So, what are the possible detrimental effects of a CBDC on the traditional financial system, specifically bank runs, if a Central Bank Digital Currency (CBDC) were to be implemented?
A concern of many commentators is whether implementing a CBDC will have a negative effect on the current banking system, specifically whether it will trigger a run on the banks. Under benign conditions, the central banks see CBDCs as a concern due to the ease with which one can move into them from other asset classes. But, during a crisis, CBDCs are touted as a safe haven to which one can turn for security and stability.
This is one of its selling points.
Bank Deposits Are Riskier in Times of Crisis
The thinking behind this is that bank deposits, especially uninsured bank deposits, would be perceived as riskier in a time of crisis, resulting in people moving into central bank currencies rather than leaving their money on deposit.
Under those circumstances, the question is, what would happen to the underlying financial system? The ease with which funds can flow into CBDCs increases the risk of a run on the banks. This is obviously dependent on the legal and operational constraints in place at the banks and any other financial service providers.
Financial Crises Cause Huge Losses of Liquidity
Based on a series of papers from the central banks and the Bank of International Settlements (BIS), we have the example of a financial crisis in Japan in the late 1990s. The data suggests that the outflow of funds from Japanese banks after the announcement of the crisis was over 10%. After a month, that figure rose to an amount in excess of 30%. However, looking at the graphs and data, one can see that the outflows appear to be greater than what they appear to be in the aggregate totals referred to in the text.
So the situation appears, on closer inspection, to be worse than the discussion document initially reveals.
This mirrors the extent of the Greek example relating to Grexit, where bank deposits fell more than 30% following the initial crisis in the period from 2010-2012 and then around 25% again between 2014 and 2016.
The value of deposits, that is overnight deposits, notice deposits, cash deposits, and cash declined from a high of €200,000 million in 2009 to €130,000 million in 2020. There was a slight increase in overnight deposits, with cash remaining relatively stable. This gives the impression that CBDCs could be a substitute for investments and low-risk assets such as money market funds and treasury bills. This leads to abrupt changes in their funding, which is where it could potentially destroy the system.
Taking liquidity out of the treasury or money markets, in general, is the same as when the repo rate spikes, resulting in a liquidity freeze and the whole market falls apart, immediately. This is similar to the situation in 2007 when the sub-prime disaster hit. It wasn’t only the high-risk loans that caused the banking system to get into trouble.
CBDCs Are An Attractive Alternative To Cash And Cash Substitutes
With CBDCs being an attractive alternative for risk-averse holders of other cash substitutes, even under benign conditions, demand can be constrained if CBDCs are restricted to retail use. This gets to the crux of the matter, as to whom will be allowed to hold CBDCs.
The discussion paper talks extensively about who should be allowed to have access to CBDCs and to what purpose they will be put. Whether CBDCs can be used by businesses or individuals for payment purposes or whether they could be used for investment purposes. And this is where the problem of bank runs comes in if the CBDC can be used for investment purposes. In other words, if it has some form of interest-bearing characteristic.
If CBDC bears interest in and of itself or through the mechanism of financial engineering, it produces profit in some form, it begs the question of whether you can create derivatives of it. And this is where people can view it as a better alternative to having money in the bank, with the outflows of deposits producing these effects on the financial system, as a whole.
Reallocating Funds into Treasuries
This scenario played out in the GFC and with the onset of the pandemic showing the increased risk of runs by non-banks under stressed conditions. CBDCs will affect the run dynamics in the prime money market funds by offering an alternative safe haven rather than reallocating funds into government money i.e. treasuries.
Where this impact is felt is in the calculation of interest rates such as LIBOR. Without sufficient underlying transaction volume, it is not possible to calculate the rates accurately and level three expert submissions are required for the mostly non-USD rates.
LIBOR serves as the benchmark interest rate which determines short-term interest rates. However, with the underlying market becoming illiquid, panel banks must submit level 3 submissions based on an assessment of borrowing rates. The system is open to manipulation and a lack of trade volume. This is the reason that LIBOR is being phased out in 2023 in favor of the secured overnight financing rate (SOFR). For more on SOFR (click HERE) and on LIBOR and its scandal (HERE).
So, the financial system is susceptible to major movements of liquid assets into CBDCs at times of crisis which could, in fact, cause damage to the banking system unless carefully controlled and managed.
For more on Central Bank Digital Currencies
References
[1] Group of Central Banks, Central bank digital currencies: financial stability implications, September 2021. https://www.bis.org/publ/othp42_fin_stab.pdf
