Q.What role of RBI is known as 'lender of last resort'?

Imagine you are the only person in your friend group who has a little extra pocket money saved up. One day, a friend runs short of cash to pay for an urgent bus ticket home. They come to you. You lend them the money, not because you want to earn interest, but because if you don't, they'll be stranded — and that chaos might spread to the whole group's plan. You are, in that moment, the lender of last resort.

Now scale that up to the entire banking system.

The Precise Meaning

In economics, the Lender of Last Resort (LOLR) is a central bank (like the Reserve Bank of India) that stands ready to lend money to commercial banks when no one else will. This happens during a liquidity crisis — a situation where a fundamentally sound bank runs out of cash to meet withdrawal demands, even though its assets (loans, investments) are worth more than its liabilities (deposits).

The key phrase is last resort. The central bank does not lend to banks as a routine business. It steps in only when:

• The bank cannot borrow from other banks (the interbank market has frozen).
• The bank cannot sell its assets quickly without taking a huge loss (a "fire sale").

The central bank lends against collateral — usually government securities or high-quality bonds — and charges a penalty rate (higher than the normal policy rate) to discourage banks from using this facility casually.

Why It Matters: The Domino Effect

Banks operate on a fractional reserve system. They keep only a small fraction of deposits as cash (say, 10%) and lend out the rest. This works fine as long as everyone doesn't demand their money at once. But if rumours spread that a bank is in trouble, depositors rush to withdraw — a bank run.

One bank run can spread to healthy banks because depositors panic. The entire payment system — cheques, digital transfers, salaries — can freeze. The economy grinds to a halt.

The central bank, by lending cash to the troubled bank, stops the panic. Depositors see that the bank can meet withdrawals. The run ends. The system stabilises.

A Word-Picture (No Diagram Needed)

Visualise a row of dominoes. One domino (a bank) starts to wobble. If it falls, it will knock down the next, and the next. The central bank is a hand that reaches in and steadies that first domino — not by gluing it permanently, but by giving it a temporary prop (cash) until the wobble passes.

Common Misunderstanding (Avoid This)

Students often confuse Lender of Last Resort with bailout. They are different:

• LOLR: A short-term loan against good collateral. The bank is expected to repay. The central bank does not lose money. …