A lender of the last resort is the rescuer of troubled financial institutes, economies, or countries. It is the type of lender that is used as the last option by the borrower when all other options seem to dry up.
Let us discuss what is the lender of last resort, how it works, and its key challenges.
What is a Lender of Last Resort?
A lender of last resort is the provider of funds when the borrower has run of other possible options.
As the name suggests, the borrowers would use this option as their last resort to get funds when in trouble. The term is usually associated with the central banks that provide emergency funds to financial institutions like commercial banks.
In most cases, borrowing entities turn to the lender of last resort when facing a liquidity crisis. It happens because banks may face a liquidity crisis when their ratings go down or they face financial trouble due to management issues.
Central banks around the world offer emergency funds to commercial banks and other financial institutions. However, the relief is a temporary one and comes with higher interest costs for the borrower.
How Does a Lender of Last Resort Work?
When commercial banks face a financial crisis, customers rush toward banks to pull their money out of the bank. It creates a liquidity crunch for that bank.
The commercial bank tries to contain this liquidity issue by utilizing the limited available resources. However, most commercial banks retain a fraction of their assets in the most liquid form like cash.
With financial trouble and lowering ratings, other banks refuse to lend money as well. The secondary markets like the stock markets do not help either.
At this stage, the central banks provide the necessary funding to prevent a liquidity crisis for the bank.
However, central banks only offer such emergency funding if the borrower remains solvent. If the bank is headed towards insolvency, the funding would be refused by the central bank too.
In some jurisdictions, the same concept of the lender of last resort applies to lenders that offer such funding to individuals.
When individuals do not find necessary loans from other types of lenders, they turn toward the lender of last resort. These lenders can be private lending firms or wealthy individuals who charge high-interest costs against emergency lending.
However, the practice of offering this service to individuals is illegal in most jurisdictions around the world.
Lender of Last Resort and Bank Runs
A bank run is a situation when a large number of bank customers rush towards the bank to withdraw their deposits due to the fear of a bank collapse.
Bank runs happen during economic crises and depressions. Customers fear that their bank may go insolvent and their funds may become inaccessible in the future.
The risk of a bank run spreads quickly because the action taken by the customers of one bank may soon prompt the customers of other banks to follow the suit.
Central banks acting as the lender of last resort offer necessary cash to troubled banks to satisfy their customers and avoid bank runs. However, the recovery process may take longer than its escalation during bank runs.
Important Considerations with the Lender of Last Resort
A lender of last resort provides emergency funding that can prevent the borrower (a bank) from going insolvent. However, the arrangement comes at a cost and with a few important considerations for the borrower.
Only for Solvent Banks
The emergency funding offered by central banks is available only for solvent banks. It means the lender of last resort option would be available only if the lender considers the borrower to remain solvent if helped.
If an applicant bank has a deeper financial crisis than a liquidity crunch, it may become insolvent despite receiving emergency cash funds.
To prevent such situations, central banks have started imposing stricter regulations that require commercial banks to maintain a certain percentage of reserve in the cash form.
Emergency funding received from the lender of last resort offers a temporary relief to the borrower.
Central banks term this relief emergency liquidity assistance (ELA). It works to solve the liquidity problems of the borrower during unforeseen circumstances.
Once the economy recovers and the borrower resumes normal activities, the emergency assistance would stop. The borrower would then start repaying the loan to the lender of the last resort.
Central banks acting as the lender of last resort would often accept collateral of low quality from the borrower. However, they would still want some sort of assurance from the borrower.
It means even during the financial crisis; the borrower would need to pledge its assets (usually reserves) with the lender of last resort. Unsecured loans may become too costly for the borrower to survive in such situations.
Incurs Interest Charges
The lending comes at a cost for the borrower obviously. However, the challenge here is to agree upon an interest rate that is acceptable for both parties.
Since the borrower would be facing a liquidity crisis already, the lender would be unsure of the ability of the borrower to repay that loan.
It means the lender would charge higher interest costs than in the case of non-emergency funding.
Why is a Lender of Last Resort Important?
Central banks offer emergency funding to commercial banks that prevent bank runs as mentioned above. However, these emergency fundings offer other benefits to the borrowers and the economy at large.
Save Economy Spreading Fallout
A troubled bank facing liquidity issues may start the fallout of other banks as well. It may start a bank run for banks around as well.
Thus, an emergency fund would prevent such fallouts. Otherwise, the spread would affect the whole economy and may end up in a recession.
Such loss of economy would eventually be burdened the taxpayers of that economy. Therefore, lenders of last resort provide a bigger relief to the economy and not only to the borrowing bank.
Bank runs and economic crises lead to joblessness quickly. If banks face liquidity issues they would stop lending money to their customers immediately.
Such situations would mean no borrowings for businesses. That eventually would mean employee layoffs from businesses as they run out of cash.
Thus, the circle continues to expand the whole economy faces rising joblessness quickly. Although reversing such downfalls take time but the emergency lending would initiate the reversal at least.
In troubled economies, the borrowing powers of the borrowers diminish. It means lenders charge higher interest rates as their perceived risks increase.
Thus, central banks would also need to control interest rates by keeping an eye on the liquidity crisis faced by commercial banks.
Criticism of the Lender of Resort Methodology
A lender of the last resort offers several advantages to the borrowers and the economy at large. However, this arrangement faces some criticism and serious concerns as well.
Critics argue that if the borrowing banks believe they’ll get emergency funding when needed, they’ll take unwanted risks.
It means they’ll be offering products and services that possess higher risks. A good example of that was seen during the 2008 global financial crisis.
However, if central banks pull out of such situations, the results could be further devastating. Thus, the central banks face a moral dilemma that could be prevented by imposing stricter regulatory sanctions on commercial banks.
Another criticism of the lender of last resort is that the service should not be offered by government-backed institutes like central banks only.
Large private institutes holding sufficient reserves can act as the lender of last resort as well. It will ease the pressure from governments and would avoid collusion between the lenders and the borrowers as well.
Critics argue that central banks should impose strict penalties on the borrowing banks due to their negligence or failure to maintain adequate liquidity levels.
The argument is to force commercial banks to maintain reserves and liquidity to avoid such situations. However, during economic recessions such occurrences become unavoidable.
Risk of Failure
Another major concern for this arrangement is that even the bailout package may not save the troubled borrower. During the global financial crisis in 2008, large financial institutions like Lehman Brothers couldn’t survive.
Thus, the critics argue that a proactive approach of imposing strict regulations and penalties to avoid a liquidity crisis should be put in place.
Lender of Last Resort Vs Central Banks
In most cases, cental banks act as the lender of last resort. However, that is not the only function of the central banks.
Central banks monitor the economic policies, control interest rates, and inflation, and provide other financial services to run an economy smoothly. Their scope of work is broader than acting as a lender of last resort.
Also, other financial institutes like the International Monetary Fund (IMF), the World Bank (WB), and the European Central Bank (ECB) can act as the lender of last resort for banks and countries as well.