Lender of Last Resort

A lender of last resort is an institution which is willing to offer loans as a last resort.
Such institution is usually a country’s central bank. In this case, we talk of a wholesale lender of last resort.

A central bank offers extension of credit to financial institutions experiencing financial difficulties which are unable to obtain necessary funds elsewhere.

The main task in front of the lender of last resort is to preserve the stability of the banking and financial system by protecting individuals’ deposited funds and preventing panic-ridden withdrawing from banks with temporary limited liquidity. For more than century and a half, central banks have been trying to avoid great depressions by acting as lenders of last resort in times of financial crisis. At first, this act provides liquidity at a penalty rate. Subsequently trough open market operations, it lowers interest rates on safe assets. And finally, this process involves direct market support.

Commercial banks usually resort to lender’s help only in times of crisis because such actions indicate financial difficulties. Loans may be granted not only to commercial banks but also to any other eligible financial institution, even private companies, which is considered highly risky.

Different institutions may act as a lender of last resort in different countries. For instance in the USA, the Federal Reserve serves as a lender of last resort. Its main purpose is to provide credit to financial institutions that are short of reserves, prevent their bankruptcy, and avoid negative impact on the economy. As a lender of last resort, the Federal Reserve encourages member banks to borrow funds from the so called “discount window”. The term refers to loans granted to member banks. The banks may use these loans either to meet reserve requirements or to pay for large withdrawals.

In the United Kingdom, the central bank, the Bank of England functions as a lender of last resort. In New Zealand this role is taken by the Reserve Bank of New Zealand, its central bank. On a global level, the International Monetary Fund also serves as an international lender of last resort, taking such role because of the recent financial crisis.

A non-central bank also may act as a lender of last resort. This is an example of a retail lender of last resort. HSBC Holdings plc, the world’s largest banking group, illustrates this case. History shows that even a physical person can assume the role of a lender of last resort. John Pierpont Morgan, an American financier and banker, has acted as a lender in the beginning of the 20th century.

Cheque cashing stores or credit card operations, dealing with highly risky private clients, may also assume the role. Sometimes, a so called criminal loan shark may act as a lender, offering loans at very high rates, which of course maybe illegal. These are not single cases of lenders of last resort, dealing with the public.
For instance, credit may be granted for the purchase of certain goods which cannot be sold for cash.

The operations of the lender of last resort are not approved by everybody. There are wide-spread arguments against, with critics claiming that such operations are immoral. In their opinion, such practice won't work in the long run. Providing institutions with financial support appears to be quite tempting as the consequences of risky actions seem less severe. As a result, an institution tends to take on more risks than normally. Such extension of credit can, in fact, conceal the true financial state of an institution, and prolong its failure. Eventually, the body fails to cure the current financial crises and instead creates new ones.

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