UPSC Prelims 2021 Q15: RBI as Lender of Last Resort — Explained
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
Statement-wise explanation
- 1: incorrect — The lender of last resort role is about banks, not trade and industry bodies. The RBI's own description uses Bagehot's dictum: in a panic, the central bank lends freely to banks against good collateral and at a penal rate, so that a bank facing a run can get through a temporary cash shortage. Firms that cannot raise money elsewhere borrow from banks and markets. The RBI does not stand behind them as lender of last resort.
- 2: correct — This is the textbook meaning. A bank that is solvent but short of cash, for example during a deposit run, can borrow from the central bank against eligible securities so the crisis does not spread. The RBI identifies Section 18 of the RBI Act, 1934 as the provision that lets it act as lender of last resort. The Marginal Standing Facility is its routine 'safety valve' window for sudden liquidity shocks.
- 3: incorrect — Lending to the government is part of the RBI's role as banker to the government, not lender of last resort. Even that lending covers only temporary gaps between receipts and payments, through Ways and Means Advances. Automatic deficit financing through ad hoc Treasury Bills ended on 1 April 1997. Under the FRBM Act, 2003, the RBI has not subscribed to primary issues of Central Government securities since 1 April 2006, except on narrow exceptional grounds.
How to eliminate
Start from the phrase itself. 'Last resort' means the lender you turn to when no one else will lend, and a central bank's direct borrowers are banks. Statement 2 is the textbook definition, so it must be in the answer. That rules out the option with statement 3 alone. Statement 1 looks tempting because it repeats the 'fail to borrow from other sources' idea. But the RBI does not lend directly to trade and industry, so drop it. Statement 3 describes a different function, banker to the government, and India stopped automatic deficit financing in 1997. If you can separate the RBI's functions (banker to government, banker to banks, lender of last resort), the question needs no memorised figure. The fact to remember: lender of last resort = temporary liquidity support to banks.
Know more
Lender of last resort (LOLR) is the central bank's promise to supply cash to banks in a panic. Walter Bagehot set out the classic rule in Lombard Street (1873): lend freely, against good collateral, at a penal rate. Each condition has a purpose. Free lending stops a run from spreading. Collateral protects the central bank. The penal rate keeps banks from using the window as cheap everyday funding.
The key distinction is liquidity vs solvency. LOLR helps a bank that has enough assets but cannot turn them into cash fast enough. A bank whose losses have wiped out its capital needs resolution or recapitalisation, not LOLR loans.
In India
- Section 17 of the RBI Act lists the RBI's normal lending business, and Section 18 lets it act as lender of last resort in special situations.
- The Marginal Standing Facility (MSF) is the routine version. Banks borrow overnight against government securities at a rate above the repo rate. It is the upper ceiling of the policy rate corridor.
Do not mix up the RBI's roles
| Role | Who borrows | Purpose |
|---|---|---|
| Lender of last resort | Banks in temporary distress | Stop runs and contagion |
| Banker to banks | All banks | Keep their reserves, settle payments, routine liquidity (repo, MSF) |
| Banker to government | Centre and states | Ways and Means Advances for temporary cash mismatches (Section 17(5)) |
| Debt manager | Government | Runs government borrowing through auctions; since April 2006 the RBI cannot subscribe to primary issues (FRBM Act) |
A related check is moral hazard. If banks expect a rescue every time, they may take more risk. This is why the support is meant to be temporary, backed by collateral and charged at a penalty.
In the news
The question is mainly static. In 2020–21 the RBI ran a string of emergency liquidity operations, such as the ₹50,000 crore Special Liquidity Facility for mutual funds announced on 27 April 2020 during COVID-19 market stress. These kept the central bank's crisis-lending role in the news.
NCERT Concepts to Revise
- Lender of last resort: The question tests exactly what this term covers: who the central bank lends to and in what situation.
- Marginal Standing Facility: The MSF is the RBI's standing emergency window for banks and shows how crisis lending works in practice.
- Central bank: Knowing the full list of central bank functions helps you sort each statement into the correct role.