Increasing CBDC Monetary Policy Impact

An important Central Bank Digital Currency (CBDC) topic is its impact on a central bank’s ability to implement monetary policy. A technical paper by the Bank for International Settlements (BIS) addresses this by examining the possible impact of paying interest on CBDCs and/or enabling CBDCs to compete with other payment methods in terms of their convenience of use ¹.

The research is based on the US financial system, which has the characteristics of having large excess reserves and the main monetary policy variable being interest rates.

The Federal Reserve sets interest rates on excess reserves held by banks. Since July 2021 this has been known as interest on reserve balances, but for the purposes of this paper it is referred to as Interest on Reserves Policy (IOR).

Bank size matters

In the US context bank size matters. When loans are made, the bank creates deposits. When the borrower spends the money, if the money is eventually deposited back with the same bank, then no reserves are transferred to other banks to settle the payment. The opportunity cost of making the loans is lower.

Four banks have 35% market share (Bank of America 11%, Chase 10%, Wells Fargo 10% and Citi 4%). The market share of deposits is both large and stable. In addition to a lower opportunity cost, these banks also offer their customers a service level that makes their lives easier, known as convenience in this paper. The banks will have large branch networks, ATM networks, better mobile apps etc.

As a result customers may choose convenience even if the interest rate paid on their deposits by these banks are lower than those of smaller banks.

This matters because both the opportunity cost and convenience benefit advantages of big banks affect how they respond to changes in IOR affecting the flow through of monetary policy.

The design of CBDCs

Central banks believe well designed CBDCs can help them fulfil their mandates, in particular by:

• Improving the financial system 

• Promoting financial inclusion

• Enhancing monetary policy transmission 

• Reducing systemic risk.

However, the paper starts with a quote from a 2016 speech given by the Deputy Governor of the Bank of England, Ben Broadbent, ‘If all a CBDC did was to substitute for cash – if it bore no interest and came without any of the extra services we get with bank accounts – people would probably still want to keep most of their money in commercial banks.’ 

While conceptually paying interest on CBDCs is straightforward to understand, convenience needs more explanation. Central banks believe CBDCs can offer a better quality of user interface, faster processing speeds, privacy (central banks have no profit motive) and access to markets.

In fact, the Banking Act for All in the US requires the design of Digital Dollar Wallets to include debit cards, online access accounts, automatic bill payment and mobile banking. There is a requirement for the CBDC to have convenience value and the 2020 European Central Bank paper on CBDCs assumes the same.

This ‘paying convenience’ may be more important to consumers than earning higher interest rates, and so the impact of both on banks and society, and their relationship with each other, needs to be understood.

The challenge

The interest rate pass through is far from complete in the US. Research shows that for every 100 basis points (BPS) that the Federal fund rate goes up, the spread between the Federal Fund rate and the deposit rate increases by 54 bps. This dilutes the impact of the monetary policy intention of the interest rate change.

In addition, if the IOR is low, large banks don’t respond, weakening the pass- through to deposit rates. Deposit rates can’t go below zero but when interest rates are low, large banks can set their deposit rates at zero. At this point they are no longer responsive to changes in the policy rate. Small banks cannot afford to do this. Large banks leave their rate at zero until the rate rises to a level where the zero lower bound on deposit rates is no longer binding.

When IOR is set at higher levels, the lower rate is not binding. At this point all banks tend to adjust their deposit rates in response to changes in IOR.

Impact of CBDC interest rates

If a CBDC has an interest rate and this is increased, it can lead to an increase in deposit rates. This can have the effect of increasing inequality in the market shares between large and small banks, both in deposit and lending markets. It can reduce the responsiveness of deposit rates to changes in the IOR rate.

The paper modelled increasing a CBDC interest rate while holding the IOR rate and the CBDC convenience rate unchanged. The impact would be to raise deposit rates of both large and small banks, bringing their weighted average closer to the IOR rate.

If the CBDC rate is equal to the interest rate, there would be full flow through of monetary policy.

However, this may make it harder for small banks to compete with large banks since they would be less able to offer higher deposit rates. The result would be to reduce their market share.

Impact of changing CBDC convenience value

If convenience can be increased to sufficiently high levels, it can increase deposit rates, cause market shares to converge and can increase the responsiveness of deposit rates to changes in the IOR rate.

If the central bank increased the convenience value of the CBDC while holding the IOR rate and the CBDC rate steady, this weakens the market power of the large banks, narrowing the gap between large and small banks. At this point, smaller banks can afford to offer deposit rates closer to those of the big banks.

However, eventually the big banks will respond by increasing their rates so that they compete with the smaller banks. This will raise the average deposit rate.

The IOR pass through increases with higher CBDC convenience and reduces with lower convenience.

Final word

Each country is different, but this paper demonstrates an useful approach to modelling and understanding the impact of design decisions for a CBDC. Many priorities need balancing, but effective monetary policy implementation must be at the top, or nearly at the top, for all central banks.

1 - BIS Working Papers No 1046: ‘The case for convenience: how CBDC design choices impact monetary policy pass-through.’ Rodney Garratt, Jiaheng Yu, Haoxiang Zhu