Lender of Last Resort (LLR) refers to an institution, commonly a country’s central bank, which offers loans to the banks and other financial institutions experiencing financial difficulties during the financial crises. As the lender of last resort, the central banks provide loans to the banks and other financial institutions to mitigate and prevent the financial crises. According to Kindleberger, the goal of the lender of last resort is essentially to prevent the financial panics as well as bank- runs that spread from one bank to another due to a lack of liquidity. The lender of last resort convinces individuals that money will be available for meeting all their demands in the course of the financial crises.
The role of the lender of last resort is prevention as well as mitigation of the financial crises. Kindleberger claims that panics and financial crises have been taking place for a long time. Financial crises and panics make some financial institutions lose confidence in their standing. If unchecked, this results to significance effects on the real economy behavior. For this reason, the LLR task of extending loans to the banks, which cannot access additional sources of liquidity during financial crises, becomes a standard role of the central banks worldwide.
The lender of last resort raises various issues. Among these issues are the problems that the implementers of sound LLR policy face. Bagehot was the first to set out ways in which the implementers of lender of last resort policy should conduct it to minimize the moral hazard costs. Implicit with his discussion of sound policy was the idea that the liquid funds should be offered to the financial markets instead directly to the financial institutions. He viewed that the provision of the liquidity to the individual financial institutions involves the discretionary government assistance, which is possible to distort the competitive landscape. Nevertheless, responding to the difficulties at a single institution through offering liquidity to the market is essentially not true last resort lending since it can only become successful if the market participants are ready to continue extending the finance to the troubled institution. The other problem faced in implementing a sound lender of last resort policy is it support of insolvent banks rather than illiquid banks. In addition, the overuse of lender of last resort powers by the central banks has been a major problem.
The other issue raised by lender of last resort is alternatives to LLR actions. Before the establishment of the Fed as LLR, private banks had assumed its role. During the financial crises, the Suffolk Bank of Boston and the clearing-house system of New York had provided the member banks with the liquidity. A private alternative had developed when a public solution was not present. Thus, free banking view advocates recommend that these examples demonstrate that there is no need for government intervention. The opinion of various authors is that the clearing-houses establishment is a proof that the central bank does not have to offer the lender of last resort.
The reason the private LLR operations are probably insufficient is that they are not responsive to the full range of the social costs that result from the banking crises. In terms of the long-run effects of the repeated bailouts, the central bank may raise the moral hazard if it announces beforehand that it will function as a lender of last resort in the future crises. Whereas Bagehot stressed that the promise benefits outweigh the costs; some central banks have deliberately not promised anything.
The inequalities produced by the LLR actions have also been a major issue. The lender of the last resort support of the insolvent banks instead of illiquid banks is unfair, and it encourages moral hazard. Many writers including Bagehot have been against LLR support of the insolvent bank as this encourages moral hazard besides generating inequalities. Regarding the role of the financial regulations, the resulting necessity for these cannot be fully addressed by the single countries working at national level. This is because it will need a greater international coordination degree than during the past. However, many authors claim that the failure will plant the seeds for the subsequent global crisis.
The interferences of the current activities of international financial institutions such as IMF with the effective performance of their roles has been the major problems involved in extending the lender of last resort to the global level. For this reason, there is a necessity to reform these international financial institutions to enhance their performance in managing the financial crises since this will help to eradicate these difficulties.