Lender of Last Resort

1. Introduction

The concept of the lender of last resort (LOLR) owes its origins to Sir Francis Barings, who in 1797 referred to the Bank of England as the “dernier resort” from which all banks may get liquidity in times of crisis.[1] The lender of last resort role of the central bank stays a major rationale for the most central banks around the world either in developed countries or developing countries.[2] It is generally considered that the operation of LOLR is most likely surrounded by a degree of ambiguity and uncertainty. However, according to the classic understanding of the LOLR doctrine, a few principles should be applied in order to operate the LOLR more clearly. To start with, the acting of the central bank as the lender of the last resort must be for a short term to prevent illiquid but solvent banks from failing. The second point is that the central bank tends to lend the bank which has lack of liquidity as much as necessary but it charges the bank in need with a high rate, which is called by some writers as (a penalty rate). The third point is that the central bank should hold any one with reasonable collateral values at pre-shock prices. The last point is that the central bank must be ready to lend clearly and in advance.[3] It is worth bearing in mind that the central banks LOLR role is considered as discretionary not compulsory. It might be said that the reason for giving the central bank this discretion is to assess the situation illiquidity or insolvency of the failure bank and whether the failure of this bank can cause a failure to other banks.

In addition there is less argument regarding the importance of having the LOLR under the umbrella of the central bank.[4] Nevertheless, at an international level, the role of the International Monetary Fund as international of last resort has been much contested in current years. It is worth noting that the problem of the financial crises in the United Kingdom and other countries is most likely because the regulatory focuses on microeconomic level (individual bank) rather than macroeconomic. Another problem is that, for example in the United Kingdom, there is a lack of cooperation between the FAS and Bank of England.

The purpose of this paper is to critically discuss the rationale for the lender of last resort. Moreover, it aims at examining the effectiveness of the lender of last resort as mechanism for financial crisis management. This paper is structured as following: the second section will consider the concept of the lender of last resort. The third section will discuss the problem of moral hazard. The issue an international lender of last resort will be discussed in the fourth section while the fifth section will discuss rationale for the lender of last resort. Examination of the effectiveness of lender of last resort will be also discussed and some conclusions will complete the paper.

2. The Concept of the Lender of Last Resort

To begin with, the notion of the lender of last resort, as it has been mentioned in the introduction, owes its origin to Sir Francis; however Henry Thornton (1802) was the one who specified the primary role of the lender of last resort. Additionally, he distinguished among the microeconomic versus macroeconomic and shock preventing in opposition to shock absorbing aspects of this role. He was also the first one who pointed out the problem of the moral hazard that might face the lender of last resort.[5] Thornton indentified the three different characteristics of the lender of last resort. First of all, LOLR has a special position as the last source of liquidity for the financial system. Therefore, the lender of last resort has high power that can be used to satisfy demands for the liquidity from any institution at any difficult time. The second characteristic of the lender of last resort, which was identified also by Thornton, was that it has the special responsibilities as the guardian of the central gold reserve. Moreover, according to Thornton, the third characteristic of the lender of last resort is not like any other banks such as (commercial banks), whose responsibilities are restricted to shareholders or stock holders, but LOLR has public responsibilities. Hence, the responsibility of the lender of last resort is to protect the economy as whole not only the individual banks.[6]

Despite Thornton's theory that emphasizes the importance of the lender of last resort, some commentators ask whether we need the lender of last resort as a solution to any financial crisis. It seems important to consider the argument for and against the lender of last resort in order to address this question.

On the one hand, a vast literature by Thornton (1802) and by the editor of the Economist, Bagehot (1873), shows that the function of the lender of last resort is to lend liquidity to “solvent but illiquid' banks under certain circumstances.[7] They have also claimed that the LOLR is primarily needed otherwise small liquidity problems may be developed into common financial crises and may cause more serious social consequences.[8]

On the other hand, the minority voice even from the central bank themselves have stressed that there is no need for LOLR because it increases the financial crises rather than mitigating the crises. In particular, it has been argued that this intervention via the lender of last resort, like any other public safety net, may lead to the problem of moral hazard.[9] The reason is that it encourages the mangers and the shareholders of the bank to be more willing to excessive risk taking. Furthermore, once depositors realize that they are guaranteed by the central bank, they will be most likely willing to stop providing market discipline throughout monitoring the banks activities. Therefore, lender of last resort may cause more losses and the financial system will be more fragile in this case.[10]

A previous discussion and argument has revealed that the importance of the lender of last resort is to prevent and mitigate the financial crises even though there are some minor problems such as the moral hazard. However, it could be said that this problem can be solved in many ways such as imposing high penalty rates.

2.1 Is the Central Bank the Only Lender of Last Resort?

It seems crucial to mention briefly that the central bank can support the failing banks in two ways. The first way is indirect by facilitating private sector solution. The second way can be done directly by acting as the lender of last resort either to the market as whole or to individual institutions which will be discussed in more details below. [11]

It is generally considered that the lender of last resort has two functions which are crisis lender and crisis manager. The crises lender provides financial support to cope with crisis while the crises manager usually takes the responsibility of dealing with the potential crises. [12] In the middle of a financial crisis, there is sometimes a potential managerial function, in which other banks or agents might be supported to take an appropriate action, for example by extending a loan to an institution whose difficulties might have systematic consequences.

From a historical perspective, the central bank plays the role of both the crises lender and the crises manager. In the U.S, in various times in private institutions like clearing houses, Treasury and the central bank played one or both of these roles. In fact, the separation of the functions of crises manager and crises lender may became more common when the task of supervision of the financial sector is separated from the central bank in some countries such as the United Kingdom. [13]

Another important question is that whether the lender of last resort needs to create money. It can be said when panic takes place and people run from bank deposits in to currency; the central bank is more willing to create the currency needed to cope with panic.[14] Nevertheless, panics which are caused by request or demand for currencies are rare. Kaufman and Schwartz argued that when panic takes a run, probably enhanced by contagion, the depositors shift their money from those banks deemed unsound to the other financial institutions thought to be healthy. Therefore, in these cases creating more money might be unnecessary. Moreover, they claimed that the market can complete this transfer when it is able to make a distinction between merely illiquid from the insolvent companies.[15]

However, it might be argued that not always the depositors shift their money from unsound bank to another bank because when panic happens, people do not trust any financial institutions in the country. In these cases, they may transfer their money to another safe country or they may invest their money in another sector. Another critical point is that there is no clear cut during the crisis between solvency and liquidity. Hence, it seems important for the central bank to create money and made credit available to solvent institutions and market as whole in order to help stemming a panic and reducing the impact of the crises.

Furthermore, the real question is that why the loan should be collateralized and evaluated at its value at pre-panic prices.[16] From economic point of view, the reason behind these requirements is that there is a good balance towards the aim of the lender of last resort which is trying to push the system. Basically, the lender of last resort may help to prevent panic in the market and manage the crises from becoming self fulfilling by lending liquidity on the ground of the value of collateral in non crisis times..[17]

3. The Problem of Moral Hazard

It is generally considered that the problem of moral hazard might be caused by the existence of public ‘safety net'. [18] This existence of public (the lender of last resort) may give the managers and the investors in the financial institution the tendency to behave carelessly or less conservatively.[19] A good example of moral hazard in individuals, when a person has fire insurance, they may take less care to prevent and stop a fire. In the case of the domestic lender of last resort, the dilemma of moral hazard may arise in two different situations. First of all, when managers of financial institutions believe they are protected from any crises and that they may receive loan from the lender of last resort during the crises time. Second, when the investors of that institution know that they may get the same protection from the lender of last resort.[20] Consequently, the central bank needs to make balance between the risk of contagion in the case of non assistance to insolvent financial institution and the moral hazard incentives. The reason is that all the funds of the central bank comes from the public such as taxpayers so the loss of the central bank may lead to the loss of public. Furthermore, it is worth bearing in mind that lending for long time may lead to increase the potential for moral hazard and may increase the risk of loss to the central bank. [21]

However, it could be argued that the problem of the moral hazard will less likely appear because of the high penalty rate in the lender of last resort and this liquidity is over a short period of time. Additionally, it has been suggested to take into account many solutions that to reduce the risk of moral hazard and it is important to recognize that there is no obsolete solution to this problem.[22]

To begin with, some scholars have suggested that it is necessary to put regulation and supervisory framework to control and administer the moral hazard.[23] A second possible solution is that the system is requested to support and encourage private sector monitoring of financial institutions, specifically by sophisticated investors. Therefore, the investors need more provision of information to help them to minimize the risk of moral hazard. In addition, the lender of last resort is required to limit and reduce the moral hazard by imposing costs on those who make some mistakes such as the managers and the shareholders of the financial institutions. [24]

After the above discussion, the problem of the moral hazard might be caused by the existence of public safety net (lender of last resort) and could lead to loss to the central bank. However, it could be said that this is not enough to refuse the idea of the lender of last resort as a way to prevent and mitigate the financial crisis. Additionally, some possible solutions which are suggested above reveal many ways to minimize the risk of moral hazard.

4. An international Lender of Last Resort

After the crisis in Asia in 1997, some scholars have triggered an argument of how the new institutions and rules might enhance the resilience of the establishment of the international monetary system.[25] It seems useful to examine in brief whether it is important to have an international lender of last resort or not. It is worth mentioning the argument, among the economists, regarding the need for international lender of last resort for and concluding with a brief evolution of this debate.

Generally speaking, there are two schools of thought between the economists on the importance for an international lender of last resort. On the one hand, some writers argue that no international LOLR is necessary and they claim that an international lender of last resort could worsen the problem of the moral hazard which is considered as the main cause of fragility and weakness of the financial system as whole. Additionally, they argue that an international last resort is acceptable and desirable in theory but in practice there might not be any chances to go well beyond what the international society is ready to accept.[26] Another group of economists argue that an international lender of last resort is not important for the same reasons why that domestic of last resort is not necessary.[27]

On the other hand, a few economists argue in favor of the importance of an international lender of last resort. They contend that “under existing institutional arrangement the most reliable mechanism for preventing sharp contractions in world reserves and world monies entails the creation of an international lender of last resort “.[28]

After the above discussion, it can be said that to some extent there is no need to consider the idea of having an international lender of last resort. The idea of having an international lender of last resort is not supported by many economists and it seems difficult to be applied in practice because of the suspension of payment.[29]

5. Rationale for Lender of Last Resort

It is generally considered that there are many justifications for having a lender of last resort as a support for the failure institution which affects the market as whole. LOLR is the reason behind the existence of discount window in the United States and the marginal lending facility in the European countries. [30]

Indeed, there are many justifications to existence of the lender of last resort which makes it useful to critically discuss them in more details. To begin with, the main objective of lender of last resort is to maintain the financial stability. In order to clarify this point the lender of last resort helps the solvent bank in financial crises and panic to prevent and mitigate this crisis. Therefore, Fischer points out that the function of the lender of last resort is to offer an assurance of credit given under certain and limited circumstances in order to stop a financial panic from getting started or spreading. [31]

The second rationale is to protect and maintain the price of assets for the failure institution from collapse. For example, when the panic takes place in the market, the depositors demand for their money. The banks try to cover all the demands but sometimes they may not have enough liquidity. As a result, banks may sell some assets in order to cover all the demands of the depositors. Meanwhile, the price of assets in the financial crisis gets lower and may not cover the liabilities of the banks. Therefore, existence of the lender of last resort is seen important to maintain the price of assets in order to promote monetary stability. [32]

The third justification for the intervention of the lender of last resort is to minimize, if not prevent, the impact of financial crises and panic on real income and the rank of economic activities in the country.[33]

Moreover, the rationale for having the lender of last resort is to maintain a sufficient confidence to the depositors and to the financial system at the same time.[34] Generally, when the depositors hear about any financial crisis or there is shortage of liquidity in bank they may take their money from the bank quickly. However, the lender of last resort gives the consumer and the depositors more confidence by giving emergency financial assistance to failure individual banks and other institutions.[35]

Another justification of the lender of last resort is to prevent credit crisis from becoming monetary crisis by preventing credit debt contraction from producing monetary contraction.[36] Another vital rationale is to offset shocks by reducing the threat to the aggregate money supply. In addition, Kaufman claimed that there is a strong tendency of the lender of last resort to deal with financial crises more than cost of intervention.[37]In fact, the central bank is the ultimate provider of currency and in this manner the central bank is considered as the guarantor of deposit to currency convertibility.[38]Additionally, it might be said that the rationale for the lender of last is not merely to prevent shocks but also to minimize the secondary repercussions which may happen after the shocks.[39] It is also important to bear in mind the monetary stabilization responsibility of the lender of last resort is related to a wider market which is called macroeconomic by some economists and not only to the individual institution, microeconomic.

The last rationale for the lender of last resort is to maintain a sufficient stock of specie to insert in the economy and to prevent the contraction in all sectors of the economy. The lender of last resort “was seen as ensuring that the aggregate economy was immunized from the adverse effects of the initial event causing the specie drain, at least as it would be transmitted through decreases in money supply”.[40] As Bagehot stated that the way to stop external drains is by raising the interest rate. Nevertheless, internal drain could be stopped by lending freely. [41]

To sum up, these are some justifications for the lender of last resort which is considered acceptable among most but not all the economists. Nevertheless, a few economists claim that these justifications are not acceptable and it will better if there is no intervention from the public sector (central bank) by the lender of last resort. Also they asserted that this intervention should be from the market operation or private sector. However, it could be argued that the market operation to some extent does have the power and the ability to prevent and manage any financial crisis.

6. The Effectiveness of the Lender of Last Resort

The last part of this paper will critically examine the effectiveness of the lender of last resort as a mechanism for financial crisis management. The discussion about the lender of last resort indicates the importance and the effectiveness of the lender of last resort in many ways. One of the effectiveness of the lender of last resort is to prevent and mitigate the wide spread of systematic crisis (systematic risk).[42] It seems necessary to emphasize and explain in more details the meaning of the systematic risk and how the lender of last resort will be effective in preventing the financial crisis. Rosa defines the systematic risk (contagion risk) as the financial difficulties at one or more institutions which might be extended to a large number of other institutions or may affect the financial system as whole.[43]

In fact, the failure of one bank may lead to decrease public confidence in other banks. Generally, these negative externalities means that even the most solvent institutions could collapse unless they are able to liquidate their assets quickly without reducing the price. Therefore, the lender of last resort can help to prevent this collapse by buying the bank assets or lending money to the failure bank in order to meet depositors' demands without unduly depressing of the capital values.[44] Nevertheless, some opponents argue that fact that it is difficult for the central bank to assess the potential for systematic risk. The answer to the question is not easy but it could be said that the central bank can assess the information of the solvent bank, how large is this bank and to what extent it can affect the market by using some models and mathematic calculations.

Despite the efficiency of the lender of last resort to prevent the financial crisis, some authors, such as Pagratis, argue that the lender of last resort to some extent is not effective because it enhances the problem of the moral hazard.[45] However, it might be argued that the problem of the moral hazard can be solved in many ways such as imposing high penalty rates and having enough collateral evaluated at its real value in non crisis time. Moreover, the central bank role is discretionary and not mandatory so it can assess if there is a moral hazard case or not or possibly lend money for short period.[46]

Some writers claim that the lender of last resort is not effective because the intervention came from the public sector rather than the private sector. Alternatively, private banks might take the responsibility and make the public intervention unnecessary.[47] However, it can be argued that the alternative private institutions to some extent are not effective simply because the private sector may face the same financial crisis. Moreover, the private bank may not have enough liquidity to help the solvent bank.

To sum up, after the discussion on the effectiveness of the lender of last resort, it can said that the LOLR seems useful and effective to prevent the financial crises and enhance financial stability to a large extent. [48]

7. Conclusion

This paper engaged to examine the rationale for and the effectiveness of the lender of the last resort as a mechanism for financial crisis management. This paper showed the concept of the lender of last resort and the debate among the economists on the role of the lender of last resort as a mechanism to prevent and manage the financial crisis.[49] Additionally, it considered the problem of the moral hazard as a result of the intervention of the lender of last resort followed by some possible solutions to mitigate this problem. For example, the lender of last resort can lend money for short period and can raise the penalty rate. Also, it discussed the argument for and against having an international lender of last resort and it concluded that to some extent there is no need it. Furthermore, it examined in details the justifications for the lender of last resort to overcome any financial difficulties. However, some writers argue against the intervention of the central bank via the lender of last resort because of the problem of the moral hazard and other problems. Nevertheless, this paper argues in favor of the lender of last resort in the financial crises as discussed above. Finally, this paper examined the effectiveness of lender last resort for financial crisis management. It can be seen that the lender of last resort to large extent is effective as a defensive operation rather than a dynamic operation to manage the financial crises.[50]

It has been suggested that it is important to enhance the cooperation between the FAS and Bank of England ,in the United Kingdom, in order to prevent or reduce the impact of financial crisis in recent days and the in future. This cooperation may help the lender of last resort to be more the effective in the financial crises.

[1] See Thomas M Humphrey and Robert E Keleher, “The Lender of Last Resort : A Historical Perspective” (1984) Cato Journal , VOL 4 (1) pp275- 316

[2] Rosa M. Lastra ,' Legal Foundations of international monetary stability' ( frist ed Oxford University Press 2006) 113

[3] See above ,p114

[4] Rosa M Lastra, “ Lender of Last Resort , An international Perspective “ (1999) International and Comparative Quarterly VOL 48 (2) pp339- 361

[5] See Thomas M Humphrey and Robert E Keleher, above n 1

[6] Ibid

[7] Jean C Rochet and Xavier Vives , “Coordination failures and the lender of the last resort : Was Bagehot right after all?” (2004) Journal of the European Economic Association 2 (6) pp 1116-1147

[8] Denis O, Brien , “The lender of last resort concept in Britain” . (2003) History of Political Economic 35(1)

[9] Freixas ,Parigi and Rochet ,” The lender of last resort : A twenty first century approach “ (2004) Journal of European Economic Association 2(6) pp 1085-1115

[10] Mikko Niskanen , “Lender of last resort and the moral hazard problem “ (Bank of Finland discussion papers 17.2002)

[11] Glenn H and Farouk S, ‘crisis management, lender of last resort and the changing nature of the banking industry' in Financial Stability and Central Bank. Routledge 2001) pp 166-184

[12] Stanley Fischer,” On the need for an international lender of last resort “,(1999) Journal of Economic Perspectives VOL 13, pp 85-104

[13] see Stanley Fischer, above n 11

[14] Ibid

[15] Ibid

[16] Risto Herrala , “ An assessment of alternative lender of last resort schemes “(Bank of Finland discussion papers 28.2001)

[17] see Stanley Fischer, above n 11

[18] Rosa M. Lastra , see above n 2, p115

[19] Rosa M Lastra, see above n 4

[20] see Stanley Fischer, above n 11

[21] Rosa M. Lastra , see above n 2, p115

[22] see Stanley Fischer, above n 11

[23] Fred Danie , walter Engert , and Dinah Maclean , “The Bank of Canada as lender of last Resort, Bank of Canada” Review winter 2004-2005 available at

[24] see Stanley Fischer, above n 11

[25] Olivier Jeanne and Charles Wyplosz , “The international lender of last resort : How large is large enough”?' 2001 available at

[26] Ibid

[27] See Thomas M Humphrey and Robert E Keleher, above n 1

[28] Ibid

[29] Jeffrey D. Sachs , ‘The international lender of last resort : What are the alternatives “

[30] Xavier Freixas and Bruno M. Parici , “ Lender of last resort and bank closure policy “ Cesifo working paper NO.2286 April (2008) available at WWW.SSRN.com

[31] see Stanley Fischer, above n 11

[32] See Thomas M Humphrey and Robert E Keleher, above n 1

[33] George G.Kaufman ,”Lender of last resort : A contemporary Perspective “, (1991) Journal of Financial Research 5 ,pp 95-110

[34] See Thomas M Humphrey and Robert E Keleher, above n 1

[35] Marvin Goodfriend and Robert G. King , “ Financial deregulation , monetary policy and central banking” (1998)May/ June Economic Review

[36] See Thomas M Humphrey and Robert E Keleher, above n 1

[37] George G.Kaufman, above n 32

[38] See Thomas M Humphrey and Robert E Keleher, above n 1

[39]Ibid

[40] George G.Kaufman, above n 32

[41] Ibid

[42] Glenn H and Farouk S , above n 10

[43] Rosa M Lastra, see above n 4

[44] Peter D. Spencer , ‘The Structure and regulation of financial markets' (Oxford University Press 2000) p 203

[45] Spyros Pagraties , “Prudential liquidity regulation and the insurance aspect of lender of last resort” (2005) Bank of England available at

[46] see Stanley Fischer, above n 11

[47] See Risto Herrala, above n 1

[48] See Thomas M Humphrey and Robert E Keleher, above n 1

[49] see Stanley Fischer, above n 11

[50] George G.Kaufman, above n 32