Lender of Last Resort
A lender of last resort is the provider of liquidity to financial institutions that are experiencing financial difficulties. In most developing and developed countries, the lender of last resort is the country’s central bank. The responsibility of the central bank is to prevent bank runs or panics from spreading to other banks due to a lack of liquidity. In the U.S., the Federal Reserve provides liquidity to affected banks, whose lack of liquidity is likely to affect the economy.
The last-resort lending function came into being in the late 1800s due to a series of panics that engulfed the banking industry. The panics led to the collapse of financial institutions, and this led to the loss of customers’ funds deposited in the institutions. The function aims to protect the depositors by providing temporary liquidity to the banks to sustain their operations. Although this function helped prevent the collapse of banks in the past, critics say that by providing additional liquidity, the Central Bank tempts banks to acquire more risks than necessary.
The classical theory of lender of last resort was developed in the 19th century by Henry Thornton and Walter Bagehot. Both theorists stressed the need to protect the money stock, instead of individual banks, and allowing insolvent financial institutions to fail. They also advocated for the charging of penalty rates, good collateral, and accommodation of sound institutions only.
When he published “An Enquiry into the Nature and Effects of the Paper Credit of Great Britain” in 1882, Henry Thornton stated that the central bank could perform the function of lender of last resort since it had the monopoly on the issuance of banknotes. He distinguished the Bank of England’s role as a lender of last resort since it exercised the role more strictly than any other central bank before it. Thornton also articulated the “moral hazard” problem of last-resort lending, which he said would create laxity and recklessness in lending to individual banks. He said that by providing relief to poorly managed banks, other banks would take excessive speculative risks without caring about the results.
The other contributor to the classical theory was Walter Bagehot. In his 1873 book “Lombard Street,” Bagehot restated most of the points made by Thornton. He noted the Bank of England’s position as the holder of the ultimate reserve, making it different from the ordinary banks. However, he advocated for huge loans at a very high interest rate as the best solution to a banking crisis. Like Thornton, Bagehot argued that last resort lending should not be a continuous practice, but a temporary measure to manage banking panics.
Preventing Bank Runs
A bank run occurs when large numbers of customers withdraw their deposits simultaneously for fear that the bank might collapse. It occurs during periods of financial uncertainty, and a bank run in one bank quickly spreads to other banks as customers become uncertain about the safety of their deposits. Banks only keep a portion of their customer’s deposits and give the other portion out as loans, and this makes them vulnerable to panics. If customers make withdrawals beyond the bank’s reserves, the bank can become insolvent.
Cases of bank runs became prevalent during the Great Depression of the 1930s after the stock market crash. There were a series of banks runs and subsequent collapses, amidst rumors of an impending financial crisis. In a move to prevent more bank failures, the government declared a national bank holiday to allow for the inspection of banks. The government also enacted new regulations that required banks to hold a certain percentage of reserves. If the reserves are inadequate to stop a bank run, the central bank must lend the bank enough money to sustain customer withdrawals. Also, prominent cash deliveries to an affected bank can convince the depositors that the bank is not going to collapse.
Although the central bank helped prevent bank runs previously, critics argue that the central bank should not act as a lender of last resort because of the following reasons:
#1 Moral hazard
Opponents of the function allege that commercial banks and other financial institutions are likely to make risky investments knowing that they will be bailed out if they experience financial difficulties. This was confirmed during the 2007/2008 financial crisis when banks invested in risky assets and were later bailed out by the Federal Reserve. Also, the International Financial Institution Advisory Commission accused the International Monetary Fund of bailing out banks in developing countries that were involved in risky investments. However, if the central bank fails to bail out banks affected by bank runs, the effects could exceed the moral hazard. The central bank can impose heavy penalties on banks that make intentional mistakes and enact regulations to guide banks borrowing from the central bank.
#2 Private Alternatives
Critics argue that private institutions can handle the function of lender of last resort without requiring government intervention. Before the formation of the Fed, the Suffolk Bank of Boston and the clearing-house system of New York provided banks with liquidity during bank runs. For example, the Suffolk Bank of Boston lessened the effects of the 1837-1839 financial panic by offering last-resort lending to member banks. The committee of the New York Clearing House Association also provided clearing-house loan certificates to banks as a way of managing the effects of the financial panic of 1857. Although these institutions were private-run, the critics argue that they played the role of a lender of last resort successfully without requiring the help of the government.
#3 Tough Penalty Rates
Imposing high penalties to banks borrowing from the central bank can force them to look for alternative sources of a bailout. The opponents claim that a strict penalty rate can make the central bank the very last lender of last resort. Banks would also be forced to institute internal measures to prevent a bank run for fear of paying harsh penalties for a loan that they could have maintained internally. For example, some banks keep an excess reserve beyond the central bank requirement during tough economic times when depositors’ withdrawals may exceed the usual limits. However, proponents of the lending function of the central bank observe that charging a high interest rate or penalty could make the loan too expensive to borrow, obscuring the intended purpose of the lender of last resort function.
The proper role of central banks continues to be debated. The following CFI resources provide further information to help you understand the banking system.