Lender of Last Resort - Explained
What is a Lender of Last Resort?
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Table of ContentsWhat is a Lender Of Last Resort?How Does a Lender Of Last Resort Work?Lender Of Last Resort and Preventing Bank RunsCriticisms of Lender Of Last Resort
What is a Lender Of Last Resort?
A lender of last resort (LOLR) is the institution that gives loans to institutions that are experiencing a lack of liquidity or an institution that guarantees liquidity or credit to financial institutions, the institution offers loans as a last resort. It is one of the main responsibilities of the central bank of any country. In some countries like the United States, the central bank which is the Federal Reserve Bank is the lender of last resort so as to prevent economic disruption when the alternatives of the financial institutions have been exhausted.
How Does a Lender Of Last Resort Work?
Commercial banks usually avoid resorting to the central banks because this is an indication that they are in financial difficulties. The banks are provided with credit by the central bank in order to guarantee that customers confidence is retained and thereby prevent customers from withdrawing out of panic which can subsequently lead to the collapse of the financial institutions or systems. The credit provided is to provide liquidity to the banks to run their operations temporarily. One major criticism of the lender-of-last-resort concept is that financial institutions because of the availability of the lender of last resort facility may make the institutions to take a more unnecessary risk as there will be a way out if they fail
Lender Of Last Resort and Preventing Bank Runs
A bank run is when customers panic and withdraw all their deposits from the banks in large numbers within a short time frame. This occurrence may exhaust the banks liquidity since banks are required to keep only a small percentage of their total deposits thereby resulting in the insolvency of the bank. The Great Depression of 1929 which was a result of the collapse of the United States stock market led to bank runs which resulted in the failure of a lot of banks. This led the US government through the Federal Reserve to make some laws that require the bank to maintain a reserve ratio in the Federal Reserve Bank. There are circumstances where the banks reserve will not be enough for the bank run, the central bank can come in, in those circumstances to provide liquidity to avoid panicking by the public so as to prevent economic disruption and ensure the stability of the financial system
Criticisms of Lender Of Last Resort
Opponents of the central bank acting as lender of last resort are of the opinion that banks are likely to take more risk that is not needful since they are aware that there is a bailout. Proponents are of the view that the risk of not having a last resort lender far more outweighs the resultant reckless by banks. The claims by the opponents were confirmed in the global financial crisis of 2007/2008