Banks Need to Be Safer Than Is Needed. Yes, That’s a Paradox
The ‘last taxi in the station’ problem explains banks’ requirement for liquidity.
A buffer that can never be used is no buffer at all. A crate of Spam in the basement that you’re not allowed to eat, even if you’re starving. The last taxi at the train station that no one’s allowed to take, because there must always be one taxi at the station. Why even call it a buffer if it doesn’t provide any cushion, any relief in an emergency?
Surprisingly, finance scholars Douglas Diamond and Anil Kashyap of the University of Chicago Booth School of Business argue that in the case of banks, the best way to make sure there’s never a run on deposits is to build a buffer of liquidity that’s designed never to be used. It’s the banking equivalent of never touching the Spam, or requiring that a taxi stay in the station even if the last passenger of the night desperately needs a ride home.