The effects of a tough economic environment in the region are beginning to show as banks grapple with increased loan defaults.
According to a stress test on the region's banks conducted last December, although commercial banks are well-capitalised, they could post lower profits due to high levels of non-performing loans (NPLs).
The stress test was conducted by the East African Community's Monetary Affairs Committee, comprising of governors of central banks in the region.
The report further reveals that banks in the region are more likely to register default on loans issued to farmers, traders and individuals, which are mostly secured through their incomes.
The researchers say the proportion of NPLs increased due to a slowdown in economic activity and low earnings by companies which, in some countries, led to layoffs, making it difficult for individual borrowers to service their loans.
Prolonged drought and delayed payments to suppliers also impacted borrowers in the agriculture and trade sectors.
Last year, East Africa was hard hit by a prolonged drought caused by El Nino and high temperatures linked to climate change, which impacted farm production causing countries like Kenya to subsidise maize flour prices as the market suffered a shortage.
The increased NPLs have caused banks to reduce lending to the private sector thereby stifling economic development in the region. Private sector lending by EAC banks slowed down in the year to June 2017, with Burundi suffering a contraction of 4.2 per cent.
According to the Bank of Uganda, the deterioration in the banks' loan books led to growth in credit risk between June 2016 and March 2017 as all countries experienced a gradual increase in NPL ratios during this period.
As at June 2017, Burundi had the highest NPL ratio of 17.4 per cent followed by Kenya with 9.9 per cent, Tanzania and Rwanda with 8.2 per cent while Uganda had the lowest NPL ratio of 6.2 per cent.
The most notable change in lending rates occurred in Kenya following the regulation on interest rate caps which Parliament passed in September 2016.
The rise in bad loans was attributed to a challenging business environment triggered by increased inflation, political uncertainties, poorly performing economy and a controlled interest rate regime.
In East Africa, Uganda has the highest lending rate estimated at 21 per cent followed by Tanzania and Rwanda whose overall lending rate averages 18 per cent.
Kenya's lending rate is currently fixed at 14 per cent. The country's average inflation for the year 2017 stood at eight per cent after hitting a high of 11.7 per cent in May 2017, driven by an increase in food prices occasioned by delayed rains and low food supplies.
In Uganda the average inflation for the year 2017 stood at 5.6 per cent, Rwanda six per cent and Tanzania five per cent, according to data from the respective countries' national bureau of statistics.
In Kenya, real GDP growth declined to an estimated 4.8 per cent in 2017 from 5.8 per cent in 2016, due to subdued credit growth caused by caps on commercial banks' lending rates, drought, and the prolonged political impasse over the presidential election.
In Rwanda real GDP growth in the first half of 2017 was an estimated 2.9 per cent, down from 8.2 per cent in the same period in 2016, due to weak performance in services and industry while in Tanzania growth in the first two quarters of 2017 averaged 6.8 per cent and was estimated at 6.5 per cent for the full year.
Uganda's economic growth for 2017 is estimated at 4.8 per cent.
Cost of loans in Kenya
Commercial banks in Kenya are required to extend loans at rates that are four percentage points above the policy rate (10 per cent), and offer deposit rates at 70 per cent of the rate.
Continued drought hindered agricultural productivity and resulted in high inflation for food prices while prolonged political activities and the presidential election impasse hurt private-sector activity.
Between August 2016 and June 2017, the average lending rate in Kenya dropped from 17.7 per cent to 13.7 per cent, during which period annual private sector credit growth declined by 2.9 percentage points to reach 1.5 per cent.
As a result, several listed companies, including Bamburi Cement, Standard Chartered Bank (Kenya), Mumias Sugar Company, East African Cables, Deacons East Africa and Britam issued profit warnings while lenders such as KCB, Barclays, National Bank, NIC Bank and First Community Bank trimmed their workforce.
Between 2016 and 2017, Kenyan banks laid off over 1,900 employees blaming their reduced earnings to the poor economy and interest rate cap.
It is argued that the impact of the rate cap in Kenya is likely to be twofold: A contraction in the supply of credit to the private sector as banks tighten lending standards to guard against credit risk, and a fall in banks' earnings because of the narrowing interest margins.
While the drop in interest rates was not as drastic in the other East African countries, the narrowing interest margins, coupled with slow credit growth, had an overall negative impact on banks' profitability in the region.
On average, banks' profitability as measured by their return on assets decreased from 2.8 per cent in the year to June 2016 to 2.3 per cent in the year to June 2017.
In Kenya, the banking sector profits declined by 14.7 per cent in the year to June 2017, largely reflecting an 18.5 per cent fall in earnings on advances, which constituted 54.4 per cent of total income.
According to the National Bank of Rwanda, the loan book of EAC banks deteriorated across the region due to delayed payments to contractors for government funded projects, drought and subdued economic performance.
"Despite these challenges the banking sector in EAC continued to be adequately capitalised," according to NBR.
In Rwanda the combined volume of NPLs of the four banks listed on Rwanda Stock Exchange (RSE) -- Equity Bank Rwanda, KCB Bank Rwanda, I&M Bank and Bank of Kigali --reportedly hit $43 million in December last year.
Last year KCB Group's gross NPLs increased to Ksh37.49 billion ($374.9 million) from Ksh31.81 billion ($318.1 million) the previous year while that of Barclays Kenya increased to Ksh12.61 billion ($126.1 million) from Ksh11.47 billion ($114.7 million) in the same period in 2016.