Question

Compare and contrast how the Conventional and Legal Restrictions explanations of banking crises view the “Lender of Last Resort” function of a central bank, including its necessity.

Answer 1

A central bank can act as a "lender of last resort" to other banks assuring depositors that they need never fear a general collapse. A crucial assumption behind the role is that fractional reserve banking is fragile and crisis-prone that central bank and fiat money are an unavoidable response to market failure.

Fractional reserve banking is not inherently fragile and unstable. They are weak because of the legal restrictions. The collapse of a fully regulated banking system would be highly improbable and central banks are at most second best solutions to the problems peculiar to regulated banking.

The emergence of the central bank as the lender of last resort and as a curb on the lending practices of commercial bankers was closely associated with its emergence as a banker's bank in the sense of allowing commercial banks to keep their own banking accounts with itself. This is when the standby theory comes into the picture under which central bank is inactive at ordinary times and active only in rare crisis situations when it has to save the banking system from collapse. The attitude of the central bank is consistent with the interest in the quality of credit granted by financial institutions to facilitate the growth of the economy.