Lender of last resort

Lender of last resort

A lender of last resort (LOLR) 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; most often the central bank of a country. The purpose of this loan and lender is to prevent the collapse of institutions that are experiencing financial difficulty, most often near collapse.

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. Borrowing from the lender of last resort by commercial banks 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, 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 for the economy. It took over this role from the private sector "clearing houses" which operated during the Free Banking Era; whether public or private, the availability of liquidity was intended to prevent ’runs’ on the banking system. In the United Kingdom this role is undertaken by the Bank of England, the central bank of the United Kingdom.

HSBC is an example of a non-central bank that has acted as a lender of last resort on several occasions.

Retail lending

Alternatively, a lender of last resort is a bank, cheque cashing store or credit card 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 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 sharks who act as lenders of last resort, offering loans at very high rates of interest (considered by many as usury). This may be illegal in itself, or involve intimidation to ensure repayment.

These moneylenders are not the only lenders of last resort dealing with the public. In some cases, credit is available for the purchase of specific goods which could not be sold for cash. 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. 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": 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 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. 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 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

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