Lender of Last Resort
IntermediateA lender of last resort is an institution, usually a central bank, that lends money to banks and other financial institutions facing short-term cash shortages when they cannot borrow elsewhere, to prevent panic and financial collapse.
Banks hold only a fraction of deposits as cash, so even a healthy bank can run short of money if many customers withdraw at once or if other lenders suddenly refuse to lend to it. Without help, a temporary cash shortage could force a solvent bank to fail, and that failure could spread panic to other banks.
The lender of last resort steps in to provide emergency loans, usually against good-quality collateral and often at a penalty interest rate. This idea is often linked to the nineteenth-century writer Walter Bagehot, who argued that central banks should lend freely in a crisis to solvent institutions, against good collateral, at high rates.
For example, during the 2008 financial crisis, central banks around the world provided enormous amounts of emergency lending to banks to keep the financial system functioning.
Simply knowing that a lender of last resort exists can help prevent bank runs. However, it can also create moral hazard, if banks take excessive risks because they expect to be rescued.
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