Briefly analyse the Lender of Last Resort facility.

Essay by tmagnusUniversity, Bachelor'sC+, April 2004

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The idea of LOLR was introduced by Walter Bagehot in 1873 . He developed a system where the central bank would provide a temporary liquidity injection into a single bank or the banking system at a time of crisis. Bagehot's idea was that a short-term temporary loan should be given to illiquid banks and ones which are insolvent should be allowed to fail. The effect being that this would help to reduce systemic risk and the collapse of the banking system . There are four main criticisms of this protection scheme as firstly LOLR could in some aspects be seen as illegal under EC law . Though if LOLR is supplied under strict conditions then it is highly unlikely that it could be considered illegal under the treaty . The second concern is that it will increase the chances of moral hazard. Thirdly, larger banks will stand a better chance of receiving financial aid due to the doctrine of being "too big to fail".

As Lastra points out a larger bank in crisis would undoubtedly create a larger risk to the financial system. Size should only be relevant if it is intertwined with significant inter-bank transactions which will affect other institutions. The fourth factor is that it can lead to distortion of competition between banks in the same market place.

LOLR assistance should only be given to banks that are illiquid and not those that are insolvent . The decision often has to be made quickly and the information necessary to decide whether a bank is illiquid or insolvent may be unavailable. The Memorandum of Understanding has as yet not been tested and so it is uncertain how effective it will be. The decision may well have to rest on prior performance and as information goes out of date quickly...