Lender of Last Resort: Function and Examples
The rate of interest charged by the banks on loans is
higher than the rate of interest paid by the banks on demand deposits
and saving deposits. Loans granted by commercial banks are generally
for long term and are given against securities. Current
deposit accounts are also called ‘demand deposits’ as the
depositor can withdraw money at any time through cheques. Businessmen
use this account to make many transactions in a single day; however,
they do not earn interest on the deposits. Banks provide account
statements to the current account holders at regular intervals.
Such claims were validated when large financial institutions, such as Bear Stearns and American International Group, Inc., were bailed out in the midst of the 2008 financial crisis. Proponents state that the potential consequences of not having a lender of last resort are far more dangerous than excessive risk-taking by banks. Furthermore, what role of rbi is known as lender of last resort with an increase in the generation of new notes, the RBI also increases its reserve proportionately to maintain the inflow of cash. It also monitors the distribution of this cash among the different financial institutions in India. Hence, one of the main functions of the RBI is to instil trust in the financial system among Indian citizens.
Powers of Reserve Bank of India
banks create credit in the economy
through demand deposits. Commercial
Banks provide financial assistance to the business community by
discounting bills of exchange. The banks purchase these bills,
produced by customers, by deducting interest from
the face value of the bill, thus providing easy finances to the
business community when required.
For example, suppose the total assets of a bank are worth Rs.200 crores and the minimum cash reserve ratio is 10%. Then the amount that the commercial bank has to maintain with RBI is Rs.20 crores. If this ratio rises to 20%, then the reserve with RBI increases to Rs.40 crores.
Federal Reserve System
For India, this means that currency is either printed or destroyed depending on the ongoing situation. This provides the Indian public with a supply of currency in the form of dependable notes and coins, a prominent issue in India. Central banks have performed the function of lender of last resort several times over the past century. When an illiquid bank approaches the lender of last resort, there should always be a suspicion of insolvency. It is advised to the candidates, that for each topic and question, they ought to be laying out an effective preparation strategy. You can first download the notes, and refer to the recommended books for kickstarting your preparation for the exam.
The US government introduced new legislation requiring banks to hold a minimum percentage of their liabilities in the form of cash reserves. When a bank is in trouble and needs money, and nobody will lend to it, the central bank may intervene and lend, frequently with conditions and strings attached. Sometimes, the central bank will close down the troubled bank, find it a new owner, or take control of it. A lender of last resort is there to prevent a country’s financial system from collapsing.
RBI as the lender of first resort
So, SLR is defined as the minimum percentage of assets to be maintained in the form of either fixed or liquid assets with RBI. The flow of credit is reduced by increasing this liquidity ratio and vice-versa. In the previous example, this can be understood as rise in SLR will restrict the banks to pump money in the economy, thereby contributing towards decrease in money supply. The reverse case happens if there is a fall in SLR, as it increases the money supply in the economy. Thus in case of a monetary crisis, they can approach the central bank for funds. In addition, it provides this facility so that depositors of such banks can access their money and not face the negative impacts of financial crises.
Thus, less money will be left with the commercial bank for lending. This will eventually lead to considerable decrease in the money supply. On the contrary, a fall in CRR will lead to an increase in the money supply. The lender of last resort (LOLR) function is one of the key roles played by central banks in the financial system. In other words, the central bank serves as a “safety net” for the financial system, providing emergency funding when needed to prevent a liquidity crisis or a bank run.
What is lender of last resort risk?
A lender-of-last-resort facility provides a form of insurance for both banks and their depositors. By reducing the costs of risk-taking, a lender of last resort can reduce the incentive for banks to manage their own liquidity and for depositors to monitor banks' activities.