Lender of last resort

Definition

A lender of last resort is a financial institution, usually a country's central bank, that provides emergency funds to banks or other financial institutions that are in distress and unable to obtain necessary funding from other sources. This role is critical during times of financial crisis, as it helps stabilize the banking system and prevents the collapse of financial institutions that could have broader negative effects on the economy and global markets.

5 Must Know Facts For Your Next Test

1. The concept of a lender of last resort was formalized by British economist Walter Bagehot in the 19th century, emphasizing the need for central banks to lend freely during crises.
2. By providing liquidity to troubled banks, a lender of last resort helps maintain public confidence in the financial system and prevents panic from spreading throughout the economy.
3. During the 2008 financial crisis, many central banks around the world acted as lenders of last resort, implementing various measures to stabilize their economies.
4. The ability of a lender of last resort to act quickly is crucial, as delays can exacerbate financial instability and lead to more severe economic consequences.
5. Central banks must balance their role as lenders of last resort with the risk of moral hazard, where banks may take excessive risks knowing they can rely on emergency funding.

Review Questions

• How does the role of a lender of last resort contribute to financial stability during a liquidity crisis?
  • The lender of last resort plays a crucial role in providing emergency funding during a liquidity crisis, which helps prevent banks from collapsing when they face temporary cash shortages. By supplying liquidity to distressed banks, central banks maintain confidence in the financial system, reducing the likelihood of panic among depositors and preventing widespread bank runs. This stabilizing effect is essential for preserving not just individual institutions but also the broader economy.
• Discuss the potential risks associated with a central bank acting as a lender of last resort and how they can manage these risks.
  • When central banks act as lenders of last resort, they face risks such as moral hazard, where financial institutions may engage in reckless behavior knowing they can rely on emergency support. To manage these risks, central banks can implement strict criteria for providing loans and enhance monitoring of institutions receiving assistance. By ensuring that support is targeted at solvent but illiquid banks and promoting transparency in lending practices, central banks can mitigate potential negative consequences while fulfilling their stabilizing role.
• Evaluate the impact of historical instances where lenders of last resort intervened during financial crises and what lessons can be learned for future policy.
  • Historical instances such as the Federal Reserve's actions during the Great Depression and the 2008 financial crisis show that timely intervention by lenders of last resort can prevent systemic collapse. These events highlight the importance of quick access to liquidity for struggling banks while also emphasizing the need for clear policies to avoid moral hazard. Lessons learned suggest that central banks must be prepared with flexible tools and frameworks to respond effectively to evolving financial crises while ensuring that financial institutions remain accountable for their risk management practices.

Related terms

Central Bank: A national bank that provides financial and banking services for its country's government and commercial banking system, often overseeing monetary policy.

Liquidity Crisis: A situation in which an entity cannot meet its short-term financial obligations due to the lack of liquid assets.

Bank Run: A phenomenon where a large number of customers withdraw their deposits simultaneously due to fears that the bank will become insolvent.