What is a Lender of Last Resort?

A lender of last resort, usually a national bank, is what banks and other financial institutions use as a place to obtain credit when nearly all other options have been exhausted. In the United States, the Federal Reserve Bank acts as a lender of last resort.

In most cases, banks and other businesses would rather issue bonds than use a bank. If they must go to a bank, they generally refer to the bank as a lender of last resort. This shows just how undesirable of an option banks are to a company borrowing money. Going to a lender of last resort often comes at a higher risk to both borrower and lender.

Bonds are preferred over a lender of last resort for a number of reasons. First, banks often place strict rules on major business loans that make it cumbersome, if not nearly impossible, for a major corporation or bank to use another bank as a lending institution. Some of these restrictions include not allowing the company to take on any more debt until the bank debt is completely paid off. The bank could also dictate that there be no acquisitions of other companies and even require a CEO to remain or the stock price maintain a certain level.

If all of these conditions are not met on a continual basis, there is a chance the interest rates could go up, causing even more hardship for the borrower. Interest rates could go up to the point where repaying the loan is not possible. Or, if it is possible, it could come at so high of a price it no longer makes any economic sense to have the loan.

These are all reasons why bonds are preferred. However, for companies in really bad financial condition, the bond market may be off limits. A company's credit may be so bad that any bonds they issue would fall into junk bond status. These bonds carry a very high interest rate and are not attractive to many people looking to buy bonds because of the risk. This is even more true if the company goes into default status with other debt obligations. Any company in this situation would have a D bond rating.

In such situations, companies may have no choice but to go to a lender of last resort. Though the interest rate may be more than a good bonding rating would bring them, these companies often do not have that to begin with. Therefore, a lender of last resort becomes just that.