Understanding Systemic Risk in Global Financial Markets

CHAPTER 14Lender of Last Resort

INTRODUCTION

A lender of last resort is ready to lend money to banks and other financial institutions when others are not. In this chapter we delve into the concept of a lender of last resort, including its benefits and risks. We further delve into various views of the function of the lender of last resort and its application. This chapter concludes through exploring the role of the U.S. Federal Reserve during the Great Depression and the Credit Crisis of 2007–2009.

After you read this chapter you will be able to:

• Define the role of a lender of last resort.
• Understand why a lender of last resort is important.
• Understand the risks associated with a lender of last resort.
• Learn about the classical view and alternative views of the function of the lender of last resort.
• Learn about the Great Depression and U.S. Federal Reserve's response.
• Learn about the Credit Crisis of 2007–2009 and U.S. Federal Reserve's response.

LENDER OF LAST RESORT CONCEPT

A central bank such as the U.S. Federal Reserve is described as “lender of last resort” as it is ready to lend money to banks and other financial institutions when others are not. In a review published in Financial Stability Review, Freixas et al. (1999) define the role of a lender of last resort:¹

The discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity ...