Lender of last resort

The term lender of last resort (LOLR) originates from the French expression dernier ressort. While the concept itself had been used previously, the term "lender of last resort" was supposedly first used in its current context by Sir Francis Baring, in his Observations on the Establishment of the Bank of England, which was published in 1797. In 1763, the king was the lender of last resort in Prussia. Different definitions of the lender of last resort exist in the literature. A comprehensive one is the following: "the discretionary provision of liquidity to a financial institution (or the market as a whole) by the central bank in reaction to an adverse shock which causes an abnormal increase in demand for liquidity which cannot be met from an alternative source".

That means that the central bank is the lender (provider of liquidity) of last resort (if there is no other way to increase the supply of liquidity when there is a lack thereof). The function has been performed by many central banks since the beginning of the 20th century. The goal is to prevent financial panics and bank runs spreading from one bank to the next from a lack of liquidity.

Although Alexander Hamilton, in 1792, was the first policymaker to explicate and implement a lender of last resort policy, the classical theory of the lender of last resort was mostly developed by two Englishmen in the 19th century: Henry Thornton and Walter Bagehot. Although some of the details remain controversial, their general theory is still widely acknowledged in modern research and provides a suitable benchmark. Thornton and Bagehot were mostly concerned with the reduction of the money stock. That was because they feared that the deflationary tendency caused by a reduction of the could reduce the level of economic activity. If prices did not adjust quickly, it would lead to unemployment and a reduction in output. By keeping the money stock constant, the purchasing power remains stable during shocks. When there is a shock induced panic, two things happen:

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