A lender of last resort acts as a financial backstop to provide liquidity to banks and other financial institutions whenever they are unable to secure it from other sources. The lender of last resort helps to prevent bank runs and financial panics, which can adversely impact the stability of the economy.

The Federal Reserve is typically the lender of last resort for banks and other financial institutions. The Federal Reserve has the power to lend up to an unlimited amount of money to an individual bank, either by providing money directly or by guaranteeing loans made by other lenders. This kind of intervention is typically limited to situations that the Federal Reserve determines are necessary to prevent a systemic failure—a run on the bank.

Critics of having a lender of last resort argue that allowing banks to borrow from a central bank encourages moral hazard: that banks can take excessive risks knowing that they will ultimately be bailed out. This practice essentially creates a form of “too big to fail” mentality among banks, which means that they become too big and interconnected to collapse, thus making the whole system vulnerable to increased risk.

Despite the potential moral hazard issues, having a lender of last resort is an invaluable tool for preventing financial chaos. It provides an emergency outlet when other sources of credit have dried up and allows banks to continue to provide credit to consumers and businesses when they otherwise wouldn’t be able to. It can also create a floor of liquidity in the banking system, even during times of crisis, which helps keep the financial system stable. Without the lender of last resort, financial disruptions can become much more severe and stop economic activity more quickly.

In short, the lender of last resort provides a necessary and important backstop for banks and financial institutions. While undesirable moral hazard issues may be associated with its use, the risk of a systemic financial failure or panic is often much greater without it.