Lender of last resort is a function of the Federal Reserve that, by its nature, walks a fine line between enabling bad policy with bailouts and its appropriate function of helping to ensure solvent institutions, providing value to the economy, do not needlessly go bankrupt in a financial crisis. The principle, set forth by Walter Bagehot, is that a central bank should lend freely, at a penalty rate of interest, to solvent commercial banks with good collateral. In the US, the trouble is that the Fed has never formally defined its responsibilities, and the Fed has seemed to go further and further in the saving of institutions that took excessive risks.
Glossary Term