The Lender of Last Resort (LOLR) is currently one
of the most important functions of the central banks around the world, the
creation of which is attributed to Henry Thornton (1802) and Walter Bagehot
(1873). It is designed to prevent the failure of banks that were solvent, but had
liquidity problems (not enough cash to give back to depositors when demanded) by
giving them an option to take out a loan from the central bank.
Bagehot’s view was that the lending should happen
against good collateral (valued at pre-crisis prices) and at a penalty rate. In
particular he thought that “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.” (Bagehot, 1873) I
think lending at a penalty rate is a logical decision, as it will deincentivise
an unnecessary use of the LOLR facility, but may exacerbate the problems of
financial sector during recession.
There are many reasons that can lead to bank panics and
cause liquidity problems. Bordo (1990) has divided them into the internal and
external categories. Internal include fraud, poor management and management dishonesty,
external include change in the price level of assets or overall price level.
The latter factor is much more relevant to the current financial crisis. Sharp changes in the price level can lead to
decrease in value of the investments, which leads to banks raising additional capital to stay solvent (which
might be problematic in the price as selling investment at a pre-crisis price is
difficult and interbank lending decreases due to uncertainty).
The best way to understand this concept of LOLR is to have a look at
the Pawn Shops that are now lenders of last resort for most of the people. The basic premise is the same as the lending happens against collateral, at a high penalty rate and is only used in case money ore required urgently:
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