SBI: RBI should act as lender of last resort, provide liquidity to NBFCs: SBI

Economists at the State Bank of India (SBI) have reminded the central bank that they should not forget their primary function of being the lender of last resort. In a nutshell, when a central bank acts as lender of last resort, it can prevent a lot of difficulties for people and businesses. Firstly, write the various functions performed by RBI – Monetary Policy of the Country, Inflation  control, Decides benchmark interest rate, Government’s banker and Regulator of Foreign Exchange etc. The central bank assists such banks through discounting of approved securities and bills of exchange. The economists said the measures taken so far by the government and RBI have been focused on long-term strengthening of NBFC sector.

Adam received his master’s in economics from The New School for Social Research and his Ph.D. from the University of Wisconsin-Madison in sociology. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. Since its inception, many serious candidates have achieved success in various Government jobs and TEMS continues to strive for betterment of material and success of students.

Joseph Stiglitz – Financial crisis as market failure

The classical theory of lender of last resort was developed in the 19th century by Henry Thornton and Walter Bagehot. Both theorists stressed the need to protect the money stock, instead of individual banks, and allow insolvent financial institutions to fail. They also advocated for the charging of penalty rates, good collateral, and accommodation of sound institutions only.

Since this increases their risks, the central banks apply a haircut to the collateral and charge banks a higher interest rate. 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. A bank run occurs when large numbers of customers withdraw their deposits simultaneously for fear that the bank might collapse.

By offering loans to the Cornrnercial Banks in situation of  emergency the Central Bank ensures that the banking system of the country does not suffer any set back and that money market remains stable. Due to the above-stated reasons, the Central Bank is termed as “Lender of Last Resort”. Goodhart[15] proposes that only discount window lending should be considered lending of last resort. The reason is that central banks’ open market operations cannot be separated from regular open market operations.

A Tale of Two Financial Crises: the 1930s and Now

Although it helped prevent the collapse of banks in the past, critics say that by providing additional liquidity, the central bank tempts banks to take on more risks than necessary. 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. The government also enacted new regulations that required banks to hold a certain percentage of reserves.

• In a move to prevent more bank failures, the government declared a national bank holiday to allow for the inspection of banks.
• The committee of the New York Clearing House Association also provided clearing-house loan certificates to banks as a way of managing the effects of the financial panic of 1857.
• As per the Banking Regulations Act 1949, Banks have to keep a portion of their demand and time liabilities as cash reserves with the Reserve Bank, thus necessitating a need for maintaining accounts with the Bank.
• In the United States, the Federal Reserve acts as the lender of last resort to institutions that do not have any other means of borrowing, and whose failure to obtain credit would dramatically affect the economy.

The NBFC sector has been in turmoil since 2018 after the collapse of infrastructure lender IL&FS. Asked several times, the RBI has refused to play its role as the lender of last resort, terming the problem at select NBFCs as one created because of asset-liability mismatches. In its report on Budget expectations, the economists said RBI should “seriously think” of providing liquidity to non-banking financial companies (NBFCs) against the assets held by the lenders. As the NBFC continues to be in distress, economists at SBI on Friday called for the Reserve Bank of India (RBI) to play its role as the lender of last resort — something that the central bank has avoided since the start of troubles in 2018.

ELA comes at a price

The opponents claim that a strict penalty rate can make the central bank the very last lender of last resort. Banks would also be forced to institute internal measures to prevent a bank run for fear of paying harsh penalties for a loan that they could have maintained internally. The banks can borrow from the RBI by keeping eligible securities as collateral or any other arrangement and at what role of rbi is known as lender of last resort the time of need or crisis, they approach RBI for financial help. There is no universal agreement on whether a nation’s central bank or any agent of private banking interests should be its lender of last resort. Nor is there on the pros and cons of actions such a lender takes and their consequences. As a Banker to Banks, the Reserve Bank also acts as the ‘lender of the last resort’.

This can prevent a downward spiral of bank failures and economic instability, which can have serious consequences for the broader economy. It is, in effect, a government guarantee to provide liquidity to financial institutions. Since the beginning of the 20th century, most central banks have been providers of lender of last resort facilities, and their functions usually also include ensuring liquidity in the financial market in general.

Role/ Functions of RBI: Lender of last resort

Cases of bank runs became prevalent during the Great Depression of the 1930s after the stock market crash. There were a series of banks runs and subsequent collapses, amidst rumors of an impending financial crisis. In a move to prevent more bank failures, the government declared a national bank holiday to allow for the inspection of banks. The last-resort lending function came into being in the late 1800s due to a series of panics that engulfed the banking industry. The panic led to the collapse of financial institutions, and this led to the loss of customers’ funds deposited in the institutions. A model developed by Flannery[19] suggests that the private market for interbank loans can fail if banks face uncertainty about the risk involved in lending to other banks.

An interbank market is created by banks because it insures them against a lack of liquidity at certain banks as long as the overall amount of liquidity is sufficient. Liquidity is allocated by the interbank market so that banks that have excess liquidity can provide this to banks that lack liquidity. As long as the total demand for liquidity does not exceed the supply, the interbank market will allocate liquidity efficiently and banks will be better off.

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His starting point was that only a central bank could perform the task of lender of last resort because it holds a monopoly in issuing bank notes. A lender of last resort (LoR) is an institution, usually a country’s central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse. In the United States, the Federal Reserve acts as the lender of last resort to institutions that do not have any other means of borrowing, and whose failure to obtain credit would dramatically affect the economy.

It can come to the rescue of a bank that is solvent but faces temporary liquidity problems by supplying it with much needed liquidity when no one else is willing to extend credit to that bank. He distinguished the Bank of England’s role as a lender of last resort since it exercised the role more strictly than any other central bank before it. When an illiquid bank approaches the lender of last resort, there should always be a suspicion of insolvency. Reserve Bank maintains current account of all other banks and provides them facility to maintain cash reserves and also to carry out inter-bank transactions. RBI provides the Real Time Gross Settlement System (RTGS) facility to the banks for inter-bank transactions.

When commercial banks have exhausted all resources to supplement their funds at times of liquidity crisis, they approach Central Bank as a last resort. This saves banks from possible failure and banking system from a possible breakdown. On the other hand Central Bank, by providing temporary financial accommodation, saves the financial structure of the country from collapse. National central banks accept collateral of a lower quality for ELA loans than for non-emergency funding.

The interregional cross-holdings of deposits cannot increase the total amount of liquidity. Critics of the practice of having a last-resort lender allege that it encourages banks to take unnecessary risks with customers’ money, knowing they can be bailed out in a pinch. 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. The lender of last resort functions to protect individuals who have deposited funds—and to prevent customers from withdrawing out of panic from banks with temporary limited liquidity. Commercial banks usually try not to borrow from the lender of last resort because such action indicates that the bank is experiencing a financial crisis.