Why is the Federal Reserve called the 'lender of last resort'?

Hello, that's a great question. I'll try to explain it using a simple analogy that you'll grasp right away.

You can imagine the entire financial system as a 'circle of friends' doing business with each other, where the members are banks of all sizes.

The "Friend Circle" Under Normal Circumstances

Normally, members (banks) in this friend circle lend money to each other. For example, if Bank A has a lot of withdrawals today and is a bit short on cash, it might borrow a bit from Bank B, which has ample funds, and repay it tomorrow. This is perfectly normal; everyone helps each other, money flows around, and everyone's business runs smoothly.

The "Friend Circle" When Panic Strikes

But now, imagine a piece of bad news spreads through the market – say, an economic crisis is coming. The friend circle suddenly goes into an uproar, and panic begins to spread.

Crisis of Trust: Everyone starts worrying if others will go bankrupt or collapse. They become afraid to lend money easily, fearing the other party won't be able to repay it, and their own money will be lost.
Liquidity Drying Up: The result is that the normal practice of inter-bank lending suddenly grinds to a halt. Bank A needs money again, but this time it searches through Bank B, Bank C, Bank D... all its friends shake their heads and say, "Sorry, I'm also very tight right now; I can't lend to you."

At this point, Bank A might be a healthy, good bank, just temporarily unable to manage its cash flow. But if it collapses because it can't secure this emergency loan, it could trigger a terrible chain reaction – those who owe money to Bank A won't be repaid, and those who do business with Bank A will also be affected. Panic will intensify, leading to more bank failures. This is like dominoes: one falls, and a whole row follows.

The "Lender of Last Resort" Appears

Just at this critical moment, a most powerful and authoritative 'big brother' steps forward. This big brother is the Federal Reserve.

It tells the struggling Bank A, "Don't panic. If your friends in the circle won't lend to you, I will lend to you! As long as your collateral is acceptable, I'll provide you with a loan."

This role played by the Federal Reserve is that of the "Lender of Last Resort."

The meaning of "Last": This word is crucial. It means you can't come to me every time you face a difficulty. You must first exhaust all other options, search all available market channels (your bank friends), and only when you've truly run out of options and no one else will lend to you, then I am your final resort.
Purpose is not to save a single company: The Federal Reserve's primary goal in intervening is not to favor Bank A, but to prevent Bank A's collapse from igniting a crisis in the entire financial system. Its objective is to maintain the stability of the entire 'friend circle', prevent panic from spreading, and avoid a wildfire burning down the whole forest.

To summarize:

So, the "Lender of Last Resort" is like the financial system's ultimate 'firefighter'. When commercial banks stop lending to each other due to panic (the water source is cut off), causing some banks to potentially 'catch fire' (collapse), the Federal Reserve, as the central bank, turns on its 'faucet' and directly provides emergency loans to these banks, thereby extinguishing the flames and preventing the fire (financial crisis) from spreading throughout the entire system.