A lender of last resort refers to an institution, typically a central bank, with the authority and capability to extend financial assistance in times of severe economic distress or liquidity crises. Its primary role is to serve as a source of emergency liquidity for commercial banks and other financial institutions that may not be able to obtain funding through conventional means.
The lender of last resort acts as a safety net, stepping in when private sources of liquidity are insufficient to meet the demand for funds or restore confidence in the financial system. In times of crisis, market participants may hoard cash, leading to a shortage of available funds for lending purposes. This can result in a decline in lending activity, increased interest rates, and a contraction in economic activity. By providing emergency funding to financial institutions, the lender of last resort aims to stabilize financial markets, prevent systemic risk, and ensure the smooth functioning of the overall economy.
The provision of emergency liquidity is typically done through various measures, such as direct lending to banks, offering collateralized loans, or purchasing eligible assets from distressed institutions. The lender of last resort acts as a lender when no other options are available, employing its ability to create or inject money into the financial system to alleviate funding pressures and restore confidence among market participants.
The lender of last resort is a crucial function in modern economies and plays a vital role in maintaining financial stability during times of crisis. Its intervention aims to prevent widespread bank failures, mitigate the risk of contagion, and safeguard the overall health and functioning of the financial system.
