How does a central bank act as a 'lender of last resort' during a crisis?

Okay, let's talk about the role of the "lender of last resort."

Imagine the entire financial system as a vast water system, with money being the water. Institutions like banks and securities firms are the large and small pools and pipes. Under normal circumstances, water (money) flows smoothly between them: you deposit money, I take out a loan, businesses invest, and the economy thrives.

Normal Days: Everyone Helps Each Other

Normally, if a bank (let's call it Bank A) is a bit short on cash today (for instance, too many withdrawals), it will naturally borrow some money from other banks (B, C, D) for temporary turnover. This is called "interbank lending." The interest isn't high; everyone is in the same circle, helping each other out, and it's repaid the next day. This is very normal, just like you temporarily exchanging some loose change with a colleague.

When Crisis Hits: Trust Suddenly Vanishes

When a financial crisis strikes, everything changes.

It's like someone suddenly shouts "Bomb!" in a crowded place. Instantly, panic spreads.

In the financial world, this "bomb" could be a rumor that a major institution is about to collapse, or a market crash. At such times, all banks become extremely panicked and distrustful.

Banks B, C, D think: "Oh no, is Bank A going to collapse? What if I lend it money and it can't pay me back? No, no, I need to hold onto my money for my own survival!"
The result is: No one dares to lend money to anyone else. All banks tightly clutch their money, and the "pipes" of the entire financial system instantly freeze up; not a drop of water (money) can flow.

This is what's known as a "liquidity crunch" or "liquidity drying up." At this point, even banks that are fundamentally healthy might collapse because they can't immediately produce cash to meet depositor withdrawals. It's like a healthy person suddenly unable to breathe, suffocating to death.

The "Lender of Last Resort" Appears: The Central Bank to the Rescue

At this critical juncture, the central bank (the People's Bank of China in China, the Federal Reserve in the US) must step forward. It is the "last" one able to provide loans, hence the name "lender of last resort."

Its role is like the financial system's "ER doctor" or "fire department."

How does it do this specifically?

Unconditionally Provide Liquidity: The central bank will announce to the entire market: "Don't panic! Whoever needs money, I have it! As long as you are healthy and just temporarily short on cash, I will lend it to you!" This immediately injects strong confidence into the market.
Lower Collateral Requirements: Normally, banks might be picky about collateral when lending to each other. During a crisis, the central bank will relax standards, accepting assets that might not usually be accepted by the market (e.g., long-term bonds) as collateral, with the aim of making it easier for banks to borrow from the central bank.
Act as a "Reassurance": The central bank's intervention itself is a strong signal, telling everyone: the state will not stand idly by, and the financial system will not collapse. This is more important than gold and can quickly restore market confidence. Once confidence is restored, banks will dare to lend to each other again, and the entire system will come back to life.

This Is Not a Free Lunch

Of course, the central bank isn't a benevolent do-gooder who saves everyone. It follows a classic principle (often referred to as "Bagehot's dictum"):

Only rescue the "temporarily distressed," not the "doomed": It only provides loans to "good kids" with sound asset conditions who are just temporarily short on cash. For "bad kids" who are already insolvent and destined for bankruptcy, the central bank will not save them. Saving them would be a bottomless pit.
Charge punitive interest: The interest rate on central bank loans will be higher than normal market rates. This serves two purposes:
- First, to prevent banks from habitually borrowing from the central bank when there's no real need, fostering dependency.
- Second, to encourage them, once the crisis subsides, to quickly find other banks to borrow from and repay the central bank's money.

To Summarize

Simply put, the central bank, acting as the "lender of last resort," steps forward during a financial crisis when the market is in panic, no one trusts anyone, and no one lends to anyone. As the ultimate authority with the sole ability to create money, it provides emergency liquidity support.

Its core purpose is not to save a specific bank, but to prevent the "fire" of individual institutions from escalating into a raging inferno that burns down the entire financial forest, thereby stabilizing the entire economy and protecting everyone's deposits and investments.