Lender of last resort

Lender of last resort

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A lender of last resort is an institution willing to extend credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...

 when no one else will. The term refers especially to a reserve financial institution
Financial institution
In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...

, most often the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 of a country, intended to avoid bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....

 of banks or other institutions deemed systemically important
Systemic risk
In finance, systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system. It can be defined as "financial system instability, potentially catastrophic, caused or exacerbated by...

 or 'too big to fail
Too Big to Fail
Too Big to Fail is a television drama film in the United States broadcast on HBO on May 23, 2011. It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson...

'.

Purpose


A lender of last resort serves as a stopgap to protect depositors, prevent widespread panic withdrawal
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...

, and otherwise avoid disruption in productive credit to the entire economy
Economic system
An economic system is the combination of the various agencies, entities that provide the economic structure that defines the social community. These agencies are joined by lines of trade and exchange along which goods, money etc. are continuously flowing. An example of such a system for a closed...

 caused by the collapse of one or a handful of institutions. Borrowing from the lender of last resort by commercial bank
Commercial bank
After the implementation of the Glass–Steagall Act, the U.S. Congress required that banks engage only in banking activities, whereas investment banks were limited to capital market activities. As the two no longer have to be under separate ownership under U.S...

s is usually not done except in times of crisis. This is because borrowing from the lender of last resort indicates that the institution in question has taken on too much risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...

, or that the institution is experiencing financial difficulties (since it is often only possible when the borrower is near collapse).

In the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

 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 for the economy. It took over this role from the private sector "clearing house
Clearing house (finance)
A clearing house is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions...

s" which operated during the Free Banking Era; whether public or private, the availability of liquidity was intended to prevent bank run
Bank run
A bank run occurs when a large number of bank customers withdraw their deposits because they believe the bank is, or might become, insolvent...

s.

Within other major world economies this role is undertaken by the Bank of England
Bank of England
The Bank of England is the central bank of the United Kingdom and the model on which most modern central banks have been based. Established in 1694, it is the second oldest central bank in the world...

 in the United Kingdom
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...

 (the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...

 of the UK), in Switzerland
Switzerland
Switzerland name of one of the Swiss cantons. ; ; ; or ), in its full name the Swiss Confederation , is a federal republic consisting of 26 cantons, with Bern as the seat of the federal authorities. The country is situated in Western Europe,Or Central Europe depending on the definition....

 by the Swiss National Bank
Swiss National Bank
The Swiss National Bank is the central bank of Switzerland. It is responsible for Swiss monetary policy and for issuing Swiss franc banknotes.The names of the institution in the four official languages of the country are: ; ; ; ....

, in Japan
Japan
Japan is an island nation in East Asia. Located in the Pacific Ocean, it lies to the east of the Sea of Japan, China, North Korea, South Korea and Russia, stretching from the Sea of Okhotsk in the north to the East China Sea and Taiwan in the south...

 by the Bank of Japan
Bank of Japan
is the central bank of Japan. The Bank is often called for short. It has its headquarters in Chuo, Tokyo.-History:Like most modern Japanese institutions, the Bank of Japan was founded after the Meiji Restoration...

 and in Russia
Russia
Russia or , officially known as both Russia and the Russian Federation , is a country in northern Eurasia. It is a federal semi-presidential republic, comprising 83 federal subjects...

 by the Central Bank of Russia.

JPMorgan Chase and HSBC
HSBC
HSBC Holdings plc is a global banking and financial services company headquartered in Canary Wharf, London, United Kingdom. it is the world's second-largest banking and financial services group and second-largest public company according to a composite measure by Forbes magazine...

 are examples of non-central banks that have acted as a lender of last resort on several occasions. John Pierpont Morgan is considered to have played the role of a lender of last resort during the Panic of 1907
Panic of 1907
The Panic of 1907, also known as the 1907 Bankers' Panic, was a financial crisis that occurred in the United States when the New York Stock Exchange fell almost 50% from its peak the previous year. Panic occurred, as this was during a time of economic recession, and there were numerous runs on...

.

Retail lending


Alternatively, a lender of last resort is a bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

, cheque
Cheque
A cheque is a document/instrument See the negotiable cow—itself a fictional story—for discussions of cheques written on unusual surfaces. that orders a payment of money from a bank account...

 cashing store or credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...

 operation which deals only with the highest risk categories of private client. These retail banks charge very high rates of interest to cover the high credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

 they face since many of the loans are not repaid. They therefore only attract customers unable to secure credit at lower interest rates elsewhere.

This term can be applied to criminal loan shark
Loan shark
A loan shark is a person or body that offers unsecured loans at illegally high interest rates to individuals, often enforcing repayment by blackmail or threats of violence....

s who act as lenders of last resort, offering loans at interest rates so high as to be considered usury
Usury
Usury Originally, when the charging of interest was still banned by Christian churches, usury simply meant the charging of interest at any rate . In countries where the charging of interest became acceptable, the term came to be used for interest above the rate allowed by law...

. This may be illegal in itself, or involve intimidation to ensure repayment.

These moneylender
Moneylender
A moneylender is a person or group who offers small personal loans at high rates of interest.-See also:* Microfinance - provision of financial services to low-income individuals....

s are not the only lenders of last resort dealing with the public. In some cases, credit is available for the purchase of specific good
Product (business)
In general, the product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced...

s which could not be sold for cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...

. Particularly in car financing, there are large companies specializing in the arrangement of credit for high risk individuals.

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
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...

. A lender of last resort provides a safety net to insulate the institution from the full consequences of their risk. The lender does not underwrite the consequences but it could be that business failure can be hidden for longer by the extension of credit.

A more theoretical critique of the institution of a lender of last resort is that its existence is predicated on the possibility of a "market failure
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...

": if the credit market accurately assesses risks then institutions not able to receive loans would not be able to misuse the capital and the idea of a panic or ‘contagious’ credit crunch
Credit crunch
A credit crunch is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates...

 spreading through the banking system would be impossible.

A modern critique of the International Monetary Fund
International Monetary Fund
The International Monetary Fund is an organization of 187 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world...

 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. Critics say that this has two deficiencies as a means of charity: one, it confuses the ability to repay with the economic reorganization demanded by the bank and other ethical
Ethics
Ethics, also known as moral philosophy, is a branch of philosophy that addresses questions about morality—that is, concepts such as good and evil, right and wrong, virtue and vice, justice and crime, etc.Major branches of ethics include:...

 considerations; and two, the fact that some countries actually do repay their loans, despite the hardship of paying and the reality that most developing nations are not expected to do so.

See also

  • Employer of last resort
    Employer of last resort
    Employers of last resort are employers in an economy which workers go to for jobs when no other jobs are available; the term is by analogy with "lender of last resort"...

    , analogous proposal for labor markets
  • Refund anticipation loan
    Refund Anticipation Loan
    A refund anticipation loan is a short-term consumer loan secured by a taxpayer’s expected tax refund, and designed to offer customers quicker access to funds than waiting for their tax refund...

  • Payday loan
    Payday loan
    A payday loan is a small, short-term loan that is intended to cover a borrower's expenses until his or her next payday. The loans are also sometimes referred to as cash advances, though that term can also refer to cash provided against a prearranged line of credit such as a credit card...

  • Title loan
  • Bailout