Lender of last resort

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A concession given to a select number of financial institutions whereby their central bank agrees to provide them with funds if they should get into liquidity difficulties.

The primary purpose of the activity by the central bank is stability of the financial system as a whole.

Secondarily, the purpose is stability of the particular institution affected.

Central banks generally avoid risk taking behaviour.

Accordingly, in principle, the central banks only lend against good security (collateral) and with a conservative haircut.

In practice, liquidity shortage may force a bank to seek to dispose of assets, even at significant losses that erode its capital.

Eventually the central bank may lend against less-good collateral and with less than its desired haircut on collateral valuation - until it won't, when the game is over and the story becomes one of resolution.

Lender of last resort activity is also often referred to as emergency liquidity assistance.

The European Central Bank's scheme is called Emergency Liquidity Assistance (ELA), for example.

See also