Overview
The Federal Reserve System (also known as the Federal Reserve and informally as the Fed) is the central banking system of the United States.
Within our financial system, the Federal Reserve is set up as a lender of last resort, which by definition is: An institution, usually a country's central bank, which offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse, although the Fed is not the only institution with the ability to assume the role and execute duties of the lender of last resort.
The Fed acts as the lender of last resort by providing credit to institutions facing a temporary credit shortage that could lead to a severe systemic impact on the economy.
The lender of last resort functions both to protect individuals who have deposited funds, and to prevent panic withdrawing from banks that have temporary limited liquidity. Liquidity shocks are intrinsic to the financial sector and in the absence of an institutional mechanism to correct them, financial crises can ensue from loss of investor confidence(“Fed 101”).
So while it is necessary for an institution to be present within the system to assume the role of lender of last resort and support insolvent institutions, provide liquidity, and maintain confidence within the system, precautions must taken to make sure the LOLR does not end up encouraging risky lending in the future, also called moral hazard, through the assurance of safety nets.
Since the onset of the financial crisis in late 2007, the US Federal Reserve has enacted a number of responses to combat the shortfall of liquidity in financial markets and restore stability within the financial markets (Cecchetti).
Acknowledging the limitations of their traditional instruments in responding to the recent financial crisis, the Federal Reserve had to evolve its role as the lender of last resort by establishing new facilities to provide the necessary liquidity to the U.S. financial system.
Within our financial system, the Federal Reserve is set up as a lender of last resort, which by definition is: An institution, usually a country's central bank, which offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse, although the Fed is not the only institution with the ability to assume the role and execute duties of the lender of last resort.
The Fed acts as the lender of last resort by providing credit to institutions facing a temporary credit shortage that could lead to a severe systemic impact on the economy.
The lender of last resort functions both to protect individuals who have deposited funds, and to prevent panic withdrawing from banks that have temporary limited liquidity. Liquidity shocks are intrinsic to the financial sector and in the absence of an institutional mechanism to correct them, financial crises can ensue from loss of investor confidence(“Fed 101”).
So while it is necessary for an institution to be present within the system to assume the role of lender of last resort and support insolvent institutions, provide liquidity, and maintain confidence within the system, precautions must taken to make sure the LOLR does not end up encouraging risky lending in the future, also called moral hazard, through the assurance of safety nets.
Since the onset of the financial crisis in late 2007, the US Federal Reserve has enacted a number of responses to combat the shortfall of liquidity in financial markets and restore stability within the financial markets (Cecchetti).
Acknowledging the limitations of their traditional instruments in responding to the recent financial crisis, the Federal Reserve had to evolve its role as the lender of last resort by establishing new facilities to provide the necessary liquidity to the U.S. financial system.
