Can widely-used retail CBDC benefit the payment system and financial stability?
Major central banks, financial international organizations, and standard-setting bodies are figuring out how to safely issue a retail, general-purpose central bank digital currency (CBDC) without destroying the bank lending business model. Restricting its access and use is one of the proposed solutions. But, this effort and approach are pointless.
Central banks around the world are actively exploring the possibility of issuing their digital currencies because of their wide range of potential benefits, such as slashing transfer fees to near zero, giving people in remote rural areas an easier way to access financial services, and guarding against the looming threat posed by stablecoins.
However, many central banks are holding back, mainly because of the risks a locally-denominated retail digital currency can pose to bank lending. It would be unsurprising if this public digital money — even if it bears no interest unlike bank deposits — becomes more attractive to bank deposit holders because as it is a claim to the state, it certainly has zero risk of being in default. No amount of financial regulation and supervision as well as protection by state deposit guarantee schemes can eliminate the risks posed by holding assets in bank deposits.
Additionally, payments made with a retail CBDC will always be received promptly by sellers since central banks always have liquid assets to facilitate transactions. In other words, such public digital currency offers zero risk on liquidity and settlement finality.
Consequently, given confidence in a retail CBDC’s payment reliability, many households and businesses will likely convert some of their preexisting digital money at commercial banks into the central bank’s digital currency. This would squeeze bank liquidity and discourage banks from issuing new loans by creating money, thus jeopardizing the current bank lending business model.
In fact, in a January 2022 publication, the US Federal Reserve raised concerns over the potential impact of a retail CBDC, as a close substitute for commercial bank money, on the structure of the US financial system. Similarly, the Monetary Authority of Singapore’s managing director said in November 2021 that even in normal periods, a retail CBDC would reduce banks’ lending capacity.
Is there really a way for central banks to issue an official digital currency without ruining the current banking system as we know it?
Many major central banks, as well as the Bank for International Settlements and the International Monetary Fund, believe there is. By limiting the holding and use of retail CBDCs as well as issuing them as zero-interest assets (like banknotes), regulators are confident they can mitigate the risks posed to bank lending.
But, can restricting retail CBDCs safeguard bank lending?
Let’s see first how banks meet their depositors’ demand for retail CBDC.
As banks give new loans to households and firms by creating money credited into borrowers’ bank deposits, banks automatically create a maturity mismatch between the majority component of both their assets and liabilities. A maturity mismatch between loans and deposits: long-term, illiquid assets vs. short-term liabilities. Bank’s liquid assets are therefore much smaller than bank deposit liabilities. Of those liquid assets, banks still have to hold the ones for complying with the required liquidity coverage ratio — to ensure banks have sufficient high-quality liquid assets to fund cash outflows over 30 days. Banks in most countries are also obliged to hold low- or zero-yield required reserves amounting to only a small fraction of their deposits liabilities, known as a fractional reserve system. With those kinds of constraints, the remaining amount of liquid assets may highly likely be insufficient to satisfy that substitution demand.
Central banks can help banks to meet their depositors’ demands for general-purpose CBDC in normal times by creating additional bank reserve money, in the form of bank reserve accounts at the central bank, banknotes and coins stored in the bank’s vault, or wholesale CBDC — a tokenized reserve money. This expansionary monetary operation hopefully would provide banks with sufficient “excess reserves” that would be converted into retail CBDC while adhering to a liquidity coverage ratio and a required reserve ratio.
The central bank will most likely have to create additional bank reserves first — to allow all banks (banks in aggregate) to convert part of bank deposits into retail CBDCs — as banks typically minimize the opportunity cost of holding “excess reserves”. Banks individually can try to attract more deposits, for instance by raising deposit rates. However, in doing so the banks compete with each other for more deposits from the money already in circulation. It can be that money in bank deposit accounts just moves from one bank to another through the reserves accounts of individual banks, while bank reserves as a whole remain the same amount.
Unfortunately, the central bank’s ability to create additional reserve money through conventional monetary policy and operation is limited. In doing so central banks can only acquire the banks’ “residual” liquid assets — the liquid assets excluding the ones for complying with the required liquidity coverage ratio and the mandatory reserve ratio. In creating bank reserves, central banks usually lend money to commercial banks in the short term by purchasing government bonds from banks, with an agreement to resell the securities at a later date. The central bank can also outright purchase government bonds held by banks. In addition, banks can convert their other forms of assets placed in the central bank, such as the deposit facility, to reserves. They can also issue bonds to central banks, paid through bank reserves.
Besides applying this conventional monetary operation, central banks can utilize quantitative easing, thus increasing bank reserves, by purchasing financial assets, mainly government bonds, usually from non-bank financial institutions. However, implementing this unconventional monetary policy for meeting retail CBDC demand may unlikely be suitable with the essential purpose of this policy.
These are why retail CBDC poses a risk to bank liquidity, and consequently banks’ ability to issue loans by creating money. Even with limits on how much retail CBDCs people can hold and use, a number of depositors substituting their bank deposits with retail CBDCs can still lead to a bank’s liquidity shortage.
Another source of limitation in adding banks liquidity is stemmed from the monetary policy framework most central banks adopt. The monetary policy depends on the state of the economy. When a retail CBDC demand needs liquidity injection through conventional expansionary monetary operation or quantitative easing, the state of the economy at the time might, instead, require the central bank to raise interest rates, absorb liquidity, or do quantitative tightening. Thus, restricting retail CBDC’s holdings and usage is more useless in this case.
Overall, substituting bank deposits with retail CBDC could worsen bank liquidity, raise interest rates, and dampen loan supply, posing risks to the resilience and the proper function of the financial system to finance economic activities.
CBDCs need widespread adoption
While limiting the use of general-purpose CBDCs might be insufficient in safeguarding bank-lending functions, doing so also means that the primary objective of addressing challenges in payment systems — increasing competition, promoting innovation, and increasing access for the underserved — would likely remain unaccomplished.
The benefits of issuing retail digital central bank money are more likely to be achieved if it is designed for wide use by the public for small- and large-value transactions, and is interoperable with private-issued digital currencies. If retail CBDCs are widely used and interoperable, they would disrupt private-issued money — whether it be bank deposits, electronic money, or cryptocurrencies, including stablecoins. But this disruption should be welcomed. It will awaken banks, non-bank electronic money issuers, and other payment system providers to step up their game and find ways to coexist with public digital money, where they can thrive and keep their businesses viable.
If retail CBDCs are universally used, they can help unbanked and underbanked households and businesses to access digital payment services that banks and non-bank payment service providers may not be able to provide in a cost-effective and viable way. As central banks are better positioned to meet this gap in the market, retail CBDCs will expand access to necessary financial services, such as credit and other business financings, thus enhancing financial inclusion. Furthermore, as retail CBDCs become increasingly available to the unbanked and underbanked people through the central bank-financed interoperable infrastructure, the current payment system providers would eventually be able to offer this market segment more affordable and innovative payment services.
Having said that, this means that central banks should design a retail CBDC’s features and capabilities to allow it to compete freely with commercial bank digital money, electronic money, and even non-fiat digital currencies as means of low- and high-value payment. Therefore, a retail CBDC should be circulated “unrestrictedly”, that is, having a balance limit and transfer amount in line with those in all those types of digital money.
So, can widely-used retail CBDCs benefit both the payment system and financial stability?
If the risk posed to bank lending should not be addressed by restricting access to and use of retail CBDC, then what should central banks do?
In the face of disruptive technology, central banks need to be open to exploring alternatives for systems of bank reserves and models of bank lending that might allow retail CBDCs to operate and achieve their benefits without jeopardizing financial stability and economic growth. For instance, financial system authorities need to assess the feasibility of a full-reserve banking system in the CBDC era.
The risks retail CBDC poses to bank liquidity can be mitigated in a full-reserve banking system, where substituting bank deposits with retail CBDC is entirely fulfilled by bank reserves. However, banks would not be able to create money when lending, only lending out money they borrow or the shareholders’ money; they will become “narrow banks”.
This full-reserve system is actually already in use by issuers of electronic money and stablecoins anchored to fiat money. Electronic money is fully backed by what is called “float funds” stored as the issuers’ liquid assets, while fiat-backed stablecoins issuers usually promise to maintain liquid reserves equal to the stablecoin in circulation.
Indeed, this alternative bank reserves system and lending model does not operate without risks either. As migration to this framework is a structural, or even radical, change, it poses risks to financial stability as well, this would stem from the time the policy change is announced to its transition period. Besides, without the support of deep and liquid financial markets, this system also poses an upward risk to the bank’s funding cost and people’s borrowing cost, possibly slowing down credit growth.
Nevertheless, if central banks do want to achieve the full potential of a state digital currency, limiting its use is not the proper solution. Instead, financial system authorities should consider internationally coordinated policy reform that might be able to address the weaknesses in the banking system that make it vulnerable to disruptions from digital innovations. They should start initiating comprehensive and exhaustive policy discussions domestically and globally, involving relevant stakeholders.
