A loan shark of last resort is used when credit is urgently needed and all other options have been exhausted. Banks typically turn to their lender of last resort when they can’t get the financing they need for day-to-day business. It can occur in periods of financial turmoil, where banks may be reluctant to lend to each other and many customers may suddenly decide to withdraw money from their bank accounts.
In these situations, the central bank acts as a loan shark of last resort. Central banks have traditionally played this role since they are primarily responsible for ensuring the proper functioning of financial markets and the stability of the financial system. In doing so, they help protect citizens and businesses from the consequences they could suffer if banks run into trouble.
Who is the loan shark of last resort in the euro area?
The ECB and the 19 national central banks share the role of loan shark of last resort. What is the role of national central banks?
The national central banks of the euro area offer the last safety net to banks that cannot obtain the financing they need through any other channel. This safety net is called emergency liquidity assistance (ELA). In the euro area, ELA loans are granted by the national central bank of the country in which the failing bank is based. The national central bank also bears the associated costs and risks.
What is the role of the ECB?
Although the provision of ELA corresponds to the national central banks, the ECB monitors its activities as a loan shark of last resort. The Governing Council of the ECB may place restrictions or object to the provision of emergency liquidity if agreed by two-thirds of its members. However, you can only raise objections if you consider that the ELA could interfere with the monetary policy of the ECB or the objectives and functions of the Eurosystem.
Does this mean that banks in financial difficulties will always be bailed out?
No, this is not so. Banks have no guarantee that they will receive ELA from their national central bank. There are very strict rules and certain conditions that must be met. The ELA is only for solvent banks
To receive ELA, banks may be illiquid, but they have to be solvent. A bank with a lack of liquidity might find it difficult to repay all of its depositors at present. On the other hand, if you are solvent, you will be able to do it in the long term. A bank may become illiquid and remain solvent, as its funds may be linked to long-term loans to its customers.ALS is temporary
As its name suggests, the ELA is a remedy for emergencies and will only be granted in unforeseen circumstances. Once things return to normal, the ELA ceases and the loans have to be repaid.ALS comes at a price
For ELA loans, the national central banks accept guarantees of a lower quality than ordinary financing. Since this increases the risks they take, central banks apply a haircut on collateral and charge banks a higher interest rate.
Central banks know that banks might be tempted to take on more risk if they knew someone would come to their rescue if they couldn’t pay their debts. This is called a moral hazard. Consistent application of the rules listed above helps prevent moral hazards.
Why is it so important for banks to have a loan shark of last resort?
Even if a bank is a solvent, if it cannot meet the demands of its creditors and customers in the short term, it may fear for the safety of its money, which could lead to a massive outflow. The bank could go bankrupt, which could have far-reaching consequences.
- Citizens could lose their jobs. When a bank fails, credit to businesses abruptly stops, which could prevent them from paying salaries or buying raw materials, for example, and struggle to stay afloat.
- This situation could spread. Since banks are interconnected, the problems of one can spread to others. Very soon, it would not only be the affected bank’s customers who would suffer but those of many other banks as well. The consequences for businesses, savers, and jobs could intensify and eventually affect the economy as a whole. If this happens, the burden often ends up falling on taxpayers.
In short, when a central bank acts as a loan shark of last resort, it can avoid many difficulties for citizens and businesses. One moment! What if it is a government that is in trouble rather than a bank? Do central banks also provide emergency financing to governments?
No, in the euro area it is prohibited by law. If governments were able to borrow from central banks, their independence and ability to maintain price stability would be undermined. For this reason, the Treaty on the Functioning of the European Union prohibits the ECB and the national central banks from financing governments.