Table of Contents
- What Is Lender of Last Resort?
- Key Takeaways
- Understanding Lender of Last Resort
- Lender of Last Resort and Preventing Bank Runs
- Criticisms of Lenders of Last Resort
- What Is the World's Lender of Last Resort?
- Why Is the Fed Considered a Lender of Last Resort?
- Who Is the Lender of Last Resort in the EU?
- The Bottom Line
What Is Lender of Last Resort?
Let me explain what a lender of last resort really is. It's an institution, typically your country's central bank, that steps in to provide loans to banks or other eligible entities when they're in deep financial trouble, seen as high-risk, or on the brink of collapse. In the US, that's the Federal Reserve, offering credit to those who can't borrow elsewhere and whose failure could shake the entire economy.
Key Takeaways
You should know that a lender of last resort delivers emergency credit to struggling financial institutions teetering on the edge of collapse. Usually, it's the Federal Reserve or another central bank stepping in for banks with no other borrowing avenues, especially when their downfall would ripple through the economy. Some point out that this setup can lead to moral hazard, where banks might chase excessive risks, betting on a bailout.
Understanding Lender of Last Resort
The main job of the lender of last resort is to safeguard depositors' funds and stop panic withdrawals from banks that are just temporarily short on liquidity. Commercial banks avoid borrowing from it if they can, because it signals they're in a crisis. Critics worry that this safety net tempts institutions to pile on more risk than they should, figuring the fallout from bad bets won't hit as hard.
Lender of Last Resort and Preventing Bank Runs
A bank run happens in financial crises when worried customers swarm to pull out their money, fearing the bank's insolvency. Since banks hold only a fraction of deposits in cash, this can drain liquidity fast and make the fear come true by pushing the bank into actual insolvency. After the 1929 crash and the Great Depression, the US government set reserve requirements, forcing banks to keep a certain percentage of liabilities as cash. If reserves aren't enough to stop a run, the lender of last resort can pump in emergency funds, letting customers withdraw without spiraling the bank into failure.
Criticisms of Lenders of Last Resort
Critics claim this practice lets banks gamble with customers' money, expecting a bailout in tough spots. This got proven during the 2008 crisis when giants like Bear Stearns and AIG were rescued. On the other side, supporters argue that without a lender of last resort, the risks to the system are even greater than banks overreaching.
What Is the World's Lender of Last Resort?
There's no single global lender of last resort to bail out institutions or countries worldwide. Each nation handles its own economy, often via its central bank. Some bodies like the IMF's supplemental reserve facility play similar roles, or regions like the Eurozone band together for mutual economic support.
Why Is the Fed Considered a Lender of Last Resort?
The Fed earns its spot as the US lender of last resort because it can prop up distressed financial institutions with loans to avoid collapse and prevent economic spillover.
Who Is the Lender of Last Resort in the EU?
In the EU, that's the European Central Bank, which offers emergency liquidity assistance—loans to a country's national central bank when it's in financial straits.
The Bottom Line
Ultimately, a lender of last resort, like a central bank, issues emergency loans to troubled financial institutions to stop collapses and broader economic harm. This can ward off bank runs and bolster stability, but it draws fire for fostering risky behavior with the promise of bailouts. Proponents insist that lacking this mechanism poses an even bigger threat to the financial system, as the 2008 crisis showed.
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