Lender of last resort and Lenders Option Borrowers Option: Difference between pages

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A concession given to a select number of financial institutions whereby their central bank agrees to provide them with funds if they should get into [[liquidity]] difficulties.
(LOBO).


The primary purpose of the activity by the central bank is stability of the financial system as a whole.
A long term borrowing instrument with periodic interest re-fixings, which incorporates two linked options:


Secondarily, the purpose is stability of the particular institution affected.
#An option for the lender to set revised (usually higher) interest rates at predetermined interest reset dates - for example annually. This is the Lender's option.
#A linked option for the borrower (exercisable only if the Lender’s option is exercised) either to pay the revised interest rate, or else to redeem the bond. This is the Borrower’s option.




Central banks generally avoid risk taking behaviour.  
LOBOs have been issued for maturities of up to 50 years.


Accordingly, in principle, the central banks only lend against good security ([[collateral]]) and with a conservative [[haircut]].  
Each of the two embedded options can be complex to value with precision, potentially making the composite borrowing instrument difficult for some less sophisticated borrowers to evaluate.


In practice, liquidity shortage may force a bank to seek to dispose of assets, even at significant losses that erode its capital.


Eventually the central bank may lend against less-good collateral and with less than its desired haircut on collateral valuation - until it won't, when the game is over and the story becomes one of [[resolution]].
Also written 'Lender's Option Borrower's Option'.
 
 
Lender of last resort activity is also often referred to as emergency liquidity assistance.
 
The European Central Bank's scheme is called Emergency Liquidity Assistance (ELA), for example.




== See also ==
== See also ==
* [[Central bank]]
* [[Option]]
* [[Emergency liquidity assistance]]
* [[Financial stability]]

Revision as of 08:11, 8 April 2015

(LOBO).

A long term borrowing instrument with periodic interest re-fixings, which incorporates two linked options:

  1. An option for the lender to set revised (usually higher) interest rates at predetermined interest reset dates - for example annually. This is the Lender's option.
  2. A linked option for the borrower (exercisable only if the Lender’s option is exercised) either to pay the revised interest rate, or else to redeem the bond. This is the Borrower’s option.


LOBOs have been issued for maturities of up to 50 years.

Each of the two embedded options can be complex to value with precision, potentially making the composite borrowing instrument difficult for some less sophisticated borrowers to evaluate.


Also written 'Lender's Option Borrower's Option'.


See also

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