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amounts of funds and lending large parcels. Liquidity risk is thus reduced (Diamond
and Dybvig, 1983). Diamond, (1984) further explains that deposit-taking institutions
also provide risk pooling and monitoring servicesig and hence idiosyncratic risk is
reduced. Regarding the delegated monitoring function, Townsend, (1978), Gale and
Hellwig, (1985) and Williamson, (1986) point out that transfer of this function from
individuals to specialised institutions can reduce cost as the latter benefit from
economies of scale. This allows borrowers to get funds at lower cost than via direct
lending. Additional resources can then be freed for productive use. Financial
intermediation then results in a more efficient allocation of resources.
The debate concerning the link between financial intermediation and growth
was initiated long before the arguments about financial liberalisation emerged.
Hamilton19,
(1791) pointed out that banks were the "happiest engine" that ever were
invented for creating economic growth. With government encouragement the number
of banks in the U. S. A rapidly rose from three in 1791 to above 800 in half of a
century. However, Hamilton does not provide any academic rationale in support of
his ideas. Bagehot (1873) and Schumpeter, (1912) underscore the causal role of
intermediaries on spurring growth. Bagehot highlights the role of banks in providing
liquidity to firms and the need for the former to get access to a public sector provider
of liquidity, the central bank. Schumpeter on his part focused on the contribution of
financial institutions in both evaluating and financing entrepreneurs in the initiation
of innovative activity as well as in bringing new products and new processes to the
" Monitoring of borrowers by lenders.
19 Hamilton was the person to act as "Secretary of the Treasury" in the USA and he made important
recommendations to government to promote the manufacturing sector. The development of banks
was part of his recommendations.
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