Despite considerable debate about data, methodology and direction of causality, evidence suggests that policies which favour the provision of broad and efficient financial services can contribute to economic growth. The most important contribution of financial intermediation is its ability to induce larger size and foster a greater degree of integration of markets for goods and services, factors of production and other assets (improve resource allocation). This expansion is necessary to facilitate the division of labour and specialisation, greater competition, use of modem technologies and exploitation of economies of scale and scope, which facilitate economic growth (Gonzalez-Vega, 1996).
Financial intermediaries contribute to this process by providing an effective and reliable payments mechanism which reduces the transaction costs of using money and promotes the division of labour in production and increased specialisation (Fry, 1988: 233 - 299). Division
of labour, use of modem technologies and exploitation of economies of scale and scope are further encouraged through intermediation between savers and investors. A flow of funds arises because savers (surplus spending units) may not all be good investors or entrepreneurs (deficit spending units), and may be unwilling to make the full amount of their savings available to investors. This is because the search and match process between potential borrowers and potential savers results in costs to locate the other party, and to negotiate and monitor contract performance. In addition, the risk, liquidity and divisibility preferences of the two contracting parties may not fully coincide (Barryet al., 1995: 427 - 451).
Financial intermediaries are able to reduce the transaction costs of the search and match process by issuing their liabilities (deposit facilities) to serve as assets for savers, with the assets earning a competitive return, and providing these assets to investors by purchasing their primary securities (loans). A wide variety of financial instruments can be created which suit both savers and investors that differ in duration, riskiness and marketability of the instruments, level and type of yield and the kind of issuer (Fry, 1988: 233 - 299). Financial intermediaries thus facilitate the transfer of purchasing power from producers and regions with resources in excess of those required for current consumption and/or limited growth, to those with investment opportunities offering higher marginal rateS of return, and where a more rapid expansion of output is possible, but which do not have enough resources to fully exploit those opportunities. However, opportunities for productive investment and incentives to invest must exist (Gonzalez-Vega, 1996).
Selection of the best possible uses of available resources is achieved through the disciplining role of interest rates, the screening and monitoring of borrowers, and loan contract enforcement. Screening and monitoring of borrowers is frequently too expensive for
individuals and hence the specialisation and resulting economies of scale give financial intermediaries a clear advantage in selecting projects with high marginal productivity which promotes economic growth (Fry, 1988).
Financial intermediaries also perform the important function of effectively managing risks inherent in financial intermediation. Firstly, the financial intermediary substitutes its own fmancial strength for that of investors. Consequently, savers do not look at investors for deposit security, but at the intermediary. Secondly the intermediary conducts screening procedures to determine whether the Investor is a worthy borrower. Thirdly, portfolio risk is managed through geographic and sectoral diversification to reduce the incidence of covariant risks (individuals living in same area or conducting similar business are subject to the same negative income shocks). This reduces the volatility of rates of return on individual investor's wealth, while the ability to diversify sectoral risks allows increased specialisation and productivity of resources. The reduction in transaction costs and the impact of risks thus encourages productive investment and economic growth through increasing the attractiveness of savings and investment by providing suitable alternatives to holding wealth in the form of tangible assets, which facilitates the flow of funds in the economy (Gonzalez-Vega, 1996;
Barryet al., 1995: 427 - 451).
Financial services are not just a demand for funds for productive investment, but are also linked to household risk management by facilitating synchronisation of income generating and consumption activities. When households or individuals need to set aside liquid assets for unforeseen events, they cannot allocate funds to higher return but less liquid investments.
Since not all households need access to funds for emergencies at similar times, deposit-taking intermediaries can provide liquidity to households without the households having to keep
large Wlused cash balances. Efficiency of investments are thus improved by directing liquid funds to illiquid projects, and by preventing the liquidation of valuable assets to meet Wlexpected cash demands. Deposit facilities may also provide valuable services for liquidity management and accumulation of stores of value (Rhyne, 1994).
Financial intermediaries thus contribute to economic growth indirectly by facilitating the flow of funds to productive investments, managing risks and encouraging savings in financial form by offering suitable loan and savings facilities. Research by King and Levine (1993) showed that financial indicators tend to be positively related to economic growth and physical capital accumulation. Frequently, while recognising but misWlderstanding the roles of fmancial markets, governments have intervened in financial markets, trying to achieve non-financial objectives with the use of fmancial instruments. These policies, and criticisms of how they have been applied, are outlined in the following section.