Definition
The lender of last resort is an institution — almost always the central bank — that stands ready to supply emergency credit to banks and other financial firms when normal sources of funding dry up during a panic. Its purpose is to keep a temporary loss of confidence from becoming a system-wide collapse.
The classic principle, often credited to Walter Bagehot, is to lend freely, against good collateral, at a penalty interest rate. The aim is to support institutions that are fundamentally solvent but caught short of cash.
Why it matters
How it works
In a panic, banks face a run: depositors and short-term creditors all demand their money at once, but the bank's assets are tied up in loans that cannot be sold quickly without large losses. A solvent bank can still fail simply for lack of cash. The lender of last resort steps in with loans secured by the bank's sound assets, breaking the run by guaranteeing liquidity. The penalty rate ensures banks use the facility only in genuine need and repay quickly. The persistent dilemma is moral hazard: a reliable rescue can encourage banks to take more risk in the first place, which is why the backstop is paired with regulation and supervision.