Question

Describe how the lender of last resort can reduce runs on banks and analyze how the provision of liquidity can help promote financial stability. What is the difference between illiquid banks and insolvent banks and how doe that affect the lender of last resort role of the Fed?

Answer 1

Bank runs occur when depositors and investors start making withdrawals from banks, fearing the banks running out of money and they would lose their deposits.

The lender of last resort refers to the institution (generally Central Bank) which offers to provide liquidity or emergency funds to banks and other deposit institutions in case they run out of money.

The presence of the lender of last resort acts as a safety net for banks, which assures the depositors that their banks would work fine in case of emergency and that their money is safe with the banks. This prevents situation of panic and bank runs in the economy.

This provision of liquidity by the lender of last resort helps promote financial safety and security in the economy, as the depositors are assured that their money is safe in the banks and there is no need to panic. This increases financial confidence in the economy and thus promotes financial stability by preventing bank runs.

Illiquid banks: In this condition, banks are unable to meet their current obligations. That is, people are withdrawing more money than it being deposited in banks

Insolvent banks: It happens when the banks are unable to pay back their debts, even if their assets are worth more than their liabilities.

In case of illiquid banks, the lender of last resort comes into play. It infuses liquidity into the banking structure by giving out loans to such banks and prevent them from going out of business.