Lender of Last Resort: Role, Functions, and Historical Context
RP
Summary:
Lender of last resort (LoR) plays a critical role, often enacted by institutions like a central bank, such as the Federal Reserve in the U.S. This entity offers emergency credit to struggling financial institutions, aiming to prevent catastrophic economic consequences. Despite its significance, concerns have been raised about the moral hazards it might create. Explore the intricacies of LoR, its functions, criticisms, and its pivotal role in preventing financial crises.
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What is the lender of last resort?
A lender of last resort (LoR), usually a country’s central bank, lends money to banks or other suitable institutions that are struggling financially, dangerous, or about to fail. The Federal Reserve is the last option lender in the United States. It helps institutions that can’t get credit any other way and whose failure to do so would have a huge impact on the economy.
Understanding lender of last resort
The lender of last resort’s job is to protect people who have invested money and keep customers from panicking and taking their money out of banks that are temporarily short on cash. Most of the time, commercial banks try to avoid borrowing from the lender of last choice because it means the bank is having a financial crisis.
Critics and moral hazards
For those who don’t like the lender-of-last-resort method, they think that the safety it offers makes qualified institutions take on more risk than they need to because they think the bad things that could happen aren’t as bad.
Lenders of last resort and preventing bank runs
A bank run happens when a lot of people who are worried about a bank’s solvency rush to the bank at the same time to take their money during a financial crisis. A bank run can quickly drain a bank’s cash flow because banks only keep a small portion of total savings as cash. This is a perfect example of a self-fulfilling prophecy because it leads to the bank going bankrupt.
If a bank’s reserves aren’t enough to stop a bank run, a lender of last resort can step in and give it money in an emergency so that customers who want to take their money can do so without starting a bank run that puts the bank out of business.
Criticisms of lenders of last resort
Some people who are against having a last-resort lender say that it makes banks more likely to take chances with customers’ money because they know they can get help in an emergency. Big banks like Bear Stearns and American International Group, Inc. were pulled out during the 2008 financial crisis, which proved these claims to be true. People who support having a lender of last resort say that not having one is much more dangerous than banks taking too many risks.
Frequently asked questions
What is the main role of a lender of last resort?
The primary role is to provide emergency credit to financial institutions facing financial difficulty or near collapse, preventing widespread economic fallout.
How does the lender of last resort protect bank customers?
By injecting emergency funds, it prevents bank runs, ensuring that customers can withdraw their funds without triggering insolvency.
What is moral hazard in the context of a lender of last resort?
Moral hazard refers to the risk that financial institutions may take excessive risks, knowing they will be bailed out, as seen during the 2008 financial crisis.
Key takeaways
- A lender of last resort provides emergency credit to financial institutions facing financial distress.
- The Federal Reserve typically assumes the role of lender of last resort in the United States.
- Some argue that this practice may lead to moral hazard, encouraging excessive risk-taking by institutions.
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