March 14, 2023

Digital Pounds - Part 3: Financial Stability

HMT and BoE recently launched a consultation on their proposal to introduce a Central Bank Digital Currency, the Digital Pound. Parts 1 and 2 of this series explore the case in favour of implementation. This post considers one of the key risks. 

The Effect On Bank Balances Sheets And Business Models

The paper’s discussion of this risk can be summarised as: possible impacts in both directions with risks which will be mitigated. The features which make such a CBDC uniquely dangerous, however, are barely covered. 

First amongst them is the risk during bank runs. At present there are two key sources of friction which prevent customers withdrawing too much cash at times of crisis. (1) ATMs run out of bank notes and (2) bank branches shut. The physical and time-limited nature of cash reduces how much any individual can move in one go. Just as consumers look to withdraw cash, corporations do similarly, up to any limit permitted and with potentially devastating consequences. With a CBDC all such limits — in a bank run, decidedly helpful limits — are removed. Of course, in a time of crisis they can be introduced, but doing so would be equivalent to announcing that one or more banks was at risk of failure, further contributing to a crisis of confidence. 

The recent failure of Silicon Valley Bank showed, in particular, the value of weekends to financial stability regulators — Friday evening to Monday morning provided an uninterrupted 60 hour period in which to find a resolution and prevent bank runs spreading to further financial institutions. If a CBDC alternative had been available over the weekend it is extremely likely that depositors would have withdrawn savings from many other banks during the period, threatening their stability and causing the contagion to spread. The current system provides a circuit breaker which a 24/7 CBDC removes. 

It may seem that electronic transfers between banks have the same risk, but there are two key differences. First, the banks involved have several hours or days in which to settle the transaction, allowing time to secure outside funding. Secondly, for individual transfers, the money stays within the commercial banking system. With a CBDC, as with withdrawals to cash, money is pulled from the system as a whole, risking not just one but multiple banks. 

With a CBDC the default expectation is of 24/7 and unlimited withdrawals (up to the suggested maximum of £20,000 per account). How exactly are banks supposed to manage their financing to facilitate this with wholesale markets that are open a fraction of this time? Will the BoE be willing to act as an out of hours lender of last resort, even when the banks involved are not able to convert illiquid assets into valid collateral at the same moment? 

The NY Federal Reserve — seemingly under direction from the Federal Reserve Board — faced similar questions when The Narrow Bank (TNB) applied for a Master Account. TNB proposed to keep all customer deposits as reserves, effectively creating an intermediated CBDC. In a move that was upheld in Federal court, the NY Fed refrained from making a decision for several years in order to prevent TNB from operating, citing fears regarding financial stability. Even when TNB offered to grow their balance sheet only slowly their account was not approved. All the same challenges would seem to apply to a BoE originated CBDC and yet the NY Fed’s analysis, or even the existence of the case, is lacking from the consultation despite being a close analogue. 

A secondary impact on retail bank finances is more long term. At present, most banks offer free current accounts. For children and students banks often include incentives such as railcards or cashback too. The reason for these loss leaders is simple: people rarely switch their current account, so by winning business young the banks place themselves to win long-term, profitable lending business later on. It seems likely that, if the Digital Pound is introduced, a basic wallet with a potentially non-bank provider will be sufficient for a large number of customers. In such a case will the banks continue to provide free current accounts? And will their relationships with a large segment of society be lost, even after years of financial inclusion efforts to build them. 

This is Part 3 of a submission in response to HMT’s and BoE’s public consultation. To continue reading Part 4 click here. The further parts are available here.

 

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