Definition
The lender of last resort is the function, usually performed by a central bank, of providing emergency liquidity to financial institutions that cannot raise funds elsewhere during a crisis. By standing ready to lend when private markets freeze, the central bank aims to prevent a temporary liquidity shortage from cascading into a system-wide collapse.
Bagehot's classical rule
The doctrine is most often traced to Walter Bagehot's 1873 work Lombard Street. His prescription was that in a panic the central bank should lend freely and early, to solvent institutions, against good collateral, and at a penalty rate above the normal market rate. The penalty rate discourages reliance on the facility in calm times, while free lending against sound collateral stops a panic from destroying fundamentally healthy banks. The distinction between illiquid-but-solvent and genuinely insolvent firms is central, though hard to judge in real time.
Trade-offs and moral hazard
Because the function backstops the banking system, critics note it can create moral hazard: institutions may take greater risks expecting rescue. It also concentrates extraordinary discretionary power in the central bank, including the ability to create money on demand to fund the lending. Understanding this backstop explains why modern banking can operate with thin reserves at all, and why monetary policy and financial stability are deeply intertwined.
For the underlying fragility this role addresses, see the Bank Run and Fractional Reserve Banking.
In Simple Terms
The lender of last resort is the function, usually performed by a central bank, of providing emergency liquidity to financial institutions that cannot raise funds…