Central bank digital currencies could improve financial stability, say academics

In a report (33-page / 401KB PDF) for the European Parliament's Committee on Economic and Monetary Affairs, researchers from the Kiel Institute for the World Economy backed the "disruptive" influence the introduction of a central bank digital currency (CBDC) could have, and highlighted the impact the measure could have on the business models of commercial banks.

"Overall, a digital currency issued by a central bank can be disruptive and bears a challenge to the fractional reserve system," the report said. "The current banking system, based on fractional reserves, would be challenged at its core, as soon as market participants increasingly held liquidity in the form of the new digital currency instead of bank deposits. To avoid recurrent instability of the banking system, commercial banks would probably be required to come up with more reliable funding sources to replace deposits."

"As the fractional reserve character of the current banking system can be a major source of instability, such a disruptive change due to the introduction of a CBDC is not necessarily a bad development, but instead could finally pave the way for a more stable financial system," it said.

The researchers warned that if holding and transferring money on CBDC accounts was "convenient, safe and frictionless", commercial banks are likely to lose customer deposits, which could spark an effect similar to a bank run.

"If a substantial share of depositors transferred their money to CBDC accounts, the fractional reserve banking system would be challenged at its core," the report said. "A sudden transfer of bank deposits to CBDC accounts would impact the financial sector like a bank run."

"In order to withdraw money from a bank, people would not even have to line up in front of ATMs. Instead, liquidity could be conveniently transferred via online banking platforms from the bank account to the CBDC account. Nevertheless, the impact on the balance sheet of that bank would be the same as during a bank run, with liquidity flowing out at an alarming rate. Banks would have to replace withdrawn liquidity with new means of (re)financing, for example by selling assets. In the end, the central bank would probably be required to provide sufficient liquidity," it said.

Commercial banks would be likely to react to the introduction of a CBDC by "charging higher fees for financial services … to make up for the loss of revenue from money creation", which central banks would assume control of, and their role in the lending market is likely to be "limited to credit intermediation", according to the report.

The researchers said that a CBDC could encourage a shift towards a cashless society, but said the introduction of a CBDC is unlikely to coincide with the immediate abolishment of cash in the financial system.

They said: "Cash plays an important role in the life-long experience and payment habits of most people, and many businesses still rely on cash as a main or only accepted means of payment. Moreover, cash payments do not leave a digital trace, nor can cash stocks effectively be controlled by government institutions. Therefore, availability of cash is desirable for criminals and tax evaders but can also be regarded as institutionalised freedom from government influence and control that many people would certainly prefer to maintain."

"Finally, it would require a political majority to legally abolish cash, which so far appears to be well out of reach. Any attempt to abolish cash would certainly face strong political resistance. Therefore, a more likely path to a cashless society would start with introducing a CBDC as a complement while cash is still available, so that people get used to the new and convenient means of transaction. In a more distant future, once digital payments were accepted almost everywhere, the government could actually consider abolishing cash entirely," they said.

Banking expert Tony Anderson of Pinsent Masons, the law firm behind Out-Law.com, said: "These arguments have been raised before concerning the possibility of bank runs if central banks issue digital currencies – most recently by the Bank for International Settlements in March. Currently commercial banks are susceptible to online withdrawals to other banks without the introduction of a CBDC, so this is not a new risk."

"Whilst having a CBDC pegged to a fiat currency deals with the issue of volatility currently seen with digital currencies such as bitcoin, if commercial banks themselves were to issue stablecoins instead of central banks, the risk of runs on such banks alluded to may also diminish," he said.

Anderson said that Japanese bank, Mitsubishi UFJ Financial Group, has already announced its intention to issue its own stablecoin pegged to the Japanese yen in 2019.

"As for digital currencies replacing cash, it is interesting to note that the Japanese population is currently one of the highest users of cash which may be part of the attraction to a digital currency," Anderson said. "Other countries such as Sweden which has little remaining use for physical cash, may not be attracted to a digital currency pegged to fiat. Identifying the advantages this would present over existing online payment methods may prove difficult to enunciate to Swedish consumers."