The Usefulness of CBDCs

Two recent pieces address the usefulness and role of CBDCs.

One explores the theoretical benefits of a CBDC in a high inflation environment, the other the impact of a CBDC if a loss of confidence in the banking system leads to a run on the banks.

Controlling inflation with CBDCs

The Observer Research Foundation has looked at the possible role of CBDCs in containing inflation. It argues that data generated from CBDC transactions can be linked to strict reserve requirements for commercial banks providing, at least in theory, a framework for controlling inflation.

The traditional approach to limiting inflation is to raise interest rates swiftly and decisively to reduce demand and bring demand and supply back into equilibrium.

Consumer Price Index (CPI) reports are usually based on market participants reporting to the central bank on assets and liabilities. Issues with this include the data being out of date, incomplete or inaccurate. Access to data from CBDCs would provide economists with near real time information on balances held at financial institutions, and metadata on what is being spent where. This would allow much more granular and useful CPI measurement.

The digital character of a CBDC allows central banks to implement customisable reserve requirements on banks, directly limiting their ability to create money. This approach could shift the money multiplier from its customary position of more than one, as observed in fractional-reserve systems, to a level of one or close to one.

In the real world, the Director of Argentina’s central bank has supported the concept of a digital peso as a way to achieve currency stability, a perennial issue for the country, and to increase the taxable base.

The impact of CBDCs in a banking crisis

There is a difference between a bank running out of money and a bank being insolvent. A new paper looks at what can happen if there is a run on the bank if there is an interest bearing CBDC ¹. The existence of a CBDC reduces the net worth of a bank but, should a crisis occur, mitigates the risk of a bank run.

The paper found that how CBDCs are presented on central bank balance sheets makes a difference. If the issuance of a CBDC is offset by asset purchases, then a CBDC delays the onset of both illiquidity and insolvency when large shocks occur. If CBDC issuance is offset by loans to banks, then illiquidity is delayed but insolvency is only marginally affected.

In the dynamic model used, the economy consists of households, banks, and a central bank which issues CBDC following an interest-rate rule. As a proxy for the firm sector, capital is modelled as a productive technology yielding a return each period that is subject to aggregate shocks. Households place their savings in CBDC, bank deposits, or capital.

In an economy without a CBDC, if a sufficiently large shock hits the economy, a bank run can affect the entire banking system. Bank failures due to illiquidity can emerge if households withdraw their deposits because they believe that other agents will run, leading to a bank run triggered by self-fulfilling beliefs. If the shocks become even larger, at a certain point only the bank run equilibrium remains and banks fail due to insolvency.

This paper examines two CBDC issuing policy scenarios: in the first policy scenario, the central bank offsets CBDC issuance by lending to banks (‘credit policy’); in the second policy scenario, the central bank offsets CBDC issuance by investing in the productive technology itself (‘asset policy’). Both policy scenarios would lead to an increase in the central bank balance sheet and are contrasted to the economy without a CBDC.

The four findings of the modelling were:

• In the steady state, a CBDC does not majorly affect aggregate output and prices, but it does affect the composition of household savings, bank funding and capital investment, leading to a reduction in bank profits.

• Both CBDC policy scenarios tend to have a small but stabilising influence in a crisis that does not trigger a bank run.

• These stabilising effects become more important in a bank run situation: both CBDC policy scenarios improve financial stability by postponing the emergence of bank runs due to larger shocks.

• The impact of a CBDC depends on the accompanying central bank balance sheet adjustments; CBDC issuance with ‘asset policy’ delays the onset of both types of bank failures to larger shocks. CBDC issuance with ‘credit policy’ substantially impedes failures due to illiquidity but has little impact bank failures due to insolvency.

This occurs because CBDC issuance will increase the size of the central bank balance sheet if CBDC issuance is not fully offset by a reduction in excess reserves or cash. A move to CBDCs flows back into the economy, either via credit to banks or direct capital purchases. This reduces the burden on households and increases the efficiency and the price of capital. These central bank interventions that channel the CBDC inflows back into the economy slow the financial accelerator dynamics and make the occurrence of bank runs more difficult, ultimately postponing their occurrence to larger shocks.

Naturally, the central bank can take measures independent of CBDC issuance to improve financial stability and to avert systemic runs. The main insight of this model analysis is that in a bank run situation inflow into CBDCs, instead of inflows into other less efficient assets, are aligned with financial stability measures and do not exacerbate bank run risks.

In a bank run situation, households do not withdraw deposits because they like CBDC but because they are concerned about

the safety of their deposits. By providing them with a safe and more efficient option to run into, the issuance of CBDC mitigates losses in a bank run scenario, stabilising capital prices and making runs less likely from the outset.

Overall, therefore, while CBDC issuance strains the banking sector in steady state by reducing deposits and net worth, it improves financial stability in times of crisis by impeding the emergence of bank runs.

1 - Banking Crises under a Central Bank Digital Currency (CBDC). Lea Bitter. Technische Universität Berlin