Question

What is the lender of last resort?

Short answer

The lender of last resort is an institution, typically a central bank, that provides financial support to financial institutions facing serious financial difficulties, in order to prevent their collapse and minimize damage to the economy. Main roles of the lender of last resort include providing temporary liquidity, preventing bank runs, maintaining financial system stability, and acting as a safety net to maintain confidence in the financial system. However, this safety net must be carefully managed to avoid encouraging moral hazard, where financial institutions take excessive risks expecting the lender of last resort to intervene if needed.

Step-by-step solution

Definition of Lender of Last Resort

The lender of last resort is an institution, usually a central bank, that offers financial support to financial institutions facing serious financial difficulties, where the failure of these institutions could lead to a financial crisis or broader damage to the economy. The lender of last resort steps in to provide liquidity and prevent the collapse of the troubled institutions by offering loans or purchasing their assets.

Role of the Lender of Last Resort

The main roles of the lender of last resort are: 1. Provide temporary liquidity: When financial institutions face a liquidity crisis, where they are unable to meet their short-term obligations or raise funds from the market, the lender of last resort steps in to provide temporary funding. This helps to restore confidence in the financial system and reduce the risk of contagion, where the problems of one institution lead to the failure of others. 2. Prevent bank runs: Bank runs occur when a large number of depositors simultaneously withdraw their funds from a bank due to concerns about its solvency. This can lead to a self-fulfilling prophecy, where the bank does become insolvent, as it struggles to meet the sudden surge in withdrawals. The lender of last resort can intervene by providing emergency loans to troubled banks, to restore confidence and prevent bank runs. 3. Maintain financial system stability: By acting as the lender of last resort, the central bank can ensure that the financial system remains stable during periods of crisis or severe economic downturns. This helps to protect the broader economy from the adverse effects of financial instability. 4. Act as a safety net: Knowing that a lender of last resort exists can help to maintain confidence in the financial system. This can deter potential bank runs and reduce the risk of contagion during periods of financial stress. However, this safety net must be managed carefully, as it can also lead to moral hazard, where financial institutions take excessive risks in the expectation that the lender of last resort will intervene to save them if things go wrong.