What is the Lender of Last Resort?
An organization known as a lender of last resort (LoR), which is typically a nation’s central bank, extends loans to banks or other qualifying entities that are having financial difficulties, are deemed extremely risky, or are in danger of failing. The Federal Reserve serves as the last-resort lender in the US for organizations without access to other funding sources whose inability to acquire credit would significantly impact the country’s economy.
Recognizing the Lender of Last Resort
The role of the lender of last resort is to safeguard depositors and stop consumers from making rash withdrawals from banks that have temporary liquidity constraints. Commercial banks typically avoid taking out loans from lenders of last resort, as doing so suggests they are going through a financial crisis.
Opponents of the lender-of-last-resort approach believe that while qualifying institutions are more likely to view the possible repercussions of risky acts as less severe, the safety it offers may unintentionally induce them to take on more risk than is necessary.
Bank Run Prevention and Lender of Last Resort
A bank run is a scenario that happens during financial crises when many bank clients rush the bank and take money out of it out of fear for the institution’s viability. A bank run can swiftly deplete a bank’s liquidity and, in a prime example of a self-fulfilling prophecy, result in the bank becoming bankrupt because banks only retain a small portion of total deposits as cash.
After the 1929 stock market crash that sparked the Great Depression, bank runs and subsequent failures were common. In response, the US government passed new laws requiring banks to maintain cash reserves above a specific percentage of their total liabilities.
Lenders of Last Resort Criticisms
The last-resort lender policy has drawn criticism for allegedly encouraging banks to take unwarranted risks with clients’ money because they know they will always be rescued in an emergency. Such accusations were proven true when major financial organizations like American International Group, Inc. and Bear Stearns were bailed out during the 2008 financial crisis. Advocates assert that the possible repercussions of lacking a lender of last resort pose a considerably greater risk than banks’ overexposure to risk.
Conclusion
- A lender of last choice gives emergency loans to banks that are having difficulty making ends meet and are about to fail.
- The Federal Reserve or another central bank usually steps in as the lender of last choice for banks that have exhausted all other options for borrowing money and whose failure to do so would have a huge impact on the economy.
- Some people say that having a lender as the last option makes banks more likely to take unnecessary risks because they know they will be paid out if they fail.
