CHAPTER ONE INTRODUCTION             Background of the study

The modern theory of financial intermediation posits that banks exist to perform two central roles within the economy: liquidity creation and risk transformation. According to the risk transformation theory, banks transform risk by issuing riskless deposits to finance risky loans. The liquidity creation theory, on the other hand, states that banks create liquidity on the balance sheet by using illiquid assets to fund liquid liabilities. The intuition behind the liquidity creation theory is that banks create liquidity because they hold illiquid assets (through the provision of long-term loans to the public), and give the public liquid liabilities (an example being transaction deposits which are paid to customers on demand). On the other hand, banks destroy liquidity by holding illiquid liabilities (through long-term borrowing of funds from the public) and investing in liquid assets which the bank can easily convert to cash to meet their need for liquid funds. Capturing these opposing effects gives a comprehensive measure of liquidity created by banks operating within an economy (Berger & Bouwman, 2009).

The need for efficiency in the banking industry depends on banks’ ability to spot and manage high-risk and high-return opportunities, and effectively control costs. For banks to sustain their growth and profitability, they need to introduce differentiated products and services; and this tends to expose them to various risks. As a result, banks need to recapitalise so they can absorb massive economic shocks and significantly contribute to the real growth of the economy (Morrison & Associates, 2016). The Basel Committee on Banking Supervision (BCBS), which was formed in 1974, is an international committee which develops standards for banking regulation. Over the years, it has developed a series of highly influential policy

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