What is a lender of last resort?
26 August 2019
A lender of last resort is whoever you turn to when you urgently need funds and you’ve exhausted all your other options. Banks typically turn to their lender of last resort when they cannot get the funding they need for their daily business. This can happen in periods of financial turmoil, when banks may have doubts about lending to each other and lots of people may suddenly want to withdraw their money from their bank account.
In situations like that, central banks act as the lender of last resort. Central banks have traditionally held this role because they are primarily the ones responsible for ensuring that financial markets function smoothly and the financial system is stable. In this way they help protect people and businesses from the difficulties that can arise when banks are in trouble.
Who is the lender of last resort in the euro area?
The ECB and the 19 national central banks share the role of lender of last resort.
What is the national central banks’ role?
The national central banks in the euro area offer the last safety net for banks that cannot get the funding they need elsewhere. This safety net is called emergency liquidity assistance, or ELA. In the euro area, ELA loans are provided by the national central bank of the country in which the struggling bank is based. That national central bank also bears any costs and risks that may arise.
What is the ECB’s role?
While national central banks are responsible for providing ELA, their lender-of-last-resort activities are checked and monitored by the ECB. The ECB’s Governing Council may restrict or object to emergency assistance if two-thirds of its members agree to do so. They may only object, however, if they believe ELA would interfere with the ECB’s monetary policy or with the Eurosystem’s objectives and tasks.
So does this mean that banks in financial difficulties will always be rescued, no matter what?
No, this isn’t how it works. There is no guarantee a bank will receive ELA from its national central bank. In fact, there are strict rules in place and certain conditions that have to be met.
ELA is only for banks that are solvent
To qualify for ELA banks can be illiquid but they need to be solvent. Being illiquid means that banks might struggle to repay all their depositors at the current time. Being solvent means that they are able to do so in the long term. A bank can become illiquid while remaining solvent because its funds might be tied up in longer-term loans it has given to its customers.
ELA is only temporary
As the name suggests, ELA is for emergencies and will only be granted in unforeseen circumstances. Once things return to normal, ELA stops and the loans need to be repaid.
ELA comes at a price
National central banks accept collateral of a lower quality for ELA loans than for non-emergency funding. Since this increases their risks, the central banks apply a haircut to the collateral and charge banks a higher interest rate.
Central banks are aware that banks might be tempted to take more or bigger risks if they know for certain that someone will come to their rescue if they cannot repay their debt. This is known as moral hazard. Applied consistently, the rules outlined above help prevent moral hazard from arising.
Why is it so important that banks have a lender of last resort?
Even if a bank is solvent, if it is unable to meet the demands of its customers and creditors in the short term, customers may fear for the safety of their money and this could lead to a bank run. The bank could then go bankrupt. The consequences of this can be far-reaching.
- People could lose their jobs. When a bank goes bankrupt, lending to businesses stops abruptly. This means that businesses might not be able to pay wages or buy raw materials, for example, and could struggle to keep their companies afloat.
- The fallout could spread. Since banks are interconnected, problems at one bank can spread to others. Very soon it wouldn’t only be the customers of the affected bank who suffer, but the customers of many banks. The consequences for businesses, jobs and savers could intensify and eventually have an impact on the whole economy. If it comes to that, very often it’s the taxpayers who end up covering the shortfall.
In a nutshell, when a central bank acts as lender of last resort, it can prevent a lot of difficulties for people and businesses.
Wait! What if it’s a government in financial difficulties rather than a bank? Do central banks provide emergency funding to them, too?
No, they don’t and in the euro area it is illegal. If governments could request funding from central banks, it would compromise the central bank’s ability to keep prices stable and undermine its independence. That’s why the Treaty on the Functioning of the European Union prohibits the ECB and national central banks from financing governments.