What CBDC Is (Not) About: Part IV
The medium-impact scenario
Note: This is the fourth post in a series about central bank digital currencies, or CBDC (you can start with Part 1 here). Today, we continue our analysis about the potential implications of introducing CBDC with the 'medium-impact' scenario.
Tl;dr: CBDC gaining meaningful market share expands the central bank's grip over the monetary system, with significant implications for bank balance sheets, financial risk, and commercial bank funding. During a financial crisis, CBDC may become a flight-to-safety instrument and exacerbate the magnitude of bank runs, causing broader systemic instability.
A more resilient payment landscape
In the 'medium-impact' scenario, CBDC has established itself as an important complement to private forms of money. Consumers and businesses continue using existing payment systems powered by private debt money, but are conducting an increasing share of their day-to-day transactions via the new CBDC infrastructure. [1] As discussed in Part 3, this implies that central bank efforts to persuade economic agents of the benefits of CBDC have been met with some success – which is by no means an easy feat in itself. [2]
Central bank are eating a slice of the cake that used to be reserved to commercial banks and other private payment service providers. But in addition to the obvious benefits associated with greater competition (i.e. more choice, lower prices), an alternative CBDC system would also contribute to a somewhat overlooked – but highly desirable – outcome: greater resilience of the electronic payments infrastructure.
Payments are the lifeblood of the economy. At a time where cash usage appears to be in decline at a global level, electronic payments infrastructure becomes systemically important. Having a sufficiently diversified landscape, based on a patchwork of different systems and applications, significantly enhances the resilience of this critical building block upon which the modern economy depends.
A change in the composition of the money supply
A notable implication of CBDC gaining traction concerns the changing composition of the money supply. Pre-CBDC, M1 was largely dominated by private bank credit. Post-CBDC, M0 will constitute a much larger share of M1. In other words, public money (M0) – in the form of CBDC – will substitute a sizeable portion of private money – primarily in the form of bank deposits.
As a result, the central bank will enjoy much greater – and direct – control over the total money supply. Where previously it was limited to creating bank reserves – an instrument akin to laundromat tokens with little utility outside a narrow permissioned system – it can now issue universally-accessible electronic money that is accepted across the economy. [3] Instead of relying on private sector intermediation to adjust the money supply, the central bank now has the ability to intervene much more directly in a targeted fashion.
In contrast to Scenario 1, a thriving CBDC with significant market share constitutes an effective direct transmission channel for both fiscal and monetary stimulus: unconventional monetary policies (e.g. helicopter money) could be implemented much more efficiently, and emergency funds be disbursed much more quickly to those in need. And think about the seemingly endless possibilities of automatically-enforceable policy decisions (e.g. negative interest rates)... [4]
The commercial banking sector
The impact on commercial banking will be considerable.
Banks will likely lose a non-trivial share of customers as CBDC increasingly crowds out bank deposits. [5] Banks will need to compete more aggressively by adjusting interest rates offered on deposits, thereby driving margins – and ultimately profitability – further down. As total deposits shrink, the aggregated balance sheet of the commercial banking sector shrinks in size, too.
The outflow of deposits will have an effect on the pricing and composition of bank funding. Bank funding costs are likely to rise as banks start looking for alternative sources of funding in the market. This development may, depending on the magnitude, lead to higher borrowing costs for the economy as a whole since costs are likely to be passed on to the borrowers. In the absence of state intervention, less bank credit would be available to push the economy – with presumably disastrous consequences for economic growth.
Concentration of power and financial stability
The shrinking balance sheet of the banking sector will be compensated by a corresponding increase in the balance sheet of the central bank. With liabilities growing as a result of issuing CBDC, the asset side needs to follow suit: the central bank has no choice but to substantially expand its asset purchases in the market.
What financial assets will the central bank decide to buy?
Sovereign debt seems an obvious candidate. But depending on the popularity of CBDC, the central bank may face a shortage of available collateral, forcing it to loosen the eligibility criteria for securities that qualify as collateral. This would further cement the central bank's stature as a major financial player in the marketplace, wielding significant power over investment decisions, and thus asset prices and funding costs. [6]
In addition to an unprecedented concentration of risk in a single institution, financial markets may become less efficient as a result of the permanent asset price distortion caused by central bank intervention. This would call into question the central bank's mandate, and, in the light of potentially unfair preferential treatment given to privileged actors or sectors, spark a discussion about the democratic legitimacy of an institution that mainly comprises unelected technocrats. The public may demand additional checks and balances.
The looming threat of digital banks runs
Let us finally consider the impact of CBDC in times of crisis.
A major concern of policymakers is that CBDC could exacerbate bank runs during panics. The ability to readily convert private bank deposits into risk-free public money could trigger a rush to safety (i.e. into CBDC) resulting in bank runs of unprecedented scale and speed. The risks to financial stability would be considerable: through a cascading effect, solvent commercial banks could fall like domino – one after the other.
This would result in deposit insurance funds being drained, calling for additional government support and intervention to prevent a complete meltdown of the system. To prevent this strain on public finances, the central bank may decide, at some point, to end the convertibility of bank money at par with CBDC. Commercial banks could continue to lend via private debt money creation, but lose the privilege of state-guaranteed parity via deposit insurance.
This would constitute the first step in what could be considered a gradual transition from private bank credit creation toward a narrow banking model where banks are eventually required to hold 100% reserves against their deposits. This scenario will be explored in more detail in the next post.
Footnotes
[1] For the sake of brevity, I pass over the implementation details here. The final arrangement (e.g. outsourced to private sector, entirely run and operated by the central bank, or some form of a public-private partnership) depends on the specific objectives and local circumstances.
[2] The new system needs to offer similar – or improved – levels of speed, cost-effectiveness, and convenience in order to gain acceptance in the market as a useful alternative to existing private networks. A recent CBDC test in Shenzhen, conducted by the People’s Bank of China (PBoC), provides a glimpse of the challenges associated with changing consumer behaviours and creating the right incentives to lure economic agents away from private offerings.
[3] True, the central bank also issues physical cash (currency in circulation). Logistics make this a rather unpractical and slow tool for quick monetary intervention, though.
[4] However, this seems unlikely as long as cash remains widely available and commercial banks continue offering non-negative deposit rates.
[5] This assumes that they will play no major role in the distribution of CBDC – an implementation detail.
[6] This is not to say that the central bank has not had a large footprint in financial markets before CBDC. The various quantitative easing (QE) programmes speak for themselves.