Lender of Last Resort

Lender of Last Resort

The problem with bank runs is not that insolvent banks will fail; they are, after all, bankrupt and need to be shut down. The problem is that bank runs can cause solvent banks to fail and spread to the rest of the financial system. To prevent this, the Fed stands ready to lend to banks and other financial institutions when they cannot obtain funds from anywhere else. This is known as the lender of last resort role. For banks, the central bank acting as a lender of last resort helps to reinforce the effect of deposit insurance and to reassure bank customers that they will not lose their money.

The lender of last resort task can come up in other financial crises, as well. During the panic of the stock market crash in 1987, when the value of U.S. stocks fell by 25% in a single day, the Federal Reserve made a number of short-term emergency loans so that the financial system could keep functioning. During the recession of 2008–2009, the “quantitative easing” policies (discussed below) of the Federal Reserve can be interpreted as a willingness to make short-term credit available as needed in a time when the banking and financial system was under stress.