Lender of Last Resort
What Is Lender of Last Resort?
A lender of last resort (LoR) is an institution, generally a country's central bank, that offers loans to banks or other eligible institutions that are encountering financial difficulty or are viewed as profoundly risky or close to collapse. In the United States, the Federal Reserve acts as the lender of last resort to institutions that have no different means of borrowing, and whose failure to acquire credit would decisively influence the economy.
Figuring out Lender of Last Resort
The lender of last resort capabilities to safeguard people who have saved funds — and to keep customers from pulling out of panic from banks with brief limited liquidity. Commercial banks generally try not to borrow from the lender of last resort on the grounds that such action shows that the bank is encountering a financial crisis.
Pundits of the lender-of-last-resort methodology suspect that the safety it gives unintentionally entices qualifying institutions to get more risk than needed since they are bound to see the expected results of risky actions as less extreme.
Lender of Last Resort and Preventing Bank Runs
A bank run is a situation that happens during periods of the financial crisis when bank customers, stressed over an institution's solvency, plummet on the bank as a group, and pull out funds. Since banks just keep a small percentage of total deposits as cash, a bank run can rapidly drain a bank's liquidity and, in a perfect illustration of an unavoidable outcome, make the bank become wiped out.
Bank runs and subsequent bank failures were common following the 1929 stock market crash that prompted the Great Depression. The U.S. government answered with new legislation forcing reserve requirements on banks, commanding they hold over a certain percentage of liabilities as cash reserves.
In a situation in which a bank's reserves fail to forestall a bank run, a lender of last resort can infuse it with funds in an emergency so customers seeking withdrawals can receive their money without making a bank run that drives the institution into insolvency.
Reactions of Lenders of Last Resort
Pundits of the practice of triumphing ultimately a last-resort lender charge that it urges banks to face pointless challenges with customers' money, realizing they can be rescued after all other options have been exhausted. Such claims were approved when large financial institutions, like Bear Stearns and American International Group, Inc., were rescued amidst the 2008 financial crisis. Defenders state that the possible results of not having a lender of last resort are undeniably more dangerous than exorbitant risk-taking by banks.
Features
- The Federal Reserve, or other central bank, regularly acts as the lender of last resort to banks that never again have other accessible means of borrowing, and whose failure to acquire credit would emphatically influence the economy.
- Some contend that having a lender of last resort energizes moral hazard: that banks can face extreme challenges realizing that they will be rescued.
- A lender of last resort gives emergency credit to financial institutions that are battling financially and close to collapse.
