thumb|200px|The [[United States Federal Reserve|Federal Reserve System headquarters in Washington, D.C.]]

thumb|200px|The [[Bank of England in London]]

thumb|200px|The [[Reserve Bank of New Zealand in Wellington]]

In public finance, a lender of last resort (LOLR) is a financial entity, generally a central bank, that acts as the provider of liquidity to a financial institution which finds itself unable to obtain sufficient liquidity in the interbank lending market when other facilities or such sources have been exhausted. It is, in effect, a government guarantee to provide 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 international markets in general.

The objective is to prevent economic disruption as a result of financial panics and bank runs spreading from one bank to the others due to a lack of liquidity in the first one.

There are varying definitions of a lender of last resort, but 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.

Classical theory

Although Alexander Hamilton, in 1792, was the first policymaker to explain 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 supply. That was because they feared that the deflationary tendency caused by a reduction of the money supply 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 supply constant, the purchasing power remains stable during shocks. When there is a shock-induced panic, two things happen:

  1. The depositors fear that they will not be able to convert their deposits into suitably safe liquid assets: in 19th-century Britain, that meant gold or Bank of England notes, the latter being a component of high-powered money. They increase the amount of cash they hold relative to deposits.
  2. Banks, on the other hand, afraid of becoming illiquid, increase their reserves. Taken together, it reduces the money multiplier which, multiplied by the amount of base money, gives the money supply. If the multiplier is reduced from a shock and the amount of base money is constant, the money supply will decrease as a consequence. Thornton and Bagehot, therefore, suggested that the lender of last resort should increase the money base to offset the reduction of the multiplier. That was meant to keep the money supply constant and prevent an economic contraction.

Thornton's foundations

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 supply constant, thereby preventing negative externalities of monetary instability,

such as unemployment, price instability, bank runs, and financial panic.

Bagehot's contribution

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".

Summary of the classical theory

Thomas M. Humphrey,

Subsequently, the model has been extended to allow for financial contagion: the spreading of a panic from one bank to another, by Allen and Gale, and Freixas et al. respectively.

Allen and Gale

That is exactly what the Report of the International Financial Institution Advisory Commission accuses the IMF of doing when it lends to emerging economies: "By preventing or reducing losses by international lenders, the IMF had implicitly signalled that, if local banks and other institutions incurred large foreign liabilities and government guaranteed private debts, the IMF would provide the foreign exchange needed to honour the guarantees." Investors are protected against the downside of their investment and, at the same time, receive higher interest rates to compensate them for their risk. That encourages risk-taking and reduces the necessary diversification and led the Commission to conclude, "The importance of the moral hazard problem cannot be overstated." Consequently, many countries have a central bank that acts as lender of last resort. These countries then try to prevent moral hazard by other means such as suggested by Stern: "official regulation; encouragement for private sector monitoring and self-regulation; and the imposition of costs on those who make mistakes, including enforcement of bankruptcy procedures when appropriate." Some authors also suggest that moral hazard should not be a concern of the lender of last resort. The task of preventing it should be given to a supervisor or regulator that limits the amount of risk that can be taken.

Macro or micro responsibility

Whether or not the lender of last resort has a responsibility for saving individual banks has been a very controversial topic. Does the lender of last resort provide liquidity to the market as a whole (through open market operations) or should it (also) make loans to individual banks (through discount window lending)?

There are two main views on this question, the money and the banking view: the money view, as argued, for example, by Goodfriend and King, suggests that the private market for interbank loans can fail if banks face uncertainty about the risk involved in lending to other banks. In times of crisis with less certainty, however, discount window loans are the least costly way of solving the problem of uncertainty.

Rochet and Vives extend the traditional banking view to provide more evidence that interbank markets indeed do not function properly as Goodfriend and King had suggested. "The main contribution of our paper so far has been to show the theoretical possibility of a solvent bank being illiquid, due to a coordination failure on the interbank market."

Goodhart he considers insolvency a possibility that arises with a certain amount of probability, not something that is certain.

Penalty rate and collateral requirement

Bagehot's reasoning behind charging penalty rates (i.e. higher rates than are available in the market) was as follows: (1) it would really make the lender of last resort the very last resort and (2) it would encourage the prompt repayment of the debt. and the Suffolk Bank of Boston had provided member banks with liquidity during crises. In the absence of a public solution a private alternative had developed. Advocates of the free banking view suggest that such examples show that there is no necessity for government intervention.

The Suffolk Bank acted as lender of last resort during the Panic of 1837–1839. Rolnick, Smith and Weber "argue that the Suffolk Bank's provision of note-clearing and lender of last resort services (via the Suffolk Banking System) lessened the effects of the Panic of 1837 in New England relative to the rest of the country, where no bank provided such services."

During the Panic of 1857, a policy committee of the New York Clearing House Association (NYCHA) allowed the issuance of the so-called clearing-house loan certificates. While their legality was controversial at the time, the idea of providing additional liquidity eventually led to a public provision of this service that was to be performed by the central bank, founded in 1913.

Some authors view the establishment of clearing-houses as proof that the lender of last resort does not have to be provided by the central bank.

Historical experience

Miron, and Goodhart show that the existence of central banks has reduced the frequency of bank runs.

Wood compares the reaction of central banks to different crises in England, France, and Italy. When a lender of last resort existed, panics did not turn into crises. When the central bank failed to act, crises such as in France in 1848, however, happened. He concludes "that LOLR action contains a crisis, while absence of such action allows a localized panic to turn into a widespread banking crisis." More recent examples are the crises in Argentina, Mexico and Southeastern Asia. There, central banks could not provide liquidity because banks had been borrowing in foreign currencies, which the central bank was unable to provide.

Federal Reserve System

The Federal Reserve System in the United States acts rather differently, and at least in some ways not in accordance with Bagehot's advice. a view shared amongst others by Milton Friedman. Critics like Michel nevertheless applaud the Fed's role as LLR in the crisis of 1987, and in that following 9/11, (though concerns about moral hazard resulting were certainly expressed at the time).

However, the Fed's role during the 2008 financial crisis continues to polarise opinion. The classical economist Thomas M. Humphrey has identified several ways in which the modern Fed deviates from the traditional rules: (1) "Emphasis on Credit (Loans) as Opposed to Money", (2) "Taking Junk Collateral", (3) "Charging Subsidy Rates", (4) "Rescuing Insolvent Firms Too Big and Interconnected to Fail", (5) "Extension of Loan Repayment Deadlines", (6) "No Pre-announced Commitment".

Indeed, some say its lender of last resort policies have jeopardized its operational independence, and have put taxpayers at risk.

Mervyn King however has pointed out that 21st century banking (and hence the Fed as well) operate in a very different world from that of Bagehot, creating new problems for the LLR role Bagehot envisaged, highlighting especially the danger that haircuts on collateral, punitive rates, and the stigma of the deposit window can precipitate a bank run, or exacerbate a credit crunch: "In extreme cases, the LOLR is the Judas kiss for banks forced to turn to the central bank for support". As a result, other strategies were called for, and were indeed pursued by the Fed. The historian Adam Tooze has stressed how the Fed's new liquidity facilities mapped onto the various elements of the eviscerated shadow banking system, thereby replacing a systemic failure of credit as LLR, (a role morphing perhaps into that of a dealer of last resort). Tooze concluded that "In its own terms, as a capitalist stabilization effort...the Fed was remarkably successful".

ECB

The European Central Bank arguably set itself up (controversially) as a conditional LOLR with its 2012 policy of Outright Monetary Transactions.

Prussia/Imperial Germany

In 1763, the king was the lender of last resort in Prussia; and in the 19th C., various official bodies, from the Prussian lottery to the Hamburg City Government, worked in consortia as LOLR. After unification, the financial crisis of 1873 forced the formation of the German Reichsbank (1876) to fulfil that role.

International lender of last resort

Theory

The matter of whether there is a need for an international lender of last resort is more controversial than for a domestic lender of last resort. Most authors agree that there is a need for a national lender of last resort and argue only about the specific set-up. There is, however, no agreement on the international level. There are mainly two opposing groups: one (Capie and Schwartz) says that an international lender of last resort (ILOLR) is technically impossible, while the other (Fischer, Obstfeld, Fischer's central argument, that the ability to create money is not a necessary attribute of the lender of last resort, is highly controversial, and both Capie and Schwartz argue the opposite.

"A lender-of-last-resort is what it is by virtue of the fact that it alone provides the ultimate means of payment. There is no international money and so there can be no international lender-of-last-resort."

That is the most prominent argument put against the international lender of last resort. Besides this point (considered "semantic" by opposing authors), Capie and Schwartz provide arguments for why the IMF is not fit to be an international lender of last resort.

Schwartz explains that the lender of last resort is not the optimal solution to the crises of today, and the IMF cannot replace the necessary government agencies. Schwartz considers a domestic lender of last resort suitable to stabilize the international financial system, but the IMF lacks the properties necessary for the role of an international lender of last resort. and suggests further that, at the height of the crisis, through the Central bank liquidity swap lines, the Fed "assured the key players in the global system...there was one actor in the system that would cover marginal imbalances with an unlimited supply of dollar liquidity. That precisely was the role of the global lender of last resort". Concern as to whether the Fed is in a position to repeat its role as global LOLR is one of the forces behind calls for a formal global currency.

In government bond markets

Although the European Central Bank (ECB) has supplied large amounts of liquidity through both open market operations and lending to individual banks in 2008, it was hesitant to supply liquidity during the sovereign crisis of 2010. According to Paul De Grauwe,

Arguments put forth against a lender of last resort in the government bond market are the following: (1) inflation risk from an increase in the money supply; (2) losses to taxpayers because in the end they bear the losses of the ECB; (3) moral hazard: governments have an incentive to take more risk; (4) Bagehot's rule of not lending to insolvent institutions; and (5) violation of the statutes of the ECB, which do not allow the ECB to buy government bonds directly.

According to De Grauwe, none of the arguments is valid for the following reason: (1) The money supply does not necessarily increase if the money base is increased. (2) All open market operations generate taxpayer risk, and if the lender of last resort is successful in preventing countries from moving into the bad equilibrium, it will not suffer any losses. (3) The risk of moral hazard is identical to the moral hazard in the financial market and should be overcome by risk-limiting regulation. (4) If the distinction between illiquid and insolvent were possible, the market would not need the support of the lender of last resort, but in practice, the distinction cannot be made. (5) While Article 21 of the treaty prohibits buying debt from national governments directly because it "implies a monetary financing of the government budget deficit", Article 18 allows the ECB to buy and sell "marketable instruments", and government bonds are marketable instruments.