Lender of Last Resort – What Is It? And How Does It Work?

The lender of last resort is usually central banks that offer loans to banks and financial institutions that are facing financial difficulty or are considered highly risky.

In the United States, the Federal reserve bank acts as a lender of last resort to institutions that do not have alternative means of borrowings, and failing such institutions would create a negative impact on the economy.

Similarly, the Reserve Bank of India holds the position of lender of last resort in India. Recently, Yes Bank a large private bank went into a situation where it had too many bad loans amid cooked books, then RBI came into the play and provided a line of credit and other assistance to bring stability to the financial system.

The lender of last resort functions to protect individuals who have deposited funds and to prevent customers from withdrawing out of panic from banks with temporarily limited liquidity.

Private commercial banks usually do not borrow from lenders of last resort as that would indicate that the bank is experiencing a crisis of its own or in the making of one.

Lender of Last Resort and Preventing Bank Runs

Run-on the bank means panic has set in regarding the financial stability of the bank. When the larger bank or financial institution goes into such economic difficulties, there is a run on the bank. This would mean the depositors would want to withdraw their money as soon as possible. This would further drain the liquidity position of the bank.

Bank runs were widely seen in the 1929 great economic depression. Recently in the 2008 financial crisis, many big institutions went into bankruptcy that resulted in federal reserve banks stepping in and make massive bailouts of banks and financial institutions in distress.

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Thoughts on Lender of last resort

Generally speaking, there are four thoughts on lender of last resort which in are as follows:

  1. Free banking school which states to abolish the central bank as state lender of last resort.
  2. Richmond fed view which states the lending should be done only through open market operations to market as a whole. This would in all abolish the discount window.
  3. New York Fed view states that lend to everybody, solvent or insolvent, and sometimes on soft terms where is necessary to keep the credit system going.
  4. Bagehot view also called the classical view states the lend freely only to solvent but also to illiquid firms against good collateral at higher interest rates.

Criticisms of Lenders of Last Resort

The critics allege that lender of last resort encourages banks to take unnecessary risk with the deposits from their customers knowing that they will be bailed out in pinch. Such claims were validated in the great financial crisis in 2008.

Bear Stearns along with other investment banks went highly leveraged on instruments with bad fundamentals. This led to the bankruptcy of Bear Stearns and the massive bailout of other firms.

Similar things have happened during the coronavirus pandemic. The Federal Reserve has infused massive funds into the banking system. They have bought billions of bonds from the open market and there is free money printing being done by the federal reserve bank.

This is excessive by any means. They are also supporting the stock markets which should not be done really as stock markets need to be free from any anchoring.

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Resolution of Lender of last resort

The populist thinks that it is necessary to immediately resolve failed banks, but in reality, it may not straightforward to do so. In many countries, the framework for a resolution to make it effective are not fully in place and the failure of banks can trigger unnecessary financial risk.

Funding of insolvent banks may break past conventions and create moral hazards. In many cases, the bilateral lender of last resort may be needed as a backstop.

Doesn’t Quantitative Easing and Fears of Inflation Cause higher Interest Rates?

This is currently happening in the United States as they have been printing money to buy bonds and injecting the banks with funds. There are certain fears over future inflation and this could lead to rising bond yields.

Further, many central banks have been doing the same more or less while the magnitude is reasonable to madness like the united states.

In the current liquidity setup, the created money is really inflationary as commercial banks are not sitting on the extra cash. Hence, markets should be indeed concerned about inflation. At the moment, they prefer inflation from massive quantitative easing.