Lender Of Last Resort

A lender of last resort (LoLR) refers to an institution that provides liquidity or emergency credit to banks experiencing financial difficulties. Usually, central banks in many countries come forward to lend the necessary funds to bail out financial entities on the verge of bankruptcy.

A LoLR intends to prevent a nation’s financial system from collapsing due to bank runs. Customers receive their funds or avoid panic withdrawals as a result, allowing banks to continue operating. It, thus, contributes to public trust in the financial sector. However, LoLR imposes certain conditions on the financial aid it offers to banks.

• A lender of last resort definition refers to an institution that provides liquidity or emergency financing to banks in trouble and helps retain their market position.
• When banks struggle financially, the first thing they lose is their customers, resulting in a bank run. Therefore, customers start to withdraw their funds out of mistrust, and banks become solvent.
• Even though LoLR gives failing banks a reprieve, it encourages them to take more risks and be less cautious when making new deals.
• The Federal Reserve in the United States and the European Central Bank in the European Union offer emergency liquidity assistance to banks so that their economy does not collapse.

Lender of last resort (LoLR) is the last hope for banks seeking to recover from financial crises and maintain their market position. When banks struggle financially, the first thing they lose is their customers, resulting in a bank run. As a result, customers start to withdraw their funds out of mistrust, and banks become solvent. Eventually, banks fail, resulting in employment losses and a cascade of negative consequences.

It affects the nation's economic status, making room for a LoLR to enter and save those banks from being insolvent. In this situation, central banks offer emergency financial assistance to prevent banking crises. As a result, customers get their money deposited in banks or stop making panic withdrawals.

A LoLR aims to prevent economic disruption and has the government's full support behind making such a decision. However, even though it provides temporary respite to failing banks, it encourages them to take greater risks and be less cautious when offering new deals.

While the Federal Reserve acts as LoLR in the United States, the European Central Bank and the 19 national central banks serve this role in the European Union. These institutions offer emergency liquidity assistance to banks to help them get out of financial difficulties so that it does not harm the economy.

Bank runs and financial panics in the late 1800s gave rise to LoLR. Sir Francis Baring, an English commercial banker, is credited with coining the term "lender of last resort." He referred to the Bank of England as "the dernier resort" in his "Observations on the Establishment of the Bank of England" in 1797. It helped the bank acquire liquidity during the financial crisis. Though the concept had been around for a while, it was not until English economist Henry Thornton made it more clear.

Thornton defined the role of the Bank of England as a LoLR in his Bullion Report speeches, Parliamentary address, and book "An Enquiry Into the Nature and Effects of the Paper Credit of Great Britain" in 1882. He was the first to define the central bank's fundamental role as a LoLR, the Bank of England in particular. Thornton also explained banks' recklessness, knowing a LoLR would save them.

Let us consider the following lender of last resort example to get a better understanding of the concept:

Example #1

During the financial crisis of 2008, the U.S. government introduced the Troubled Asset Relief Program (TARP) under the Emergency Economic Stabilization Act of 2008. It allowed the government to buy toxic assets of failing companies to save them from going bankrupt, given the stunted economic growth it would lead to. TARP originally authorized $700 billion to be spent on saving the biggies of the market. 

Example #2

In the 1930s post-stock market crash, the fear of insolvency arose when banks were mistrusted and customers withdrew their funds, leading to the Great Depression. As a result, multiple banks suffered a bank run and were on the verge of collapsing. In such a situation, the American government created the Home Owners’ Loan Corporation to buy defaulted mortgages from banks and refinance the same at lower rates.

This scheme helped families enjoy lower rates on the refinanced mortgages, helping the homeless population has a residence to live in. However, the government continued holding those mortgages until the entities paid off. It also introduced a law requiring banks to have cash reserves.

This has been a guide to Lender of Last Resort (LoLR) and its meaning. Here we explain how lender of last resort works, its history, and examples. You can learn more from the following articles -  

• Letter Of Comfort
• Debt to Income Ratio (DTI)
• Solvency