Lender of Last Resort

What it is

A lender of last resort (LoR) is an institution—typically a country’s central bank—that provides emergency credit to banks or other eligible financial institutions when they cannot obtain funding elsewhere. The goal is to prevent a liquidity shortage at one institution from triggering wider financial instability.

Key takeaways

• LoRs supply emergency liquidity to prevent bank runs and contain contagion.
• Central banks (e.g., the U.S. Federal Reserve, the European Central Bank) commonly serve this role.
• Emergency lending can create moral hazard: institutions may take greater risks if they expect support.
• There is no single global LoR; international bodies and regional arrangements can play supporting roles.

How it works

• Emergency lending: When a bank faces a sudden withdrawal of deposits or market funding, the LoR can extend short-term loans so the bank can meet withdrawals and normal operations.
• Liquidity vs. solvency: LoR lending is intended to resolve temporary liquidity shortages, not to rescue insolvent institutions. Loans are typically collateralized and priced to discourage routine reliance.
• Market signal: Borrowing from an LoR is often seen as a sign of distress, so banks generally avoid using such facilities unless necessary.

Preventing bank runs

Banks operate on fractional-reserve principles—holding a fraction of deposits as cash while lending or investing the remainder. If many depositors withdraw simultaneously (a bank run), even a solvent bank can run out of cash and fail. By providing emergency funds, a LoR reassures depositors and prevents runs from becoming self‑fulfilling.

Historical reforms after widespread bank runs (for example, during the Great Depression) led to reserve requirements and strengthened central‑bank backstops to reduce systemic risk.

Criticisms and trade-offs

• Moral hazard: Knowing that a central bank will intervene can encourage banks to accept higher risks, expecting a bailout if things go wrong.
• Not a cure-all: Emergency lending can stabilize liquidity but cannot fix fundamentally insolvent institutions; supporting failing firms can also transfer losses to taxpayers or public balance sheets.
• Debate after crises: High‑profile interventions (e.g., during the 2008 financial crisis with institutions such as Bear Stearns and AIG) highlighted both the stabilizing role of LoRs and concerns about rewarding reckless behavior.

Who serves as lender of last resort?

• United States: The Federal Reserve acts as the LoR, providing emergency loans and liquidity facilities when needed.
• European Union: The European Central Bank provides emergency liquidity assistance (ELA) through national central banks; the ECB is the primary LoR for the euro area.
• Global context: There is no single worldwide LoR. Institutions such as the International Monetary Fund can provide supplemental support to countries, and regional arrangements can offer mutual assistance.

Conclusion

A lender of last resort is a central tool for containing financial panics and preserving system stability by supplying emergency liquidity. While it reduces the likelihood of bank runs and contagious failures, it also creates moral‑hazard risks that require careful design—conditionality, prudent collateral requirements, and pricing—to limit dependence and protect the broader economy.