What is a 'Lender Of Last Resort'

A lender of last resort is an institution, usually a country's central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse. In the United States, the Federal Reserve acts as the lender of last resort to institutions that do not have any other means of borrowing and whose failure to obtain credit would dramatically affect the economy.

BREAKING DOWN 'Lender Of Last Resort'

The lender of last resort functions to protect individuals who have deposited funds – and to prevent customers from withdrawing out of panic from banks with temporary limited liquidity. Commercial banks usually try not to borrow from the lender of last resort because such action indicates that the bank is experiencing a financial crisis. Critics of the lender-of-last-resort methodology suspect that the safety it provides inadvertently tempts qualifying institutions to acquire more risk than necessary, since they are more likely to perceive the potential consequences of risky actions as less severe.

Preventing Bank Runs

A bank run is a situation that occurs during periods of financial crisis when bank customers, worried about an institution's solvency, descend on the bank en masse and withdraw funds. Because banks only keep a small percentage of total deposits as cash, a bank run can quickly drain a bank's liquidity and, in a perfect example of a self-fulfilling prophecy, cause the bank to become insolvent.

Bank runs, and subsequent bank failures, were prevalent following the 1929 stock market crash that led to the Great Depression. The U.S. government responded with new legislation imposing reserve requirements on banks, mandating they hold above a certain percentage of liabilities as cash reserves.

In a situation in which a bank's reserves fail to prevent a bank run, a lender of last resort can inject it with funds in an emergency so that customers seeking withdrawals can receive their money without creating a bank run that pushes the institution into insolvency.

Controversy

Critics of the practice of having a last resort lender allege that it encourages banks to take unnecessary risks with customers' money, knowing they can be bailed out in a pinch. Such claims were validated when large financial institutions, such as Bear Stearns and American International Group, Inc., were bailed out in the midst of the 2008 financial crisis.

Proponents counter that the potential consequences from not having a lender of last resort are far more dangerous than excessive risk-taking by banks.

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