Lender of Last Resort refers to an official central financial institution which provides emergency loans to commercial and savings banks as well as other financial institutions which are suffering from extreme financial hardship or are believed to be nearing collapse. Generally such a lender turns out to be a national central bank. Within the U.S., it is the Federal Reserve which functions as the last case lender to those institutions which find themselves without any other way to borrow funds quickly. Their inability to gain access to funds and credit could lead to a devastating consequence for the greater economy in general. This is why the central banks will provide credit extensions on an expedited basis to those financial institutions which are undergoing extreme financial stress and so in consequence cannot get funds from anywhere else.
The principal job of such a Lender of Last Resort is to maintain the financial system stability and the banking system integrity through safeguarding the deposited funds of individuals and businesses. This is critical to foster confidence in the financial system and to prevent wholesale panic from taking hold of depositors who might otherwise cause runs on the banks by attempting to draw out all of their funds at once. Such an action would create an illiquidity event for the bank and force them to close their doors.
It has been over a century and a half since central banks made it their missions to head off great depressions through being the effective Lenders of Last Resort when financial crises erupted. The action does deliver the liquidity funds with a penalty interest rate. As open market operations take over the funding facility, the interest rate drops for safe assets as collateral. The process also includes direct support to the market.
Commercial banks do not enjoy borrowing from the Lender of Last Resort at any time. It would be a sure fire warning that the bank was undergoing financial stress or even experiencing a crisis of liquidity and a crisis of confidence would next follow. This is the reason that critics of this type of arrangement feel that it tempts banks into taking on a higher level of risk than they should in a form of moral hazard. This could happen because they believe that consequences for engaging in risky financial behavior will not be so severe.
The alternatives to a trustworthy central banking institution not functioning as a Lender of Last Resort can be serious. Bank runs are what result in times of financial crisis when the customers of banks begin to show concern over the solvency of their home financial institution. These customers can be seized with sudden panic and descend en masse on the bank demanding to withdraw all of their funds when confidence in the individual bank or the banking system as a whole erupts.
Banks only maintain s tiny percentage of their deposited funds on hand in their vaults. This is how a bank run can result in the liquidity of a bank rapidly disappearing. Literally these panicked customer actions can set into motion a self-fulfilling prophecy which leads to the bank failing as a result of insolvency.
This actually occurred in 1929 and throughout the 1930s. Bank runs led to catastrophic and widespread bank failure throughout the United States after the 1929 stock market crashes. This snowballed into the Great Depression which gripped the country and developed world economies for the next roughly fifteen years. The American federal government responded too late with tough new legislation which mandated severe reserve requirements on the banks. It required by law that they keep a specific minimum percentage of their deposits as available cash reserves.