The Bitcoin of Central Banks?

Imagine a time when every trader is tugging at their collar and banks’ share prices are as steep as ski slopes. Constantly refreshing your online banking app, staring nervously at your savings, you wonder if transferring them to any other bank would be safer. Luckily, moving your funds into a central-bank digital currency (CBDC),  a virtual store of value issued by the government, will save your skin. Does this seem too good to be true?

That’s because it is.

This year more than 80% of central banks are studying the subject. Making payments easier and reducing the probability that cryptocurrencies replace government issued currency are a few of the advantages. Despite the claim that CBDCs would also incentivize users to run away from commercial banks in times of a recession or crisis, these would also be attractive to hold during “normal” times as well. Indeed, they could pay interest and be a tool of monetary policy, similar to today’s central bank-issued money.

The possibility of commercial banks being depleted of the deposits needed to fund their lending is a foreseeable consequence of CBDCs. This could result in a disintermediation of the banking system in which banks do not hold the loans on their balance sheet and sell them instead. This process of banking disintermediation would also make it impossible to procure redeemable deposits.

Limiting the amount of CBDC that can be held is an alternative put forth by the Bank of England and the European Central Bank. There has also been another idea from the Initiative for Cryptocurrencies and Contracts research group which is to rely on banks managing the public’s holdings of CBDCs. They also point out there is a potential loss of privacy as current privacy enhancing technologies are complex, and so a CBDC system will most likely expose sensitive information to its operators.

In any case, if individuals plump for CBDCs, the central bank can lend their funds, at the policy interest rate, to commercial banks. Thus, as pointed out by Markus Bunnermeier, “issuance of CBDC would simply render the central bank’s implicit lender-of-last-resort guarantee explicit.”  Although that might imply an unwanted government expansion, deposits are currently already concentrated in big banks, and households trust government-provided deposit insurance. Indeed, the deposit market is not quite a laissez-faire one.

Yet, a notable issue with the central bank funding banks is the risk of default, that is the probability a borrower will pay, in full, his debt obligation. Unlike policymakers, central banks are experienced in determining which loans and assets qualify when there is a crisis. To prevent moral hazard, it is a fair assumption only high quality assets will be accepted.

Another vulnerability is that any entrenched design mistakes as CBDCs will be a “technical experiment with significant risk of information-security failures.” With such structural changes it might also be challenging for regulators to address these financial novelties, and finding the just balance between government involvement, central-bank supervision and innovation.

All in all, banks are dispensable when it comes to lending and borrowing, and in the U.S., a high percentage of these activities occur in capital markets. An argument can be made that instead of stifling innovation, governments could explicitly subsidize bank credit. Evidently, this will not sit right with beneficiaries and regulators, and risks national opprobrium.

CBDCs can give rise to the idea, posing a risk for financial systems, that banks, as a whole, are unneeded. These forms of digital innovation are certainly going to disrupt our future, thus CBDCs have many risks that have to be dealt with before being implemented.