Question

5. What is the lender-of-last-resort function of the central bank in modern economies?

What is its justification? Should commercial bank borrowing from the central bank be a privilege or a right? Discuss.

Answer 1

A last resort borrower is an entity, typically the central bank of a state, providing loans to banks or other qualifying entities that have financial difficulties or are considered highly risky or near collapse. The Federal Reserve in the United States acts as the lender of last resort to institutions that have no other means of borrowing and whose failure to obtain credit would have a dramatic impact on the economy.

Last resort lender functions to protect individuals who have deposited funds and to prevent clients from withdrawing from banks with temporary limited liquidity out of panic. Commercial banks usually try not to borrow from the last resort lender because such action indicates a financial crisis for the bank. Lender-of-last-resort methodology critics suspect that the security it provides inadvertently tempts qualifying institutions to acquire more risk than necessary as they are more likely to perceive the potential consequences of risky actions as less severe.

Commercial banks borrow primarily from the Federal Reserve to meet reserve requirements when their cash on hand is low before the business day's closing. A bank borrows money from the central bank of the government using what is known as the discount window to put itself back over the minimum reserve threshold. It is easy to borrow at the discount window because it is always available and there is no negotiation or detailed paperwork in the borrowing process. Though, the downside is the discount rate, or the interest rate that the Federal Reserve loans to banks, is lower than if they borrow from another lender.

Robust borrowing activity often depletes the cash reserves of a commercial bank to where they fall below the minimum reserve requirement of the state. The bank has two options at this point in order to avoid running out of the law. It can borrow from another bank, or the Federal Reserve can borrow. Borrowing from another bank is the cheaper option, but many commercial banks choose to borrow from the discount window because of its convenience, particularly if they only take out an overnight loan to meet reserve requirements.