Understanding the Impact of Retail CBDCs on Banking

In the last few years, the number of papers written about CDDCs has exploded as the world’s central banks rush to think about and investigate them. The Bank of Canada (BOC) has carried out a literature review focusing in particular on the potential impact of introducing a CBDC on private banks, which it has published as a staff discussion paper ¹. As part of this work, it has also identified some key research gaps where further work is needed.

The role of banks is threefold – to provide payment services, to lend and to enable liquidity and maturity transformation.

Banks lend money for investment in long- term illiquid projects by issuing short-term liquid deposits to consumers. They use these for transactions. Banks fill the role of liquidity transformers for the economy. The question is whether, or to what extent, might a CBDC disrupt this.

The paper suggests that more work is needed to study CBDCs through the lens of industrial organisation, exploring issues such as platform competition and business models. It also wants more work to be done looking at the crypto space and its new developments such as stablecoins and decentralised finance. How will CBDCs interact with and affect these?

CBDC design choices

What does the relationship between central banks and the retail public look like in the future? How should central banks plan for it? A retail CBDC is defined by BOC as being accessible to the majority of consumers for general payments. In that context, there are three main design choices that have to be made: 

• How should the public access CBDCs? One part of this is whether holders of CBDCs should be identified or not.

• What should be the architecture of the system? Should it be issued and managed by the central bank or through intermediaries?

• Should the CBDC have a rate of remuneration? Should it pay interest?

Impact on traditional banking

The literature review addresses three main areas where a CBDC is likely to affect banks.

1. Impact on bank deposits

If the public holds cash, then that money is not deposited in bank accounts and is not available for banks to use to create money to lend. Similarly, if the public hold CBDCs then they won’t be available for banks to use to create credit for lending. The literature concentrates, therefore, on estimating what will be the demand for CBDCs.

The two approaches used are (1) direct surveys asking people and organisations whether they would hold and use a hypothetical CBDC, and (2) to build structural models to estimate demand. These models have to assume the functionality of the CBDC being offered. Current research suggests a high demand for CBDCs, but the level of demand is determined by the assumed design characteristics. The range of demand is from 4% to 52%.

2. Impact on lending

The first question is about whether the existence of CBDCs will change the funding costs of banks. If a CBDC is interest bearing it will act as a substitute for bank deposits. The literature finds that even if a CBDC is non-interest bearing, it would also have an impact. But these findings leave out the effects of the banking system’s market structure as well as the general equilibrium effect.

In a competitive banking sector, if a CBDC pays a rate of interest that is greater than the equilibrium rate, then people will prefer to hold CBDCs, reducing the funds available to banks and therefore reducing the availability of credit.

In an oligopolistic banking sector, it could actually increase lending. As an outside option for depositors, banks would increase interest rates on those deposits it does have, resulting in attracting more funds and therefore enabling more lending.

General equilibrium theory says an interest bearing CBDC would increase demand for goods. Consumers would receive interest for their deposits which they would spend on goods. The increased demand would also lead to an increased demand for loans to finance production of those goods.

3. Impact on liquidity and maturity transformation

The creation of short-term liquid liabilities by banks which they use to finance investments in illiquid assets creates the possibility of bank runs. Research suggests that CBDCs could increase both the likelihood of a bank run and make it happen faster. Because a CBDC is easier to access and to move than cash, consumers are more likely to move their money.

Researchers have, though, put considerable thought into how this could be mitigated. Four mitigations were covered: 

• CBDCs could provide an alternative means for digital deposits

• While CBDCs may make withdrawals easier, they will also make them easier to spot and to spot early. That could also make them easier to manage 

• It should be possible to design bank deposit contracts that stop bank runs

• CBDCs can be co-ordinated with proper central bank asset-side policies to mitigate runs.

All of these focus on traditional tools and the BOC paper sees the need for further research.

New research on market structures

BOC is keen that the impact of CBDCs on market structures should be studied through the lens of industrial organisation (IO).

In particular, it wants work on the business models of payment service providers and the payment business of banks. For example, will the traditional product bundle of banks be disrupted, weakening the economies of scope that they currently enjoy, particularly deposit and payment services?

New research on crypto and stablecoins

The key questions that need addressing are how will CBDCs interact with cryptocurrencies, stablecoins and decentralised finance? New regulations are being introduced to manage all of these, but how will CBDCs work with these regulations?

A slightly separate question is whether, and how, will CBDCs support programmability?

Final word

There is a wealth of detail in the paper but for those short of time, it offers a good alternative to reading the original literature.

More work is needed on estimating the demand for CBDCs, evaluating the possible quantitative impact on bank deposits and loans, which bank run mitigations offer the most potential, the best market structure for the fast-evolving payment systems and new developments in the crypto space, and a holistic welfare assessment to evaluate different trade-offs and inform policy decisions around CBDCs.

1 - Central Bank Digital Currencies and Banking: Literature Review and New Questions (bankofcanada.ca).