In the initial period of central banking, the central bank in every country performed two basic functions which strategically positioned it at the centre of the financial system. The first function was that of note issue. Second one is the lender of last resort (LoLR) facility extended by central banks to commercial banks.
Under LoLR, the central bank provides emergency money or liquidity to the bank when the latter faces financial stringency. When the central bank extends financial help, the bank can escape from the liquidity crisis. Thus, LoLR is a financial safety net provided by the central bank to commercial banks.
LoLR was the kingpin part of central banking, though it was used in rare circumstances when the bank concerned was on the verge of failure. The LoLR has inarguably strengthened the position of central bank as the banker’s bank.
Providing financial help during the crisis time can be also viewed as a reciprocal measure offered by the central bank. This is because, banks in general holds a certain percentage of their deposits as cash reserves with the central bank. LoLR and the reserve holding have empowered central banks to administer regulatory and supervisory measures on the banking system.
Lender of last resort’ (LoLR) thus, is an exclusive function of a central bank, whereby it lends money to support financial institution facing temporary liquidity stress after exhausting recourse to the market and whose failure is likely to have systemic implications.
Though LoLR is last source of funds, whether or not LoLR should be extended to a crisis ridden bank is left to the central bank itself. In 2007, when British bank Northern Rock faced failure, the Bank of England, which is the central bank there, has not provided the LoLR. As a result, the bank failed.
Many in the central banking field believe that unlimited extension of LoLR will make banks to take too much risk, expecting that the central bank will comes to the rescue of a risk taking and failing bank.