Lender of Last Resort

Lender of Last Resort

What is a lender of last resort?

A lender of last resort is an institution, usually the central bank of a country, that offers loans to banks or other eligible institutions that are experiencing financial difficulties or are considered to be very risky or almost in the process of collapse. In the United States, the Federal Reserve acts as a lender of last resort to institutions that have no other means of borrowing and whose failure to obtain credit would significantly affect the economy.

Key points to remember

  • A lender of last resort is an institution, usually the central bank of a country, that provides loans to banks or other eligible institutions in financial difficulty.
  • The Federal Reserve acts as a lender of last resort to institutions that have no other means of borrowing and whose failure to obtain credit would significantly affect the economy.
  • Critics of the practice of having a lender of last resort claim that this encourages banks to take unnecessary risks with clients’ money, knowing that they can be bailed out.

Understanding the lender of last resort

The function of the lender of last resort is to protect those who have deposited funds and to prevent clients from withdrawing from bank panic with temporarily limited cash. Commercial banks generally try not to borrow from the lender of last resort, as such action indicates that the bank is going through a financial crisis.

Critics of the lender of last resort methodology suspect that the security it inadvertently provides encourages eligible institutions to acquire more risk than necessary, as they are more likely to perceive the potential consequences of risky actions as less serious.

Lender of last resort and prevention of bank outflows

A bank transfer is a situation that occurs during periods of financial crisis when bank customers, worried about the solvency of an establishment, go en masse to the bank and withdraw funds. Since banks only keep a small percentage of total cash deposits, a bank transfer can quickly drain a bank’s liquidity and, in a perfect example of a self-fulfilling prophecy, result in the insolvency of the bank.

Bank breaks and subsequent bankruptcies prevailed after the stock market crash of 1929 which led to the Great Depression. The US government has responded with new legislation imposing minimum reserves on banks, requiring them to hold over a certain percentage of liabilities as cash reserves.

In a situation where a bank’s reserves do not prevent a bank transfer, a lender of last resort can inject funds into it in an emergency so that customers requesting withdrawals can receive their money without creating a bank transfer which pushes the institution to insolvency.

Reviews of lenders of last resort

Critics of the practice of having a lender of last resort claim that this encourages banks to take unnecessary risks with clients’ money, knowing that they can be bailed out if need be. These requests were validated when large financial institutions, such as Bear Stearns and American International Group, Inc., were bailed out in the midst of the 2008 financial crisis. Supporters say the potential consequences of not having a lender last are much more dangerous than excessive risk taking by banks.

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