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 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 borrowing. Failing such institutions would negatively impact the economy.

Similarly, the Reserve Bank of India holds the position of lender of last resort in India. Recently, a large private bank went into a situation where it had too many bad loans amid cooked books.

RBI came into play and provided a line of credit and other assistance to stabilize the financial system.

The lender of last resort protects individuals who have deposited funds and prevents 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 bank’s financial stability. 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, resulting in federal reserve banks stepping in and making massive bailouts of banks and financial institutions in distress.

Thoughts on Lender of last resort

Generally speaking, there are four thoughts on the 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 states that 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.
See also  Advantages and Disadvantages of Corporation – All you need to know

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 a pinch. Such claims were validated in the great financial crisis in 2008.

Bear Stearns and 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 by the federal reserve bank.

This is excessive by any means. They also support the stock markets, which should not be done as they need to be free from anchoring.

Resolution of Lender of last resort

The populist thinks it is necessary to resolve failed banks immediately, but it may not be straightforward.

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 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 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 to massive quantitative easing.

Why the Central Bank Is Called the Lender of Last Resort

The phrase “lender of last resort” describes a central bank, like the Federal Reserve in the United States, which acts as a lender of funds when other sources are unavailable.

See also  What Is Conventional Mortgage? (All you need to know)

The purpose of this institution is to provide stability to financial markets and protect against systemic risk.

In times of economic distress, such as during the Great Recession of 2008, the central bank can inject money into the economy through quantitative easing or purchasing assets from banks so they can continue to lend.

Having a lender of last resort stems from two key points.

Firstly, it provides liquidity when normal lending channels dry up due to market uncertainty or macroeconomic conditions.

Through its actions, the central bank can help relieve short-term funding pressures while simultaneously providing incentives for banks to lend more cautiously in the future.

Secondly, it helps promote financial stability by preventing runs on banks and promoting confidence in financial institutions; if people know that their deposits are secure due to a lender of last resort, then there is less incentive for them to withdraw their savings during times of economic volatility.

This helps ensure that funds stay within banking channels, keeping credit flowing and stimulating economic growth over time.

Lastly, by extending loans at meager interest rates – sometimes even zero percent – lenders of last resort encourage economic growth since more money will be available for businesses and households to borrow and invest in projects that drive economic expansion, like new jobs or construction projects.

This further ensures that resources remain in circulation rather than stagnant or withdrawn from markets, provoking deflationary headwinds.

In conclusion, lenders of last resort exist because they play an essential role in keeping economies functioning smoothly and allowing people access to capital during times of hardship – whole uplifting communities instead of punishing those affected most.

Overall, having a lender of last resort can be beneficial for countries during difficult times – helping ongoing spur growth without any significant disruptions due to chaotic market forces!

Disadvantages of the Lender of Last Resort

  1. One major disadvantage of having a lender of last resort is that it can cause a moral hazard if not properly supervised.
  2. This occurs when banks expect government support and take on excessive risk — as they know that the Central Bank will provide a safety net if their bet does not pay off, thus encouraging imprudent behavior.
  3. Another problem with having a lender of last resort is that it could become overburdened due to its role in providing liquidity during times of crisis. If banks depend too much on the Central Bank’s support, it could be hard for them to recover from financial distress without additional help from outside sources or governments.
  4. Additionally, there are questions of fairness regarding Central Bank lending — since some business activities may benefit more than others from these lower-than-market interest rates provided during times of economic stress.
  5. Furthermore, this type of emergency financing should only be used sparingly and not abused as a crutch that businesses rely upon all the time – as this could lead to misallocation of resources and inefficiencies in the long run!
  6. Finally, it should also be noted that this type of lending carries certain risks, such as potential high inflation due to increased money supply or unfavorable terms attached to loans by the Central Bank – so careful consideration and careful oversight must always accompany any decision regarding lender-of-last-resort activities!
See also  What is Operating Gearing? Definition, Analysis, Example, and Usages

Advantages of the Lender of Last Resort

  1. Having a lender of last resort can help provide stability to financial markets, thus reducing systemic risk and protecting customers’ deposits in times of economic distress.
  2. This institution can also inject money into the economy through quantitative easing or purchasing assets from banks so that they can continue to lend.
  3. By providing liquidity when normal lending channels dry up due to market uncertainty or macroeconomic conditions, the lender of last resort can help relieve short-term funding pressures while simultaneously providing incentives for banks to lend more cautiously in the future.
  4. Further, by extending loans at meager interest rates – sometimes even zero percent – lenders of last resort encourage economic growth since more money will be available for businesses and households to borrow and invest in projects that drive economic expansion, like new jobs or construction projects. This helps ensure that resources remain in circulation rather than remaining stagnant or withdrawn from markets, provoking deflationary headwinds.
    • Finally, having a lender of last resort may also promote confidence in financial institutions as people know their deposits are secure due to this support, thus helping ensure that funds stay within banking channels, which keeps credit flowing and stimulates economic growth over time.