Q. In India, the central bank’s function as the “lender of last resort” usually refers to which of the following?

1. Lending to trade and industry bodies when they fail to borrow from other sources
2. Providing liquidity to the banks having a temporary crisis
3. Lending to governments to finance budgetary deficits

Select the correct answer using the code given below

  • 1 and 2
  • 2 only
  • 2 and 3
  • 3 only

Answer: b) 2 only

Notes:
  • A lender of last resort 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.  
  • 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.
    • Some argue that having a lender of last resort encourages moral hazard: that banks can take excessive risks knowing that they will be bailed out.
  • In India, RBI is the lender of last resort. As a Banker to Banks, the Reserve Bank also acts as the ‘lender of the last resort’.
    • Lender of last resort does not lend money to trade and industry bodies when they fail to borrow from other sources.
    • RBI does lend to governments to finance budget deficits but it does not come under Lender of last resort.
Bank Runs
  • A bank run is a situation that occurs during periods of the financial crisis when bank customers, worried about an institution’s solvency, descend on the bank en masse, and withdraw funds. Because banks only keep a small percentage of total deposits as cash, a bank run can quickly drain a bank’s liquidity and, in a perfect example of a self-fulfilling prophecy, cause the bank to become insolvent.
Reserve Bank as Banker to Banks
  • The current accounts of individual banks are being opened in e-Kuber (CBS of RBI) by Banking Departments of the Regional Offices. These current accounts are also maintained for participation in centralized and decentralized Payment Systems and are used for settling inter-bank obligations, such as clearing transactions or clearing money market transactions between two banks, buying and selling securities and foreign currencies. Thus, Reserve Bank acts as a common banker, known as ‘Banker to banks’ function, the operational instructions for which are issued by the concerned Central Office departments of the Reserve Bank.
  • Among other provisions, the Reserve Bank stipulates minimum balances to be maintained by banks in these accounts. It is the responsibility of each bank maintaining current account with the Reserve Bank to ensure that sufficient balance is available in the account to avoid defaults in payments and settlements.
  • As Banker to banks, the Reserve Bank provides short-term loans and advances to select banks, when necessary, to facilitate lending to specific sectors and for specific purposes.