What is a Lender of Last Resort? The Bailout Saviors

Table of Contents

Lender of last resort

What is a Lender of Last Resort?

A lender of last resort (LoR) refers to an institution that provides emergency loans to at-risk banks (or other financial institutions). A nation’s central bank (e.g. the Federal Reserve) typically operates as the lender, intervening before the borrower collapses.

Resort lending may occur when (1) the borrower cannot secure loans anywhere else due to their financial troubles and (2) its collapse could have disastrous effects on the economy.

During the late 1800s, a series of banking panics in the U.S. destabilized the finance world. Financial institutions failed, and many lost their deposits. The lender of last resort was introduced to protect depositors by lending temporary liquidity to at-risk institutions.

Since the lender of last resort’s introduction, the Fed has bailed out countless companies. But critics argue that last-resort lending tempts banks to take unnecessary, and perhaps unethical, risks. High-risk, high-reward gambles arguably become low-risk, high-reward guarantees. All while endangering the economy, often harming the public.

In this article, the Zero Theft Movement will cover the theory behind the lender of last resort, as well as go in-depth on the potential moral pitfalls last-resort lending creates. We do this to ultimately ask the question: does the lender of last resort function enable crony capitalists to unethically profit off of excessively risky investments?

Massive bailouts often allow shareholders to make profits on failed investments. That’s not how an investment works for most people. 

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The Theory behind Last-Resort Lending

Economist Henry Thorton and journalist Walter Bagehot conceived the classical theory of lender of last resort. Thornton and Bagehot both emphasized the need to protect the money supply (i.e. total value of money available at a point in time), as opposed to individual banks. They argued that at-risk financial institutions generally should not have the option of last-resort lending. That individual banks should be left to fail. They also championed charging penalty rates, good collateral, and the exclusive accommodation of institutions that have established records of sound practices.

In 1802, Thorton published An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. He identified The Bank of England (BoE) as a model for a lender of last resort because it had control over the issuance of banknotes and displayed a strictness in its lending. It could encourage relaxed, careless, and even reckless behavior by both individual and central banks. Thornton feared that the safety net would embolden financial institutions. That they would take wild speculative ‘risks,’ purely operating based on the guarantee that they would be saved. Of course, to Thorton, the consequences of failure to the economy or the public would matter much less to individual banks than the extreme potential success they could achieve without really taking any actual risk.

In 1873, Bagehot published Lombard Street: A Description of the Money Market. Bagehot made many of the same claims that Bagehot did while elaborating on the potential hazards of having a lender of last resort. Bagehot believed he had the best solution to fixing banking crises: huge loans offered at a very high-interest rate. He concluded that last-resort lending should function only as a temporary measure to address banking panics.

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The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.   

Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.  

A Lender of Last Resort and Preventing Bank Runs

The lender of last resort protects customers’ deposits and deters them from making panic withdrawals en masse. This is known as a ‘run on the bank.’ The term refers to when a bank’s customers, fearful that the institution will experience insolvency, rush to withdraw their funds. Banks generally maintain only a small percentage of total deposits as cash, using the rest for investments, loans, etc. So when a bunch of customers tries to withdraw their funds in a short period of time, the bank will lose its liquidity and become insolvent. Exactly what the depositors are afraid of.

When a bank does not have the reserves to handle a bank run, a lender of last resort can intervene by injecting the institution with emergency funds. Customers seeking withdrawals still receive their money while the bank does not become insolvent

Notable bank runs occurred due to the 1929 Wall Street crash, which made the U.S. spiral into the Great Depression. The government enacted new legislation establishing a minimum reserve requirement on banks.

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Debates around the Lender of Last Resort

The Fed has had to operate as a lender of last resort quite a few times after the Great Depression. Bailouts involving billions of dollars unsurprisingly polarize the general public and experts alike. Let’s cover some of the main points of contention. 

Moral hazard

Those opposed to the lender of last resort claim, as Thorton and Bagehot did, that it tempts commercial banks and other financial institutions to make excessively risky investments. They often cite the 2007-2008 financial crisis as the prime example of this moral hazard. In short, banks overwhelmingly invested in high-risk assets, pushed the global economy to the brink of collapse, but bailed out by the Fed.

The International Financial Institution Advisory Commission (IFAC) (a.k.a. the Meltzer Commission), as well as other regulatory bodies, have tried to better define the function of the International Monetary Fund (IMF). In particular, IFAC recommended the IMF operate as an international lender of last resort, bailing out those in need around the globe if they meet certain requirements.

Proponents of the lender of last resort argue that if the central bank refuses to bail out failing banks, the damage would be even greater. Excessive risk-taking can be prevented by imposing severe penalties on those who make intentional mistakes (can be difficult to prove) and establish regulations to control borrowing from the central bank.

The Private Lender of Last Resort

Critics, however, push back against the idea that financial institutions need to be saved by the Fed. Why can’t another institution intervene and acquire the failing enterprise?

They argue that private institutions have the means to function as a lender of last resort. This is especially true as collapsing institutions cannot command a high price. For example, a Warren Buffet-led investment group offered $250 million to save the hedge fund Long Term Capital Management (LTCM). LTCM had managed to draw over $1 billion in assets before it collapsed when the Russian economy tanked in 1987. Even with the offer from the investment group, the Fed still stepped in as a quasi lender of last resort. LTCM shareholders received a much better package than they would have if the Fed had not intervened. The Cato Institute, a public policy research organization, published a report arguing there was no need for the Fed to intervene.

There are some examples of successful private lenders of last resort prior to the formation of the Fed. The Suffolk Bank of Boston and the clearing-house system of New York furnished financial institutions with capital during bank runs. The Suffolk Bank of Boston mitigated the impacts of the 1837-1839 financial panic by offering last-resort lending to member banks. The committee of the New York Clearing House Association gave out loan certificates to banks to cushion the blow of the financial panic of 1857.

Both the Suffolk Bank of Boston and the New York Clearing House Association successfully functioned as the role of a lender of last resort without government assistance.

Read about cases where the Fed has operated as a lender of last resort:

AIG: The One-Way Bet Behind the 2008 Financial Crisis?

The Savings and Loan Crisis

Tough Penalty Rates

If the central bank imposes severe penalties on borrowers, then financial institutions might either be deterred from taking so much risk or will look for private lenders of last resort.

Critics propose that a strict penalty rate can make the central bank the least attractive option for financial institutions that need bailing out. In other words, the central bank would serve as a true lender of last resort. Banks would have to remain within their own means, instituting and abiding by internal regulations to prevent a bank run and its consequent penalties. Some banks opt to maintain more capital than the central bank requirement during turbulent economic periods. They are accounting for the increased chance of withdrawals. 

Advocates of last-resort lending contend that strict penalty rates would make loans too expensive to borrow, defeating the intended purpose of the last resort function. 

Should we keep or eliminate the lender of last resort?

The lender of last resort remains a hotly contested topic of debate to this day. The moral hazard especially will continue to raise questions as long as last-resort lending isn’t reformed. Corporations who put the economy and our livelihoods at risk maybe shouldn’t get saved for trying to dangerously maximize their profits.

So what do you think about the lender of last resort? Do we need it, but with more restrictions? Or should the Fed get rid of it completely? 

The Zero Theft Movement seeks to end the corporatocracy and rid moneyed interests from U.S. politics. Our mission is and will continue to be, on waking up 330 million American citizens to the harmful effects of a rigged economy. We can all profit from an ethical, powerful, and safe financial system if we stand up against the crony capitalists. 

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Beyond the Lender of Last Resort…

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