What is a Lender of Last Resort?
The term 'Lender of Last Resort' refers to financial institutions or individuals that provide credit and/or liquidity to other financial institutions and/or individuals who have exhausted their remaining alternatives for credit or liquidity.
How Does a Lender of Last Resort Work?
There are generally two types of lenders of last resort: (1) financial institutions that provide credit to other financial institutions that require credit to remain solvent for their depositors; (2) institutions or individuals providing credit to individuals, commonly referred to as retail lending. This latter form can take the appearance of illegal practices widely known as loan sharking.
Today, the lender of last resort among financial institutions refers to the Federal Reserve Bank in the U.S or the Bank of England in Great Britain, both of which serve as the central banks of their respective countries. The credit that they provide to banks serves as a type of guarantee, preventing public confidence in the banking system from being undermined and thereby preventing a 'run' on the banking system as a whole.
In retail lending, this service is provided to individuals who have no other recourse in obtaining credit. For example, this can take the form of car or home loans to individuals in the high risk category. The incentive for the loan providers in these cases is monetary, due to the high rates of interest demanded for high risk loans.
Historically, the lender of last resort system has been used by various entities to provide liquidity to the credit markets when it would not otherwise be forthcoming. Two historical examples of this use are the Great and the Panic of 1907.
Why Does a Lender of Last Resort Matter?
A 'run' on the banking system is when depositors line up to withdraw all of their deposits from the banking system en masse. Most banks do not have this amount of cash on hand at any one point in time, due to the fractional reserve banking system used in most of the Western world. The inability to handle a bank run can lead to panic and plunge society into civil breakdown and a state of social unrest. For this reason the lender of last resort system is viewed as an essential backstop in the banking system.
One criticism of the lender of last resort system is that it allows financial institutions to take greater risk with their own investments knowing they have an entity that will absorb some of that risk if the bank fails.
Another criticism is towards the International Monetary Fund (IMF), which provides loans to countries as a lender of last resort. The criticism leveled here is that countries who borrow from the IMF are bad credit risks that are almost not expected to pay off their loans.