Lender of last resort

Definition

A lender of last resort refers to a financial institution, usually a central bank, that provides emergency loans to banks or other financial institutions facing liquidity crises. This function is crucial in maintaining stability in the financial system by preventing bank runs and ensuring that solvent institutions can access necessary funds during times of distress.

5 Must Know Facts For Your Next Test

1. The concept of a lender of last resort is rooted in the need to provide stability to the banking system during times of financial panic or crisis.
2. Central banks like the Federal Reserve act as lenders of last resort by offering short-term loans to financial institutions that are temporarily illiquid but fundamentally solvent.
3. Providing emergency funding can prevent systemic failures in the banking sector, thereby preserving public confidence in the financial system.
4. The lender of last resort function can sometimes create moral hazard, where institutions may engage in riskier behavior knowing they have access to emergency funds if needed.
5. This role has evolved over time, especially during significant financial crises, prompting central banks to adapt their policies and frameworks to ensure effective intervention.

Review Questions

• How does the lender of last resort function help maintain stability in the financial system?
  • The lender of last resort function is essential for maintaining stability in the financial system by providing emergency liquidity to banks facing temporary solvency issues. By stepping in during times of crisis, central banks can prevent bank runs and restore confidence among depositors. This support helps ensure that solvent institutions can continue operating and avoids broader systemic failures that could lead to significant economic downturns.
• Discuss the implications of moral hazard associated with the lender of last resort function.
  • Moral hazard arises when financial institutions engage in riskier behaviors because they believe they will receive support from a lender of last resort during difficult times. This expectation can lead banks to take on excessive risks, potentially jeopardizing the stability of the financial system. As a result, central banks must carefully consider how they implement their lending policies, balancing the need for stability with the risks associated with encouraging irresponsible behavior among financial institutions.
• Evaluate how the role of lenders of last resort has changed in response to recent financial crises.
  • In recent years, the role of lenders of last resort has evolved significantly, particularly in response to major financial crises like the 2008 global financial meltdown. Central banks have adopted more proactive measures, such as providing broader access to emergency funding and implementing unconventional monetary policies like quantitative easing. These changes reflect a recognition that traditional approaches may not suffice during severe economic disruptions, emphasizing the need for flexibility and adaptability in maintaining financial stability.

Related terms

Liquidity: The availability of liquid assets to a market or company, which allows institutions to meet short-term obligations without incurring significant losses.

Bank Run: A situation where a large number of depositors withdraw their funds from a bank simultaneously due to fears that the bank will become insolvent.

Monetary Policy: The actions undertaken by a central bank to control the money supply and interest rates to achieve macroeconomic objectives like controlling inflation, consumption, growth, and liquidity.