The Lender of Last Resort

Why central banks lend to banks in a panic, the rule set out by Walter Bagehot, and the risks of rescuing banks.

Even a healthy bank can fail if too many depositors try to withdraw their money at once, because most of its money is tied up in loans. To prevent such panics from spreading, central banks act as the lender of last resort: they lend to banks that cannot get money elsewhere.

Liquidity versus solvency

Economists distinguish two kinds of bank problems:

A liquidity problem: the bank has enough assets to cover its debts, but cannot turn them into cash quickly enough.
A solvency problem: the bank’s assets are worth less than its debts, so it is fundamentally broke.

The lender of last resort is meant to help with liquidity problems, preventing sound banks from failing just because of panic.

Bagehot’s rule

In 1873, the British writer Walter Bagehot, in his book Lombard Street, set out a famous rule for central banks in a crisis: lend freely, to solvent banks, against good collateral, at a high rate of interest.

Lend freely so panic ends.
To solvent banks so the central bank does not rescue failing ones.
Against good collateral so the central bank is protected.
At a high rate so banks do not rely on it in normal times.

In practice

During the 2008 financial crisis, central banks around the world lent huge amounts to banks and created new lending programmes. In March 2020, as markets froze at the start of the pandemic, central banks again acted as lenders of last resort, including to markets beyond banks. In March 2023, the U.S. Federal Reserve created a new lending facility after the failure of Silicon Valley Bank to reassure depositors elsewhere.

Stopping a run

Rumours spread that a bank is in trouble, and depositors line up to withdraw money. The bank has plenty of good loans, but they cannot be sold instantly. The central bank lends it cash against those loans. Depositors see they can withdraw, the panic fades, and the bank survives. Without the loan, a sound bank might have collapsed.

Moral hazard

Critics warn of moral hazard: if banks expect to be rescued, they may take more risks. That is why Bagehot insisted on penalty rates and good collateral, and why regulators also impose capital requirements and supervision.

Thinking the lender of last resort bails out every bank

The role is meant to provide temporary liquidity to sound banks, not to rescue insolvent ones. Deciding which is which during a crisis is one of the hardest jobs central banks face.

Key takeaways

Central banks act as lenders of last resort to stop banking panics.
They aim to help banks with liquidity problems, not insolvent ones.
Bagehot's rule: lend freely, to solvent banks, against good collateral, at a high rate.
Rescues risk moral hazard, so regulation and supervision are also needed.