lender of last resort - Origin, Purpose, Retail lending, Criticisms

An institution, usually a central bank, willing and able to lend to banks unable to borrow money elsewhere to meet their liabilities. The point of having a lender of last resort is to avoid financial collapse during a general financial panic, in which everybody tries to hold cash and refuses to lend. If any bank is in financial trouble, the lender of last resort has to decide whether or not to rescue it. The benefit of assisting any one bank in difficulties is that one default is liable to provoke a general panic. The disadvantage is that if the troubled bank's problems arise through irresponsible lending to risky firms, bailing it out will encourage similar conduct by it and others in the future. This policy dilemma is particularly acute when the problem bank is too large to fail.

A lender of last resort is an institution willing to extend credit when no one else will.

Origin

Originally the term referred to a reserve financial institution that secured other banks or eligible institutions, as a last resort;

Purpose

The lender of last resort serves to protect depositors, prevent widespread panic withdrawal, and otherwise avoid damage to the economy caused by the collapse of an institution. This is because borrowing from the lender of last resort indicates that the institution in question has taken on too much risk, or that the institution is experiencing financial difficulties (since it is often only possible when the borrower is near collapse.)

In the United States the Federal Reserve serves as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse of which would have serious implications on the economy.

Retail lending

Alternatively, a lender of last resort is a bank, check cashing store or credit card operation which deals only with the highest-risk categories of private client.

This term can be applied to criminal loan sharks who act as lenders of last resort, offering loans at very high rates of interest (considered by many as usury).

These moneylenders are not the only lenders of last resort dealing with the public.

Criticisms

Critics of the backing of institutions point to the ability of having a lender of last resort as a temptation for an institution to take on more risk.

A more theoretical critique of the institution of a last resort lender is that its existence is predicated on the possibility of a “market failure”: if the credit market accurately assesses risks then institutions not able to receive loans would probably misuse the capital and the idea of a panic or ‘contagious’ credit crunch spreading through the banking system would be impossible.

A modern critique of the International Monetary Fund as the international lender of last resort is that it is effectively an inefficient subsidy system, since it is mandated to provide loans to countries unable to raise funds through the bond market, with loans paying below market interest rates.