UPSC Prelims 2021 Q15: Indian Economy – Monetary Policy & Money Supply
- (a) 1 and 2
- (b) 2 only
- (c) 2 and 3
- (d) 3 only
Answer: (b) 2 only
Explanation
RBI as Lender of Last Resort (LOLR)
| Statement | Claim | Verdict | Detail |
|---|---|---|---|
| 1 | Lending to trade and industry when they fail to borrow | FALSE | RBI does NOT lend to trade/industry directly. Its clients are banks and government, not private firms. |
| 2 | Providing liquidity to banks having a temporary crisis | TRUE | This IS the classic LOLR function. When a solvent but illiquid bank faces a run or short-term crunch, RBI provides emergency liquidity to prevent contagion. |
| 3 | Lending to governments for budget deficits | FALSE | RBI cannot directly finance government deficits (post-FRBM 2003). Government borrowing is a normal RBI function, not LOLR. LOLR is specifically for BANKING crises. |
Only statement 2 is correct - LOLR = emergency liquidity to banks in temporary distress.
Answer: (b) 2 only.
Why each option is right or wrong
- (a) Incorrect. RBI does NOT lend directly to trade/industry. LOLR is a banking-sector function.
- (b) CORRECT. LOLR means providing liquidity to banks facing a TEMPORARY crisis (not solvency crisis). This prevents bank runs, contagion and systemic collapse.
- (c) Incorrect. LOLR is not about government deficit financing. It is specifically a banking-sector rescue function.
- (d) Incorrect. Government deficit lending is a normal WMA (Ways and Means Advances) function, not LOLR.
Key point
LOLR = RBI providing emergency liquidity to banks facing TEMPORARY (illiquidity, not insolvency) crisis. Prevents bank runs and contagion. Not for trade/industry (not RBI's clients) or government deficits (WMA is separate). Bagehot's rule: lend freely, at penalty rate, on good collateral.
Remember
The RBI's function as 'lender of last resort' refers to providing liquidity to banks having a temporary crisis (statement 2 only). It does NOT include lending to trade/industry (statement 1) or to governments for deficit financing (statement 3, which is WMA). Answer: 2 only.
Common mistakes
- Confusing LOLR with normal RBI facilities (LAF, MSF, WMA). LOLR is EMERGENCY liquidity, activated in crisis - not routine.
- Thinking LOLR helps insolvent banks. It only helps illiquid-but-solvent banks. Insolvent banks are resolved (merger, closure, IBC).
- Confusing WMA (Ways and Means Advances to government - short-term, 90 days) with LOLR (banking crisis function).
Exam tip
LOLR = Emergency banking liquidity. Bagehot's Rule (1873): lend freely, at penalty rate, on good collateral. India examples: YES Bank rescue (2020), PMC Bank moratorium (2019). LOLR is one of RBI's four traditional roles: banker to banks, LOLR, monetary policy, currency issuance.
Sources
- RBI Act, 1934 - Section 17 (Business of the Bank)
- RBI - Report on Trend and Progress of Banking in India