers. Fundraising efforts to support capital requirements are also likely to suffer delays. Capital preservation during these challenging times will be important.
Most financial institutions have liquidity buffers that exceed the minimum regulatory requirements. With the economic pressures faced by customers and financial institutions, it is likely that these liquidity buffers may be stressed. Additionally, there may be a need to set aside liquidity to handle pandemic-related additional expenses. Financial institutions should monitor their balance sheet positions regularly and seek such liquidity support from the Central Bank when required.
8. Impact on funding arrangements
Financial institutions which have obtained lines of credit for on-lending from Development Finance Institutions, other lenders and those which manage administered funds should examine the underlying funding arrangements for opportunities to renegotiate terms and seek payment moratoria matching the impact on their own lending to customers.
9. Implications of moratorium on dividends and other discretionary payments
Bank of Uganda in a circular issued to financial institutions suspended bonus and dividend payments in a bid to reserve capital to support the economy and absorb losses. Financial institutions need to review their shareholding arrangements and employment contracts to establish whether such suspension exposes them to shareholder or employee claims. This assessment may form a case to be presented to Bank of Uganda for approval of an exceptional payment in the circumstances. To support exceptional approval, it may also be important to disclose the institutions stress tested capital position and strategy to reserve capital.
The issues that may be relevant to a financial institution are varied and are likely to evolve depending on the timeline of the COVID-19 pandemic and the extent of the measures put in place by government to curb the pandemic. The effectiveness of the mitigation measures taken by government and the Central Bank is also central in limiting the COVID-19 effects on financial institutions. As the COVID-19 situation evolves, financial institutions should continually monitor the impact of the pandemic on the economy, their businesses and their customers.