CHAPTER ONE INTRODUCTION   Background of the Study

The role of banks in any economy is, for the most part, financial intermediation between entities (households or firms) with surplus funds and entities with deficits (Werner, 2015). They accept surplus funds through vehicles such as savings and other short and long-term deposits and offer them to deficit entities through loans, overdrafts and other means (Beckmann, Hake, & Urvova, 2013; Jokipii & Milne, 2008; Werner, 2015). This fundamental role played by banks is also associated with some level of costs incurred by these financial institutions. The theory of financial intermediation features several activities, generally known as qualitative assets transformation and these activities are usually regarded as core functions of banks (Bhattacharya & Thakor, 1993). It must be however be noted that these activities come along with risks specifically liquidity risk, credit risk and other risks associated with the transformation of maturity.

Bhattacharya and Thakor (1993) opined that there is some level of risk related to maturity of assets and liabilities as a result of the arrangement of liquidity when short-term deposits are utilised to finance fixed-rate long-term credits. This creates a gap known as the “maturity gap”, which can be attractive and desirable for banks especially when the associated term premia are lucrative. Term premium refers to the compensation that investors or banks require to bear risks that are associated with short-term treasury yields, since they usually do not evolve as expected. In this instance, banks have an incentive to increase income by being more aggressive in their intermediation role and in the process,

may assume more risks than usual. This is generally referred to as the “lure of interest rate risk” (Greenbaum & Anjan, 2004).

Almeida and Divino (2015) pointed out that credit concession is necessary in the financial sector in order to advance development, through the distribution of financial resources to different sectors of the economy. One of the significant pointers of productivity in financial institutions is the interest rate spread or the loan fee spreads. Interest rate spreads are the differences between the cost of acquiring savings and the profits on these assets from a bank’s point of view; that is, the difference between the financing cost banks charge on advances to their customers and the financing cost that they pay to depositors.

Indeed, financial institutions are susceptible to diverse risks such as operational risks, credit and liquidity risks, because they serve as a risk dealer (Ho & Saunders, 1981) by creating liquidity from savers and investors and providing funds to borrowers, and they are always expected to provide funds to their savers and investors whenever the need arises. This becomes more perilous because the banks do not know the timing needs of their savers and also there is likelihood that their borrowers will also not be capable to fulfil their obligations when their repayment of funds is due. Hence, banks are more cautious about liquidity and credit risk. Arif and Nauman Anees (2012) defined liquidity risk as a situation where banks are not capable of fulfilling their financial obligations without mislaying assets or incurring unexpected expenditure. In order to have a sound financial stability to compact unforeseen withdrawals, banks need to have a sufficient liquidity buffer. If banks need to hold or maintain a sufficient buffer to avoid future occurrences of panic withdrawals as suggested by ( Arif and Nauman Anees, 2012), then

they would always be disadvantaged on the cost of holding too much money even when customers do not need their monies at that particular period. Following this conversation in the literature, we argue that, banks need to be aware of and understand the state of the economy in which they operate and what each state of the economy may demand. For instance, if the economy is at a boom period, the question of whether or not customers will need more money for consumption or the banks will invest customers’ deposit needs to be asked. In a period where banks give funds to borrowers on the assumption that they will redeem repayments when due but the borrowers fail to repay the loans granted them, it results in credit risk. So, the timing for holding more liquidity and investing customers’ savings is a crucial decision for the banks. The economy grows when the banks are able to give credit to borrowers to take risky ventures. It is for this reason that, banks need to have a comprehensive facts and understanding of the business cycle and know how liquidity and credit risks responds to a specific phase of the cycle and its effects. In order for banks to compensate all costs attributed to their financial intermediary roles, having considered all the necessary risks, they charge a rate of interest on loans and also pay a depositor rate of interest to depositors.

Market analysts consider bank spread (the difference between deposit rate and lending rate) to be an indication of banks’ efficiency in their financial intermediation role. Aydemir and Guloglu (2017) indicated that when competition is weak in the financial institution sector, bank spreads are relatively to be high and this would be symptomatic of inefficiency in financial intermediation. High bank spreads will dampen investment in the economy as a consequence of high costs of borrowing. Moreover, if deposit rates are low,

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