Investment Operations

HOW WOULD A CENTRAL BANK DIGITAL CURRENCY AFFECT FINANCIAL STABILITY?

CBDC OFR

A well-designed central bank digital currency may enhance rather than weaken financial stability, according to an OFR working paper released in July. As central banks consider whether the benefits of creating digital cash outweigh the risks, the paper finds that at least one risk—bank runs—is not as big as initially feared.

The Federal Reserve and other central banks worldwide are considering offering a new digital form of cash, often called central bank digital currency (CBDC). One concern raised repeatedly in policy discussions is that a CBDC could make runs on banks and other financial intermediaries more frequent or more severe. The idea is easy to understand – if depositors and other short-term creditors have the option to hold a safe, convenient CBDC, they may be quicker to pull funds out of financial institutions in periods of financial stress. In a new OFR working paper, Cyril Monnet and I study the effects of introducing CBDC into a model of financial crises and identify two countervailing effects.

Banks lower their maturity mismatch when depositors have access to CBDC, reducing their exposure to depositor runs.

Banks provide depositors with liquidity services, that is, the ability to withdraw funds and make payments as needed. They also issue loans and hold longer-term assets, which means their investments have a longer maturity than their liabilities. This mismatch makes banks susceptible to a run; if too many depositors request to withdraw at once, a bank may not have enough liquid assets on hand to meet these requests. A CBDC would also provide liquidity services to individuals and businesses. We use our model to show how having access to a CBDC would decrease depositors’ demand for liquidity services from banks. Banks respond to this lower demand by reducing the maturity mismatch on their balance sheets, which makes them less exposed to a run. In this way, the adjustments on bank balance sheets, in response to a CBDC, can have a stabilizing influence on the financial system.

The flow of funds into a CBDC provides policymakers with a new source of real-time information.

Policymakers’ ability to observe the flow of funds into a CBDC would provide real-time information about the financial system’s state and about depositors’ confidence in their banks. For example, in periods of financial stress, depositors and other creditors may withdraw their funding either to meet their own liquidity needs or as part of a run driven by concerns about a bank’s solvency. Monitoring the flows into CBDC would allow policymakers to infer more quickly when a run is underway and to place troubled banks into resolution sooner. Depositors anticipate this faster policy reaction, which decreases their incentive to join the run. In other words, by allowing a quicker policy reaction to a crisis, this information effect is another channel through which a CBDC may improve financial stability.

Our paper also highlights an important tradeoff policymakers would face in choosing the design features of a CBDC. Decisions about how CBDC balances are held and transferred, as well as any fees or interest payments on balances, will determine how attractive the CBDC is to users in normal times and in periods of stress. Design choices that make a CBDC attractive in normal times will lead to the largest decrease in banks’ maturity mismatch. However, heavy use of the CBDC in normal times makes it more difficult for policymakers to identify incipient runs or other problems quickly. A CBDC that is used less in normal times would have a smaller impact on banks’ maturity mismatch but would provide more precise signals in periods of financial stress. Policymakers must balance these competing concerns to design a CBDC that enhances rather than weakens financial stability.

This article was published by Todd Keister on the US Treasury’s Office of Financial Research blog on August 8, 2022.