Central banks’ function as the lenders of last resort and the moral hazard of financial institutions

Confronting the societal challenge of financial system stabilization

On March 10, 2023, Silicon Valley Bank (SVB) in the United States filed for bankruptcy. It happened just two days after the bank realized losses of approximately $‍1.8 billion through the liquidation of mortgage-backed securities (MBS) and U.S. bonds and announced a capital increase of $‍2.25 billion. Behind this sudden financial collapse was a large-scale withdrawal of deposits facilitated by the spread of information on social media such as Twitter (now known as X). This phenomenon is known as a “bank run.” Even when a bank is financially sound, a bank run can occur if trivial, negative information spreads. Throughout history and across nations and eras, banking crises have repeatedly unfolded since the emergence of banks in the economic systems.

How should we address a banking crisis? Central banks have a function known as the “lenders of last resort.” This function involves central banks temporarily lending funds, secured by safe assets such as promissory notes or government bonds, to financial institutions facing a liquidity shortage. Its purpose is to prevent the disruption and collapse of the financial system due to the bankruptcy of a bank. In Japan, it is known as the “Tokuyu (special loans)” (Bank of Japan Nichigin Tokuyu) and was applied to multiple financial institutions during periods such as the stock market slump in the 1960s and the late 1990s.

While many economists and policymakers recognize the importance of the lenders of last resort, there is no consensus on criteria used to select financial institutions, amounts, and interest rates of the lending. With their impact, the lenders of last resort also cause concerns about banks’ pre-crisis risk-taking behavior, a phenomenon known as moral hazard. In other words, if private banks anticipate central bank bailouts during a crisis, they may neglect proper screening and monitoring in their daily lending activities and encourage excessive holdings of risky assets.

The establishment of a system to stabilize the financial system while mitigating the moral hazard of financial institutions is a societal challenge. To address this challenge, I, along with my research collaborators, incorporated the Diamond-Dybvig model, which was a recipient of the 2022 Nobel Prize in Economic Sciences, into monetary search theory to develop theoretical models and conducted theoretical analyses on the lender of last resort policies. The results indicate that low-interest emergency lending within collateral limits does not induce moral hazard. However, this means that lending beyond collateral limits presents potential for moral hazard. We are committed to continuing this research and making academic contributions to the stability of the financial system.

The Function and Concerns of the Leader of Last Resort

Department of Management, Graduate School of Management


Graduated from the doctoral program in economics at Kyoto University Graduate School of Economics. Ph.D (Economics). In current position since 2023.