Lender of Last Resort
In a panic, a central bank acts as lender of last resort, supplying emergency liquidity so a solvent bank is not brought down by a pure liquidity run. Bagehot’s rule is the classic guide. Lend freely, against good collateral, at a penalty rate. The discount window is the standard channel, and the cost of this backstop is the moral hazard it encourages.
Why it matters
A run can sink even a healthy bank, because it cannot turn illiquid loans into cash fast enough. A lender that stands ready to advance cash against sound assets stops the panic. Charging a penalty rate and demanding good collateral keeps the help aimed at illiquidity, not at rewarding bad bets.
Worked examples
A solvent bank faces a sudden deposit run but holds plenty of sound loans. How does Bagehot’s rule say the central bank should respond?
Lend freely to the bank against its good collateral, but at a penalty rate above the normal market rate. The bank gets the cash it needs to meet withdrawals, the panic subsides, and the penalty rate discourages banks from leaning on the window in ordinary times.
Common mistakes
- ✗A lender of last resort should rescue any failing bank. Bagehot’s rule lends only against good collateral, aiming the support at illiquid-but-solvent banks rather than insolvent ones.
- ✗Lending at a penalty rate is meant to punish the bank. The penalty rate exists to limit moral hazard and to keep the window a backstop, not a cheap routine funding source.
- ✗The discount window is a normal way for banks to fund themselves. Heavy use signals trouble, so it is reserved for stress.
Revision bullets
- •Central bank supplies emergency liquidity in a panic
- •Bagehot’s rule: lend freely, against good collateral, at a penalty rate
- •The discount window backstop carries a moral-hazard cost
Quick check
Bagehot’s rule for a lender of last resort is to lend
Connected topics
Sources
- Mishkin (2018), Ch. 16Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The lender-of-last-resort role and the discount window as a tool of monetary policy.
- Mishkin (2018), Ch. 10Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The government safety net and the moral hazard created by lender-of-last-resort support.