Lender of last resort

Definition

A lender of last resort is a financial institution, typically a central bank, that provides emergency funding to banks or other financial institutions that are experiencing financial difficulties. This role is crucial during times of economic stress, as it helps maintain stability in the financial system by preventing the collapse of institutions that are otherwise solvent but temporarily illiquid. By acting as a safety net, the lender of last resort aims to reassure depositors and investors, promoting confidence in the banking system.

5 Must Know Facts For Your Next Test

1. The concept of a lender of last resort was popularized by economist Walter Bagehot in the 19th century, who argued that central banks should lend freely during times of crisis to solvent institutions.
2. The Federal Reserve serves as the lender of last resort in the United States, providing emergency liquidity to banks during financial turmoil, such as during the 2008 financial crisis.
3. Lending by the lender of last resort usually comes with conditions to ensure that only institutions that are fundamentally sound can receive assistance.
4. By providing liquidity during crises, the lender of last resort plays a key role in preventing bank runs, where large numbers of customers withdraw their deposits simultaneously out of fear of insolvency.
5. The role of a lender of last resort is critical for maintaining public confidence in the banking system, as it helps prevent systemic collapses that could lead to broader economic downturns.

Review Questions

• How does the role of a lender of last resort help prevent systemic risk in the banking system?
  • The lender of last resort plays a vital role in preventing systemic risk by providing emergency liquidity to banks facing short-term financial distress. When solvent banks experience sudden withdrawals or liquidity issues, they may struggle to meet their obligations. By lending to these institutions during crises, the lender of last resort helps maintain stability and prevents panic from spreading throughout the banking system, thereby protecting the broader economy.
• Discuss the potential drawbacks or criticisms associated with the concept of a lender of last resort.
  • One major criticism of having a lender of last resort is that it may create moral hazard, where banks take on excessive risk knowing they can rely on emergency funding if needed. This could lead to reckless behavior in lending practices and inadequate risk management. Additionally, some argue that continuous reliance on a lender of last resort might discourage banks from maintaining healthy liquidity buffers since they assume they will always be rescued during tough times.
• Evaluate how the lender of last resort function has evolved in response to modern financial crises and what this means for future monetary policy.
  • The function of the lender of last resort has evolved significantly, especially following major financial crises like the 2008 collapse. Central banks have expanded their roles beyond traditional emergency lending to include new tools such as quantitative easing and direct market interventions. This evolution suggests that future monetary policy may increasingly rely on proactive measures to manage liquidity and stabilize markets, raising questions about how far central banks should go in their intervention efforts and the potential long-term effects on market behavior.

Related terms

Central Bank: A central bank is a national institution that manages a country's currency, money supply, and interest rates, and oversees the banking system.

Liquidity Crisis: A liquidity crisis occurs when financial institutions or markets are unable to access sufficient cash or liquid assets to meet short-term obligations.

Discount Window: The discount window is a facility through which banks can borrow money from the central bank, typically at a higher interest rate than they would pay for regular loans.