The currency issued by the European Central Bank, and by all the world’s central banks, takes two forms: banknotes and reserves. Reserves is a digital currency but only available to banks or other financial institutions that have an account at the central bank. While ordinary citizens and businesses use digital money in addition to banknotes for their transactions, it is money issued by commercial banks via deposits. Every time a commercial bank provides a loan, it also issues money by entering in its liabilities an amount equivalent to the credit given. Therefore, deposits constitute a digital currency created by commercial banks and through which most transactions are regulated today. When you use a debit card to pay for a good or a service, you do so through your bank deposit in electronic form – you are paying by digital currency.
The Central Bank Digital Currency (CBDC) is instead a currency that can be used by everyone, so it is a ‘retail’ digital currency instead of a ‘wholesale’ one, as reserves are. It is therefore a new form of currency to be used in daily transactions that would coexist with banknotes and deposits.
What could be the impact on the banking sector, on its activity and on its financial stability, of the issuance of a CBDC? To answer to this question, let's start by understanding what makes this currency different from those already used by households. Compared to a physical currency, it would have all the advantages of the digital currency that households already use. But, while deposits are insured by a guarantee up to a certain threshold (100 thousand euros in Europe), a CBDC would be completely free of credit risk, since it would be issued by the central bank. Therefore, it seems possible that, once a CBDC is issued, it could replace at least part of commercial bank deposits – that is the part that exceeds the guaranteed threshold. Therefore, there would be a partial disintermediation of the banking sector, since the total assets, and thus loans to households and businesses, would also be reduced together with total liabilities if deposits were not replaced by other forms of funding. In short – banks would find themselves poorer.
It is therefore likely that, in order not to lose deposits, banks would have to offer a higher return than that offered by the Central Bank. An immediate consequence for the banking sector would be an increase in the cost of funding, a cost that would be all the greater the higher the credit risk of a bank. In order to defend profit margins, banks would try to transfer this to households and businesses by increasing loan interest rates and, keeping everything else constant, which would imply a reduction in total lending.
There is another concern about deposits. Under current regulation, it is necessary for banks to have stable funding to meet the liquidity requirements imposed by Basel III (the Liquidity Coverage Ratio and the Net Stable Funding Ratio). At the moment, the most stable funding source are deposits. But would they continue to be so in a world where liquidity held at a commercial bank could be transferred to an account at a central bank? If it is true that in a situation of stress for a single banking institution, deposits under 100 thousand euros might not be transferred because they are covered by a guarantee, what would happen in a situation of systemic crisis such as the subprime or sovereign debt? Would households continue to believe that their deposits are safe or would they not prefer to transfer them all into a central bank account, even at the cost of losing a higher return?
Here is the second consequence for the banking sector: a greater instability of funding, even of that part of deposits under 100 thousand euros, which would expose the system to a greater frequency of bank runs. In fact, if a bank run is always possible, the practical difficulties of keeping large amounts of banknotes in safe custody limits the occurrence of these episodes to situations perceived as highly risky for the solvency of the banks, and not at the first negative news about one’s bank.
In order to reduce the risks to financial stability of the introduction of a CBDC, central banks have two tools: the interest rate on the currency and the imposition of limits on the amount of CBDC that can be held. If, for example, the CBDC was not remunerated, the degree of disintermediation of the banking sector would be lower, since a positive interest rate is typically paid on deposits with commercial banks. It is clear that in an environment such as the present one of zero interest rates, a negative rate would have to be paid on CBDC in order for households to hold part of their liquidity in bank deposits. This is possible, at least as long as holding savings in cash instead of CBDC has a higher cost than the negative interest rate paid by the central bank. A second option to limit the outflow of deposits from the banking sector would be to set a limit on the amount of digital currency that could be held by an individual or a company. This would ensure that CBDC is used to make payments and not as an alternative to saving money, thus limiting the disintermediation of the banking sector.
The partial disintermediation of the banking sector could also have a negative impact on service revenues: fees on receipts, payments and on credit cards would be reduced. Furthermore, and even more importantly, the relationship that banks establish through opening of a deposit with a customer is essential for the provision of a range of services, including those related to investment management. Over the years, fees on the placement of investment products and insurance protection to households have generated a significant contribution to the sector's overall revenues. If this component were to disappear or be reduced as a result of the reduction in the customer base, the profitability of the sector, which is already severely weakened, would suffer further, affecting the overall sustainability of the business.
In short, the effects on the banking sector of the issuance of a CBDC are extremely significant, which is why central banks are carefully considering appropriate strategies to design it in a way that increases public welfare, of which financial stability is certainly an important component.
This article has first been published in Italian on Econopoly, blog of ilsole24ore.com