Question

The Fed, as lender of last resort, provides a critical service by reducing the likelihood of bank panics. However, its role as lender of last resort could actually increase the likelihood of a financial crisis. Why is this?

Answer 1

The Fed's lender of the last resort refers to the lending which the Fed makes to the banks or other institutions that are experiencing financial difficulty or are considered highly risky and are near collapse.The Fed acts as the lender of last resort to the organizations that cannot borrow from any other source and if they fail,then it will greatly impact the economy.

Consider when these institutions approaches the Fed to borrow.This will send out the message to the depositors that the institution is not doing so well and is near collapse.This will improve the risk associated with it even more as these people will rush to the institution to withdraw their money which will make it even worse for these instutions to perform.It will push the institution into insolvency.

Secondly,by helping the banks and providing them with money,the Fed will indirectly encourage these institutions to unnecessary risks with the public money as they know that if they can't succeed ,the Fed would be here to bail them out.Such actions have actually taken place in the past financial crisis of 1920 and 2008.The Fed has already bailed out a lot of these financially weak firms that have failed to invest public money