Lender Of Last Resort Meaning

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A LoLR intends to prevent a nation’s financial systemFinancial SystemA financial system is an economic arrangement wherein financial institutions facilitate the transfer of funds and assets between borrowers, lenders, and investors.read more from collapsing due to bank runs. Customers receive their funds or avoid panic withdrawals as a result, allowing banks to continue operating. It, thus, contributes to public trust in the financial sectorFinancial SectorThe financial sector refers to businesses, firms, banks, and institutions providing financial services and supporting the economy. It encompasses several industries, including banking and investment, consumer finance, mortgage, money markets, real estate, insurance, retail, etc.read more. However, LoLR imposes certain conditions on the financial aid it offers to banks.

Lender Of Last Resort Explained

Lender of last resort (LoLR) is the last hope for banks seeking to recover from financial crisesFinancial CrisesThe term “financial crisis” refers to a situation in which the market’s key financial assets experience a sharp decline in market value over a relatively short period of time, or when leading businesses are unable to pay their enormous debt, or when financing institutions face a liquidity crunch and are unable to return money to depositors, all of which cause panic in the capital markets and among investors.read more and maintain their market position. When banks struggle financially, the first thing they lose is their customers, resulting in a bank run. As a result, customers start to withdraw their funds out of mistrust, and banks become solvent. Eventually, banks fail, resulting in employment losses and a cascade of negative consequences.

Key Takeaways

  • A lender of last resort definition refers to an institution that provides liquidity or emergency financing to banks in trouble and helps retain their market position.When banks struggle financially, the first thing they lose is their customers, resulting in a bank run. Therefore, customers start to withdraw their funds out of mistrust, and banks become solvent.Even though LoLR gives failing banks a reprieve, it encourages them to take more risks and be less cautious when making new deals.The Federal Reserve in the United States and the European Central Bank in the European Union offer emergency liquidity assistance to banks so that their economy does not collapse.

It affects the nation’s economic status, making room for a LoLR to enter and save those banks from being insolvent. In this situation, central banks offer emergency financial assistance to prevent banking crises. As a result, customers get their money deposited in banks or stop making panic withdrawals.

A LoLR aims to prevent economic disruption and has the government’s full support behind making such a decision. However, even though it provides temporary respite to failing banks, it encourages them to take greater risks and be less cautious when offering new deals.

While the Federal Reserve acts as LoLR in the United States, the European Central BankEuropean Central BankThe European Central Bank is the apex bank of the member European countries, monitoring the banking and financial functions of all member countries in order to maintain the price stability of the European currency, the Euro.read more and the 19 national central banks serve this role in the European Union. These institutions offer emergency liquidity Liquidity Liquidity is the ease of converting assets or securities into cash.read moreassistance to banks to help them get out of financial difficulties so that it does not harm the economy.

Lender Of Last Resort History

Bank runs and financial panics in the late 1800s gave rise to LoLR. Sir Francis Baring, an English commercial banker, is credited with coining the term “lender of last resort.” He referred to the Bank of England as “the dernier resort” in his “Observations on the Establishment of the Bank of England” in 1797. It helped the bank acquire liquidity during the financial crisis. Though the concept had been around for a while, it was not until English economist Henry Thornton made it more clear.

Thornton defined the role of the Bank of England as a LoLR in his Bullion Report speeches, Parliamentary address, and book “An Enquiry Into the Nature and Effects of the Paper Credit of Great Britain” in 1882. He was the first to define the central bank’s fundamental role as a LoLR, the Bank of England in particular. Thornton also explained banks’ recklessness, knowing a LoLR would save them.

Real World Examples

Let us consider the following lender of last resort example to get a better understanding of the concept:

Example #1

During the financial crisis of 2008, the U.S. government introduced the Troubled Asset Relief Program (TARP) under the Emergency Economic Stabilization Act of 2008. It allowed the government to buy toxic assets of failing companies to save them from going bankrupt, given the stunted economic growthEconomic GrowthEconomic growth refers to an increase in the aggregated production and market value of economic commodities and services in an economy over a specific period.read more it would lead to. TARP originally authorized $700 billion to be spent on saving the biggies of the market. 

Example #2

In the 1930s post-stock market crashStock Market CrashA stock market crash occurs when stock prices in all sectors begin to fall rapidly. It is often the result of global factors such as war, scam, or the collapse of a certain industry. In such a crash, panic acts as a catalyst.read more, the fear of insolvencyInsolvencyInsolvency is when the company fails to fulfill its financial obligations like debt repayment or inability to pay off the current liabilities. Such financial distress usually occurs when the entity runs into a loss or cannot generate sufficient cash flow.read more arose when banks were mistrusted and customers withdrew their funds, leading to the Great DepressionGreat DepressionThe Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939.read more. As a result, multiple banks suffered a bank run and were on the verge of collapsing. In such a situation, the American government created the Home Owners’ Loan Corporation to buy defaulted mortgages from banks and refinanceRefinanceRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more the same at lower rates.

This scheme helped families enjoy lower rates on the refinanced mortgages, helping the homeless population has a residence to live in. However, the government continued holding those mortgages until the entities paid off. It also introduced a law requiring banks to have cash reserves.

This has been a guide to Lender of Last Resort (LoLR) and its meaning. Here we explain how lender of last resort works, its history, and examples. You can learn more from the following articles –  

A lender of last resort (LoLR) refers to an institution that helps and supports banks when they are going through difficult financial situations. A LoLR aims to prevent economic disruption and has the government’s full support behind making such a decision. The central banks, acting as the LoLR, prevent banking crises. 

When banks fail, it impacts the nation’s economy, allowing a LoLR to enter and save those banks from going bankrupt. In this case, central banks step in to provide emergency financial support to avoid a banking crisis. As a result, customers get their deposited funds or refrain from making panic withdrawals.

Bank runs and financial panics in the late 1800s gave rise to LoLR. In the 1930s post-stock market crash, the fear of insolvency emerged when banks were mistrusted and clients withdrew their funds, leading to the Great Depression. Multiple banks were on the edge of collapse due to a bank run. In such a situation, the American government came up with schemes to save the struggling financial institutions.

  • Letter Of ComfortDebt to Income Ratio (DTI)Solvency