28 October 2021

SUERF: The one trillion euro CBDC: Issuing a digital euro without disrupting the bank lending channel

Introducing a general-purpose Central Bank Digital Currency (CBDC) carries the risk of bank disintermediation, potentially jeopardizing financial stability and monetary policy transmission through the bank lending channel.

Nonetheless, a digital euro could be issued on a large scale without leading to bank disintermediation or a credit crunch, subject to two conditions. First, the central bank would require proper mechanisms to manage the volume and the user cost of CBDC in circulation. Second, the central bank should continue to facilitate access to its long-term lending facilities, to maintain a bank funding source alternative to retail deposits at an equivalent cost. Depending on its design, a digital euro could improve bank profitability by absorbing large amounts of idle (and expensive) excess reserves without penalizing lending. A digital euro could also strengthen banks’ competitive position relative to non-bank lenders and encourage bank digitalization.

The conditions for a smooth introduction of the digital euro

In July 2021 the ECB Governing Council launched a two-year investigation phase of a digital euro project. A digital euro would be an electronic form of central bank money offered by the Eurosystem to citizens and firms for their retail transactions, complementing the existence of cash and central bank deposits. The Eurosystem has identified several reasons to supply a digital euro, such as providing a safe and trustworthy form of digital money (as opposed to risky cryptocurrencies and other similar private monies) or an alternative to foreign payment providers in Europe. A digital euro could also offer a contingency solution if physical cash declined significantly or non-EU digital money were to largely displace payments in euro (ECB, 2020).

However, like for other CBDCs, introducing a digital euro could lead to bank disintermediation, threatening financial stability and monetary policy transmission through the bank lending channel. If central banks allowed private individuals and firms to exchange a substantial share of their bank deposits for retail CBDC in real time, this might facilitate bank runs. Even in normal times, commercial banks could be deprived of an important source of cheap funding, inducing them to reduce their lending and shrink their balance sheets, with negative repercussions on economic activity and output.

A recent BcL Working Paper examines this issue by means of a realistic and comprehensive model exploring the impact on banks from the introduction of a digital euro (or €-CBDC)2. By adapting the analytical framework of Dutkowsky and VanHoose (2018, 2020) to the euro area to model the €-CBDC introduction as an exogenous shock affecting bank deposits, the BcL study clarifies two conditions that are required to avoid triggering bank disintermediation or a credit crunch.

Condition #1: Ability to control €-CBDC volumes

First, the central bank would require proper mechanisms to manage the volume of digital euros in circulation. This would be crucial to limit future shocks on bank deposits. Moreover, this would allow the central bank to better calibrate its monetary policy stance: e.g., by reabsorbing a large fraction of excess reserves that, in the current juncture, may become unnecessary for the effectiveness of unconventional monetary policies. The theoretical analysis confirms that banks with sufficient excess reserves to cover client deposits shifting to €-CBDC could increase their profitability proportionately, without a negative impact on their lending. Since the overall volume of excess liquidity as of September 2021 totals 4.4 trillion euro, a conservative back-of-the-envelope estimation calibrated on pre-pandemic conditions suggests that slightly more than one trillion euros could be issued as €-CBDC. This amount would represent less than 25 percent of euro area banks’ excess liquidity, but roughly the same as the maximum market capitalization of Bitcoin until today (22/10/2021)....

more at  SUERF

© SUERF