Lender of Last Resort – Why are they necessary?

Lender of Last Resort – Why are they necessary?

Lender of last resort: definition

The term “lender of last resort” is used to describe financial institutions (or individuals) whose job is to provide credit and/or liquidity to institutions or individuals whose alternatives for credit are running low. Throughout the years, lenders of last resort have saved various financial entities by providing liquidity in the face of financial straits, such as the Panic of 1907.

Typically, there are two types of lenders of last resort:

  • Financial institutions that provide credit to other financial institutions
  • Financial institutions (or individuals) who provide credit to individuals (this is also known as retail lending)

In the U.S., the lender of last resort is the Federal Reserve Bank, which serves as the country’s central bank. If there is a need for financial back-up, the Federal Reserve Bank can provide credit for other banks, thus serving as a “guarantee” that there will be no difficulty in conducting all financial transactions and operations. It is just like a mortgage broker with a really good mortgage broker business plan as a back-up.

Retail lending is a service that is offered to individuals who do not have any other way of obtaining credit. A good example of this practice is found in car or home loans for people who are in the high-risk category.

Why lenders of last resort matter?

In the instance when all the depositors of a bank decide to withdraw all deposits at once, a “run on the bank” occurs. Due to the fractional reserve banking system , under which most western countries operate, a bank cannot deliver the whole amount of money asked for, because it simply does not have it on hand. The “bank run” is a very serious occurrence, which could even lead to social unrest, and that is why the system of lenders of last resort is essential to the banking system.

The drawbacks

Some people are highly critical of the lender-of-last-resort system. One of their main arguments for not backing this system is the notion that financial institutions are bound to take greater risks knowing that they have a powerful institution to help them out when/if necessary. If a bank knows that there is a lender of last resort behind it, then there is enough room for irresponsible business conduct.

A lot of criticism is also directed towards the International Monetary Fund (IMF). It serves as a lender of last resort to many countries, but there is a lot of doubt about whether the countries that borrow from the IMF would be able to pay off their loans in due time.

Non-conforming lenders and asset-based lenders

When it comes to money-lending, there is also the category of non-conforming lenders and asset-based lenders. Non-conforming lenders are characterized by the absence of mortgage insurance; the cover the risk by amount of rate (the greater the risk, the bigger the interest rate). They also allow for the borrower to have a bad credit history and to go as high as 90% LVR (Loan to Valuation Ration), whereas most lenders go up to 80% LVR.

Asset-based lenders offer loans that are secured by assets (collateral). The good thing here is that the interest rates are lower, due to the nature of the business deal; if the borrower defaults at any point, the lender can reclaim the assets. These loans are also known as “asset-based financing”.

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