Question

Do you think banks need the Fed to act as "lender of last resort" more often during good economic times or bad economic times? Explain your answer

Short answer

Banks typically need the Fed to act as 'lender of last resort' more often in bad economic times. This is because during these periods, defaults on loans tend to increase and banks may face liquidity challenges. The lending from the Fed can prevent a potential collapse of the banking system.

Step-by-step solution

Understand the 'lender of last resort'

A central bank like the Fed acts as the 'lender of last resort' to prevent a potential collapse of the banking system during a crisis. It lends money to banks when no one else will.

Assess the economic conditions

During good economic times, banks are less likely to experience defaults on loans they've given out. The economy is generally stable and people as well as companies are able to repay their debts. Hence, they are less likely to need the Fed to act as a lender of last resort.

Evaluate the need for a 'lender of last resort' during bad times

On the contrary, during bad economic times, rates of loan defaults are usually high, banks may experience liquidity issues and might be unable to meet their short-term liabilities. Hence, they may need the help of the Fed as a lender of last resort.

Key concepts

Federal Reserve

The Federal Reserve, often referred to as "the Fed," is the central banking system of the United States. Its primary goal is to ensure a stable financial system and manage the nation's monetary policy. One of the key roles of the Fed is to act as the "lender of last resort". This means providing financial assistance to banks during times of stress or when traditional funding sources are unavailable. The Fed’s role becomes crucial during financial crises when banks face liquidity shortages. These shortages could otherwise lead to bank failures, adversely affecting the entire economy. The Fed ensures that banks have enough funds to meet their short-term obligations and continue operating smoothly.

Bank Liquidity

Bank liquidity refers to a bank's ability to quickly convert assets into cash to meet its immediate financial obligations. Liquidity is vital for the day-to-day operation of banks. A bank with high liquidity can smoothly handle withdrawals and provide loans without facing financial strain. During stable economic periods, banks usually maintain adequate liquidity levels as the economy supports regular repayment schedules and low default rates.
However, in times of economic distress, banks may face higher withdrawal rates and defaults on loans. This can cause liquidity bottlenecks, making it difficult for banks to meet their demands. During these times, the Fed often steps in as a lender of last resort to provide the necessary liquidity to stabilize the banking system.

Economic Stability

Economic stability refers to a state wherein an economy experiences steady growth and low inflation, ensuring consistent financial conditions beneficial for both individuals and companies. During periods of economic stability, businesses thrive, employment rates are high, and consumers can afford to spend and repay their debts easily.
In such conditions, banks operate efficiently, often boasting between sufficient liquidity and low default rates. The Fed's role during these periods is more about maintaining a balance in the economy, monitoring inflation, and ensuring continued growth. It is during unstable times that the Fed's interventions as a lender of last resort are more noticeable, helping to recover stability by supporting banks and other financial institutions.

Loan Defaults

Loan defaults occur when borrowers fail to meet their debt repayment schedules. While manageable during prosperous times, defaults often spike during economic downturns. In such situations, borrowers may face financial difficulties that hinder their ability to repay loans, leading to an increase in delinquent accounts.
For banks, high rates of loan defaults can be particularly challenging as they reduce the inflow of cash needed to maintain liquidity. Such a scenario increases the risk of financial instability, sometimes necessitating the intervention of the Fed. By acting as a lender of last resort, the Fed can provide essential support to troubled banks, thereby preventing potential bank runs and financial crises.