The lender of last resort function is important for financial stability from "summary" of The Economics of Money, Banking and Financial Markets, eBook, Global Edition by Frederic S. Mishkin
The lender of last resort function plays a crucial role in maintaining financial stability. This function is important because it helps prevent bank runs and financial panics, which can have devastating effects on the economy. By providing emergency liquidity to banks that are experiencing a sudden withdrawal of funds, the lender of last resort can help stabilize the financial system and prevent a domino effect of bank failures. During times of crisis, when depositors lose confidence in the banking system and rush to withdraw their funds, banks may not have enough liquid assets on hand to meet these demands. This can lead to a liquidity crisis, where banks are forced to sell off assets at fire-sale prices or even declare bankruptcy. The lender of last resort steps in to provide emergency funding to banks facing these liquidity shortages, helping them weather the storm and avoid insolvency. By acting as a lender of last resort, central banks can help restore confidence in the banking system and prevent a self-fulfilling prophecy of bank failures. This can help prevent a downward spiral of economic activity, as bank failures can lead to a contraction in credit supply, which in turn can lead to a decline in investment and consumption. While the lender of last resort function is important for maintaining financial stability, it is not without risks. Providing emergency funding to banks can create moral hazard, as banks may take on excessive risks knowing that they will be bailed out in times of crisis. To mitigate this risk, central banks must carefully monitor the activities of the banks they lend to and impose conditions on the emergency funding they provide.- The lender of last resort function is a crucial tool for central banks to maintain financial stability and prevent systemic crises. By providing emergency liquidity to banks in times of need, central banks can help stabilize the financial system and prevent the spread of panic and contagion. This function is essential for ensuring the smooth functioning of the financial system and promoting economic stability.
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