A lender of last resort is an institution, typically a central bank, that provides liquidity to solvent but illiquid financial institutions during a crisis when no other source of funding is available. By standing ready to lend freely against good collateral at a penalty rate, it aims to halt bank runs and contagion and to preserve financial stability. The role embodies Bagehot’s principle of lending to solvent firms to stem systemic panic.
Overview
- Bagehot’s rule: lend freely, against good collateral, at a penalty rate.
- Targets illiquidity, not insolvency, to distinguish rescue from bailout.
- Tension with moral hazard, since the backstop can encourage risk-taking.
Mechanisms
- Discount-window and emergency liquidity facilities.
- Collateral eligibility and haircut policies.
- Penalty pricing to discourage routine reliance.
- Coordination with prudential regulation and deposit insurance.
Applications
- Containing bank runs and interbank-market freezes.
- Stabilising financial systems during crises.
- Backstopping payment and clearing systems.
- Cross-border swap lines among central banks.