What is a Lender of Last Resort?

What is a Lender of Last Resort?

A Lender of Last Resort (LLR) is an institution, usually a country’s Central Bank (like the Federal Reserve in the United States), that offers loans to banks or other organizations that are having financial difficulties or that are near a collapse or a bankruptcy.

Generally, LLRs borrow money to those companies or financial institutions whose failure to obtain credit would dramatically affect the whole Economy.

Lenders of Last Resort have been also important to avoid bank runs, which are particular situations, usually during financial crisis, when banks customers, worried about the firm’s solvency, decide to withdraw their funds from their accounts. Since banks keep only a small percentage of total deposits as cash, a bank run can potentially cause the bank to become insolvent (perfect case of a self-fulfilling prophecy).

Injecting funds into banks, LLRs prevent bank runs, indirectly delivering to the institutions’ clients the money they would have otherwise withdrawn.

Lenders of Last Resort are often criticized because of the suspect that the financial safety they provide to banks inadvertently allows these institutions to be less careful about the risks acquired with their customers’ money, being certain of having a parachute on their back in case of distress.

On the other side, LLRs’ supporters claim that the potential consequences from not having a Lender of Last Resort are far more dangerous than the excessive risk taken by banks.

Sources:

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