Lender of last resort

A lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market and other facilities or sources have been exhausted. It is, in effect, a government guarantee of liquidity to financial institutions. Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general. The objective is to prevent economic disruption as a result of financial panics and bank runs spreading from one bank to the next from a lack of liquidity in one. Different definitions of the lender of last resort exist in literature. A comprehensive one is that it is 'the discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source'. A lender of last resort (LOLR) is the institution in a financial system that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market and other facilities or sources have been exhausted. It is, in effect, a government guarantee of liquidity to financial institutions. Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general. The objective is to prevent economic disruption as a result of financial panics and bank runs spreading from one bank to the next from a lack of liquidity in one. Different definitions of the lender of last resort exist in literature. A comprehensive one is that it is 'the discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source'. While the concept itself had been used previously, the term 'lender of last resort' was supposedly first used in its current context by Sir Francis Baring, in his Observations on the Establishment of the Bank of England, which was published in 1797. In 1763, the king was the lender of last resort in Prussia. Although Alexander Hamilton, in 1792, was the first policymaker to explicate and implement a lender of last resort policy, the classical theory of the lender of last resort was mostly developed by two Englishmen in the 19th century: Henry Thornton and Walter Bagehot. Although some of the details remain controversial, their general theory is still widely acknowledged in modern research and provides a suitable benchmark. Thornton and Bagehot were mostly concerned with the reduction of the money stock. That was because they feared that the deflationary tendency caused by a reduction of the money stock could reduce the level of economic activity. If prices did not adjust quickly, it would lead to unemployment and a reduction in output. By keeping the money stock constant, the purchasing power remains stable during shocks. When there is a shock induced panic, two things happen: Thornton first published An Enquiry into the Nature and Effects of the Paper Credit of Great Britain in 1802. His starting point was that only a central bank could perform the task of lender of last resort because it holds a monopoly in issuing bank notes. Unlike any other bank, the central bank has a responsibility towards the public to keep the money stock constant, thereby preventing negative externalities of monetary instability. Bagehot was the second important contributor to the classical theory.In his book Lombard Street (1873), he mostly agreed with Thornton without ever mentioning him but also develops some new points and emphases. Bagehot advocates: 'Very large loans at very high rates are the best remedy for the worst malady of the money market when a foreign drain is added to a domestic drain.' His main points can be summarized by his famous rule: lend 'it most freely... to merchants, to minor bankers, to 'this and that man', whenever the security is good'. Thomas M. Humphrey, who has done extensive research on Thornton's and Bagehot's works, summarizes their main proposals as follows: (1) protect the money stock instead of saving individual institutions; (2) rescue solvent institutions only; (3) let insolvent institutions default; (4) charge penalty rates; (5) require good collateral; and (6) announce the conditions before a crisis so that the market knows exactly what to expect. Many of the points remain controversial today but it seems to be accepted that the Bank of England strictly followed these rules during the last third of the 19th century. Most industrialized countries have had a lender of last resort for many years. Why it is done can be explained by different models. The various models propose that a bank run or bank panic can arise in any fractional reserve banking system and that the lender of last resort function is a way of preventing panics from happening. The Diamond and Dybvig model of bank runs has two Nash equilibria: one in which welfare is optimal and one where there is a bank run. The bank run equilibrium is an infamously self-fulfilling prophecy: if individuals expect a run to happen, it is rational for them to withdraw their deposits early: before they actually need it. That makes them lose some interest, but that is better than losing everything from a bank run. In the Diamond–Dybvig model, introducing a lender of last resort can prevent bank runs from happening so that only the optimal equilibrium remains. That is because individuals are no longer afraid of a liquidity shortage and so have no incentive to withdraw early. The lender of last resort will never come into action because the mere promise is enough to provide the confidence necessary to prevent a panic.