The Role of the Lender of Last Resort in Modern Financial Stability: A Critical Analysis

Introduction The concept of a lender of last resort (LOLR) is a crucial component in the architecture of modern financial systems. It refers to a financial institution, usually a central bank, that provides funds to banks or other financial institutions that are facing short-term liquidity crises. The purpose of this report is to critically analyze the role of the lender of last resort in promoting financial stability in contemporary economies. This analysis will explore both the theoretical foundations and practical implications of the LOLR function, examining how it has evolved in response to crises and the challenges it faces in today’s interconnected financial landscape.

Theoretical Foundations of the Lender of Last Resort The theoretical underpinnings of the lender of last resort are rooted in classical economic thought, notably articulated by Walter Bagehot in the 19th century. Bagehot advocated that central banks should lend freely but at a penalty rate to solvent institutions facing liquidity problems, thereby preventing contagion and maintaining public confidence in the banking system. This principle remains relevant today, as emer