Lender of Last Resort

Lender of Last Resort

A lender of last resort (LoR) is an institution, usually a country’s central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse.

In the United States, the Federal Reserve acts as the lender of last resort to institutions that do not have any other means of borrowing, and whose failure to obtain credit would dramatically affect the economy.

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.

Criticisms of Lenders of Last Resort

Critics of the practice of having a last-resort lender allege that it encourages banks to take unnecessary risks with customers’ money, knowing they can be bailed out in a pinch. Such claims were validated when large financial institutions, such as Bear Stearns and American International Group, Inc., were bailed out in the midst of the 2008 financial crisis.

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Proponents state that the potential consequences of not having a lender of last resort are far more dangerous than excessive risk-taking by banks.