“Lender of last resort” refers to a final solution, utilized when all other options have been exhausted. In finance, it typically describes a central bank providing emergency loans to banks facing severe financial difficulty, unable to borrow elsewhere. This often occurs during financial instability, when banks hesitate to lend to each other and depositors may rush to withdraw funds.
Central banks act as lenders of last resort to ensure smooth financial market operation and overall system stability. By doing so, they protect individuals and businesses from potential hardship arising from banking troubles. For example, the European Central Bank (ECB) and national central banks within the euro area share this crucial role.
National central banks provide a final safety net through Emergency Liquidity Assistance (ELA) to banks unable to raise capital elsewhere. ELA consists of loans from the national central bank where the struggling bank is located, with that bank bearing all associated costs and risks. The ECB monitors and oversees these national central bank lending operations.
However, not every struggling bank receives a bailout. Strict rules and conditions determine ELA eligibility. Firstly, the bank must be illiquid but still solvent. Illiquidity means difficulty returning depositor funds immediately, while solvency implies long-term repayment capability.
Secondly, ELA is a temporary solution for unforeseen emergencies. Once normalcy returns, ELA ceases, and loans must be repaid. Finally, ELA comes at a cost. Central banks accept lower-quality collateral for ELA loans compared to non-emergency funding. This increased risk leads to higher interest rates and asset discounts.
The lender of last resort role is vital in preventing widespread hardship. If a bank can’t meet short-term obligations, customer panic and mass withdrawals can occur, potentially leading to bankruptcy. This can trigger job losses, difficulties for other banks, and ultimately, broader economic consequences.
Importantly, central banks do not provide emergency financial assistance to governments. Within the euro area, this is illegal as it could compromise price stability and central bank independence.
