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	== See also ==		== See also ==
	* [[Central Banking]]		* Central Banking
	* [[Bank Liquidity Crisis]]		* Bank Liquidity Crisis
	* [[Monetary Economics]]		* Monetary Economics

	== References ==		== References ==

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A '''lender of last resort''' is an institution, typically a central bank, that provides liquidity to financial institutions during periods of stress, when they cannot obtain funds from other sources. The function is a central element of the safety net for the financial system.

== Concept ==
The lender of last resort provides liquidity to solvent but illiquid institutions, allowing them to meet their obligations and preventing the spread of a liquidity crisis. The distinction between solvency and liquidity is central, since an institution that is insolvent should be resolved rather than supported.

The function is based on the observation that banks are vulnerable to runs, since they hold illiquid assets and liquid liabilities. A run can force a solvent bank into insolvency, and the failure of one bank can spread to others, through the interconnection of the financial system.

== Principles ==
The classical principles of the lender of last resort were articulated by Walter Bagehot in the nineteenth century. The principles hold that the central bank should lend freely, at a penalty rate, against good collateral, to institutions that are solvent but illiquid.

The principle of lending freely is intended to reassure the market that liquidity will be available and thereby to prevent runs. The penalty rate is intended to discourage unnecessary borrowing and to ensure that the facility is used only by institutions that need it. The requirement for good collateral protects the central bank from losses.

== Modern Practice ==
Modern practice has evolved beyond the classical principles. Central banks now lend against a wider range of collateral, and they have extended the provision of liquidity to a broader range of institutions. The distinction between liquidity and solvency has become more difficult to draw, and the measures taken during crises have blurred it further.

The global financial crisis saw an extensive use of the lender of last resort function, with central banks providing liquidity on an unprecedented scale. The measures included the expansion of the collateral accepted, the lengthening of the terms of the loans, and the provision of liquidity to institutions beyond the banking sector.

The extension of the function raises issues of moral hazard, since institutions that expect to be supported may take excessive risks. The design of the facility must balance the need to provide liquidity against the need to limit the incentive for excessive risk-taking.

== Debate ==
The role of the lender of last resort is a subject of debate. Some argue that the function is essential to the stability of the financial system and that its exercise should be broad and flexible. Others argue that it creates moral hazard and that it should be limited and subject to strict conditions.

The debate is connected to the analysis of the regulation of the financial system. The provision of liquidity is one element of the safety net, which also includes deposit insurance and the resolution framework. The design of the safety net as a whole determines the incentives of financial institutions.

== The Classic Doctrine ==
The classic doctrine of the lender of last resort was developed in the nineteenth century, in the context of recurrent banking panics. The doctrine held that the central bank should lend freely to solvent institutions, at a penalty rate, against good collateral.

The rationale was to prevent panics from spreading, by assuring depositors and creditors that their claims would be met. The penalty rate was intended to discourage unnecessary borrowing and to ensure that the facility was used only when necessary.

The doctrine has been refined and debated over the years. The distinction between solvency and liquidity, which is central to the doctrine, is difficult to apply in practice, since the value of the assets of a bank depends on the market conditions, which may themselves be affected by the panic.

== The Crisis Experience ==
The financial crisis saw an extensive use of the lender of last resort function. Central banks provided liquidity on an unprecedented scale, through a range of facilities and against a wide range of collateral.

The measures included the provision of liquidity to individual institutions, the introduction of facilities to support specific markets, and the expansion of the collateral accepted. The measures were directed at preventing the failure of institutions and at restoring the functioning of markets.

The experience raised questions about the scope of the function and about the conditions under which it should be exercised. The extension of the function to a broader range of institutions and to a wider range of collateral blurred the distinction between the lender of last resort and the provision of general liquidity.

== The Moral Hazard Problem ==
The provision of liquidity creates a moral hazard problem, since institutions that expect to be supported may take excessive risks. The problem is particularly acute when the support is provided to institutions whose failure would threaten the financial system.

The design of the framework must address the problem, through the conditions attached to the support, through the supervision of the institutions, and through the resolution framework that allows failing institutions to be wound up without disrupting the system.

The problem also has a systemic dimension, since the expectation of support can encourage risk-taking across the financial system. The design of the safety net as a whole, including the deposit insurance and the resolution framework, determines the incentives of the institutions.

== Summary ==
The lender of last resort is a central function of the central bank, and its exercise has evolved in response to the crisis experience. The design of the function must balance the need to provide liquidity against the need to limit moral hazard.

== See also ==
* [[Central Banking]]
* [[Bank Liquidity Crisis]]
* [[Monetary Economics]]

== References ==

<ref name="r1">Research on the lender of last resort and on financial stability.</ref>
<ref name="r2">Studies of the central bank response to financial crises.</ref>
<ref name="r3">Analyses of moral hazard and of the design of the safety net.</ref>

<references />

[[Category:Central banking]]
[[Category:Banking]]
[[Category:Monetary economics]]

Lender of Last Resort - Revision history

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