Introduction
A lender of last resort (LoR) is an institution, commonly a country’s central bank, that provides emergency loans to banks or other eligible institutions facing financial distress or near collapse. In the United States, the Federal Reserve functions as the lender of last resort to institutions that cannot source funds elsewhere, preventing systemic economic crises due to the inability to obtain credit.
Key Takeaways
- A lender of last resort offers emergency credit to financial institutions in peril of failing.
- The Federal Reserve customarily acts as the U.S.’s lender of last resort for struggling banks, ensuring economic stability.
- Some argue that the presence of a lender of last resort might encourage banks to take undue risks due to moral hazard.
Understanding Lender of Last Resort
The primary role of a lender of last resort is to protect depositor funds and to avert mass withdrawals caused by panic during temporary liquidity shortages. Banks generally seek to avoid borrowing from the lender of last resort as it signals financial trouble.
Critics argue that the assurance provided by lenders of last resort inadvertently induces financial institutions to take greater risks, believing the repercussions of their actions will be less detrimental.
Lender of Last Resort and Preventing Bank Runs
A bank run transpires during financial crises when depositors, fearing an institution’s solvency, rush to withdraw their savings collectively. Since banks hold only a fraction of deposits as cash, heavy withdrawals can swiftly deplete liquidity, potentially resulting in insolvency.
Bank runs and ensuing failures were prominent post-1929 stock market crash, during the Great Depression. In response, the U.S. government enforced reserve requirements, compelling banks to hold a particular percentage of liabilities as cash reserves. Should a bank’s reserves fall short during a run, a lender of last resort can inject emergency funds, ensuring customers can withdraw their money and preventing further crisis-induced insolvency.
Criticisms of Lenders of Last Resort
Detractors suggest that the policy of having a last-resort lender encourages banks to manage customer funds irresponsibly, relying on potential bailouts in dire times. Such concerns came to light during the 2008 financial crisis when major financial entities like Bear Stearns and American International Group, Inc., were rescued. Advocates of the lender-of-last-resort concept argue that the absence of such a safety net poses graver risks than the potential for excessive risk-taking by banks.
By providing stability during financial turmoil, lenders of last resort play a critical, albeit contentious, role in maintaining economic confidence and preventing widespread financial collapse.
Related Terms: central bank, liquidity, bank run, moral hazard.
