The lender of last resort is the safety net for economies following the central banking model. In the United States, the Federal Reserve operates as the lender of last resort for banks and other large institutions that are flirting with disaster. These institutions are considered to be invaluable to the economy because their collapse due to a lack of available credit would have dire consequences for the economy as a whole. The Fed uses its own funds as well as that of member banks to provide capital to the struggling institution in hopes of preventing more widespread damage in the form of lost deposits and general panic.
This system has its pros and cons. On the pro side, the lender of last resort is able to prevent financial collapse and keep a country’s economy intact through panics, crashes, and depressions. On the con side, the idea of a safety net may actually lead financial institutions to take more risks than they would otherwise. There are, however, two reasons that the Fed believes that the system can’t be undermined by the charge of encouraging risk. One, going to the lender of last resort is avoided at all costs by most institutions because of the signal it sends about their health and management. Second, the Fed has been historically stingy in bailing out institutions, preferring to have the banking system work itself out and punish the careless people who brought on each crisis. Whether this latter point still holds after the Wall Street bailout after the 2008 subprime mortgage crisis is an open question.
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