While effective lending of last resort can mitigate the negative financial and real effects of liquidity shocks (Carlson et al., 2011; Richardson and Troost, 2009), it is frequently associated with the notion of moral hazard (Freixas et al., 1999).
Counterparties that experienced a functional lender of last resort during past episodes of liquidity distress may become tempted to “bank” on the safety net provided by the central bank. As observing and learning agents, they form expectations based on their experience and project them forward.