A lender of last resort is an institution that provides credit or liquidity options to other financial institutions or individuals when they have run out of options to raise funds. In any country, a lender of last resort is usually the central bank which has the capacity and the authority to bail out financial institutions that are illiquid and in need of credit. For central banks who are in a crisis themselves, they can turn to the International Monetary Fund (IMF) which acts as the international lender of last resort.
The existence of an ultimate source of credit in the event that banks are unable to use market sources for gaining liquidity allows the government to retain public’s confidence in the country’s financial establishment. This responsibility is assumed by central banks in most countries: for example the lender of last resort in America is the Federal Reserve, and in England is The Bank of England.
A non-central bank may also assume the role and act as a retail lender of last resort; for instance, the biggest banking group, HSBC Holding Plc. provides credit to individuals when they have no other recourse to obtain funds. These funds may be needed to purchase property or a car and the individuals may fall in the high-risk category. Credit is extended by retail lenders in these cases only to gain monetary benefit as high interests are demanded for high risk loans.
Case in Point
UK’s Northern Rock, the ninth largest bank in the region, was one of the first to announce illiquidity problems which the global financial crisis started unraveling in the 2007. People queued up to get their deposits out of the bank as there was widespread panic regarding the bank running out of funds. This phenomenon is called a “bank run”. To safeguard the economy and restore public trust, the government had to stop the bank runs by announcing that all the depositors would be protected by the state. In this case, the government was acting as the lender of last resort.
The lender of last resort system works well to provide a backstop to the financial system and provides a cushion to absorb some risks. However, this is exactly why it is criticized also; the fact that institutions and individuals have an entity at hand that is ready to absorb all their risky decisions makes them more reckless with their finances.
Similarly, the IMF is criticized for lending to countries that are bad credit risks. These countries are almost understood to not pay off their loans, ever.