The Lender-of-Last-Resort Function Inherent in Central Banking Encourages Capital Inadequacy in the Banking System

The lender-of-last-resort function inherent in central banking also encourages capital inadequacy in the banking system. The central bank agrees to lend reserves to illiquid banks even if they also are insolvent. The lender of last resort is not concerned with the cause of the illiquidity, even if it arises due to depositors anticipating a bank’s insolvency. The illiquidity, not the insolvency, is seen as the problem requiring a solution. When illiquidity arising from the threat of bank insolvency is remedied by such nonmarket “lending” as the central bank provides, and when such lending is promised unconditionally as a matter of policy, capital adequacy is further undermined, or at least not rectified. 

The expectation that central bank lending is unconditional and unlimited derives from the fact that it is not actually lending at all. Last resort lending by a central bank does not have its source in some existing supply of capital or reserves. In the marketplace, “lending” consists of the transfer of existing purchasing power from one party to another, in which one foregoes its use over time in return for interest. But a central bank committed to rectifying banking system liquidity does not lend or transfer existing reserves. It “creates” reserves, not out of real resources or capital but solely by virtue of its monopoly power over fiat base money creation. This monopoly power sanctions risky banking and promotes banking system leverage through enhanced inflating capacity. Advocates of central banking believe that such a reserve base is beneficial because it is nearly costless. But the creation of fiat reserves costs the banking system its long-term strength.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 29-30.