JOHN WHITTAKER, LANCASTER UNIVERSITY – WRITTEN EVIDENCE (CDC0012)

 

CENTRAL BANK DIGITAL CURRENCIES INQUIRY

 

I am an economist at Lancaster University, specialising in monetary policy, banking and financial markets, and central bank operations.

 

Preamble

1.              The type of CBDC considered is that discussed by the Bank of England (2020, section 3.1)[1]. The Bank accepts unlimited sterling-denominated retail deposits from UK residents; and it processes payments between these CBDC accounts, and between CBDC accounts and accounts at the commercial banks, either directly or indirectly through ‘payment interface providers’. The Bank of England will continue to issue cash (banknotes) on demand. I am not here concerned with the technology and procedures for accounting and payments, nor whether the CBDC is account-based or token-based, nor any advantages that may arise if the BoE were to accept foreign deposits or coordinate with other central banks.

2.              Of the questions listed in the call for evidence, I address question 5 and, briefly, question 7, with my main conclusions as follows:

Question 5. What effects might a CBDC have on the financial sector?

Having embarked on a CBDC, the Bank of England is faced with unpalatable choices about how to use the funds received in payment: does it buy government debt, or corporate debt, or offer to recycle the funds back to the banks? Depending on its decisions, riskier borrowers from banks may face higher interest rates, possibly negating any benefit from greater payments efficiency.

Question 7. How might a CBDC affect monetary policy?

The presence of CBDC would not impair the Bank of England’s ability to apply monetary policy.

Abbreviations: in the following, the Bank of England is ‘BoE’ and commercial banks are ‘banks’.

 

Question 5. What effects might a CBDC have on the financial sector?

3.              How much demand will there be for a CBDC? The attractiveness of CBDC will depend on the convenience and the form of transactions arrangements, also whether the CBDC pays interest and, if so, at what rate. If CBDC bears interest at a rate close to Bank Rate and if the BoE’s charges for processing retail transactions are small, there could be substantial migration of deposits from banks to the BoE. In its modelling, the BoE (2021, section 3.1)[2] considers an ‘illustrative scenario’ in which 20% of sterling deposits move, based on the current value of banks’ non-interest bearing deposits.[3] This amounts to about £700bn, but the actual movement could be larger and, as often stressed[4], it could rise suddenly if there is a crisis of confidence in the banking sector.

4.              Initially, the flow of funds into the BoE from the banks will be balanced by an equal reduction in bank reserves – the deposits of the banks at the BoE. However, this reduction is limited by the banks’ liquidity requirements. At present the banks’ LCRs (Liquidity Coverage Ratios) are well above the required 100%, thanks to the reserves created to fund the BoE’s asset purchases, so they could afford some reduction, subject to the cost of replacing reserves by borrowing from the BoE, should this become necessary.

5.              Suppose, then, that the banks would be content to see a fall in their combined reserves of £200bn. If the total of CBDC is £700bn, the remaining inflow into the BoE is £500bn. The key decision for the BoE is then how to dispose of these funds, and there are three options: it can provide finance to the government, the banks or the non-bank private sector. In practical terms, the BoE can buy government debt, or it can recycle the funds back to the banks – which requires a decision about the terms of such lending – or it can buy corporate debt. All of these options are unpalatable; I consider them in turn, and their possible effect on the banks.

disposal by the BoE of £700bn of deposits received as payment for CBDC

£200bn

reduction of bank reserves

 

purchase of government debt

£500bn

lending to banks

 

purchase of corporate debt

 

What will the BoE do with the funds accruing from its CBDC issue?

6.              (a) the BoE could buy more UK government debt, which would be equivalent to further quantitative easing (QE), but financed by its issuance of CBDC instead of by bank reserves. On banks’ balance sheets, the short-term deposits withdrawn to buy CBDC would be replaced by deposits from the sellers of government debt (e.g. pension funds and insurance companies) as they receive payment.

7.              Thus the movement of bank deposits to the BoE would not deprive the banks of funds. However, the new deposits would likely be exchanged for longer-term claims on the banks such as term deposits or debt securities bearing higher interest rates. This may, in turn, cause the banks to raise their lending rates, particularly for their higher-risk borrowers, who may thus be inclined to seek credit outside the formal banking sector.[5]

8.              However, the BoE already possesses about £850bn or 32% of all outstanding government debt, purchased under earlier and current QE programmes; the scope for further purchases is limited by the availability in the market of conventional bonds of suitable maturity. More important, the BoE expects imminently to begin tightening monetary policy, implying a reversal of QE rather than a large increase, so this option (a) is unlikely to find favour.

9.              (b) the BoE could lend the CBDC funds back to the banks. This would be a new, routine procedure, distinct from the BoE’s lender-of-last-resort facility (the ‘discount window’), at an interest rate close to Bank Rate.[6] The BoE (2020, section 5.2)[7] recognises this possible outcome, stating that a large scale CBDC “would require banks to seek to borrow significantly more from the Bank of England”.

10.              Yet, while the banks’ capacity for retail lending would be undiminished, the BoE would require collateral security against its lending to the banks. The banks would therefore need to reflect the BoE’s aversion to risk by adjusting their assets in favour of high quality debt and/or low-risk lending.[8] As in option (a), some of the banks’ existing higher-risk borrowers would find themselves paying a higher rate of interest or no longer able to borrow.

11.              (c) the BoE could use its new funds to buy corporate debt[9]. This would cause much the same changes in banks’ balance sheets and the same conclusions as option (a). The problem with this option is that any purchase of private debt, or indeed direct lending by the BoE to the private sector, gives an advantage to the debt issuer or borrower. Without dwelling on the wisdom of the BoE making decisions about which companies are so favoured, its choices would again be inclined towards low risk. Finance for higher-risk borrowers would continue to rely on the banks and/or private debt markets, with the same implications for borrowing rates as options (a) and (b) above.

The higher cost of finance may negate any advantages from CBDC

12.              The main motivation for CBDC is its potential for improving the efficiency of the retail payments system and/or reducing its cost, prompted, in part, by the rise of new private digital moneys such as stablecoins. However, a prevalent view[10] is that, at least as regards domestic payments, there is little to be gained. Given competition amongst banks and other payments service providers, the CBDC offers limited scope to bring improvements that cannot be achieved by other means.

13.              The decision over whether the BoE should implement CBDC thus presents a trade-off: a doubtful improvement in payments efficiency at the cost of potentially more expensive retail borrowing.

14.              This raises the question as to whether it would be possible to gain some benefit to payments while minimising the disruption of the banks, by limiting the scale of CBDC. This might be achieved by a lower interest reward for CBDC or higher transaction charges, or there could be a fixed maximum per holder.[11] The problem with this argument is that, if there is any payments system improvement to be had, this will rely on a ‘network effect’: there needs to be enough CBDC holders that a significant proportion of all retail transactions is between their CBDC accounts.

15.              All this suggests that it may be hard to improve on the current arrangement in which the ‘money’ that we mainly use for payments is bank deposits which the banks create by granting loans.

 

Question 7. How might a CBDC affect monetary policy?

16.              The BoE’s main monetary policy instrument is the interest rate paid to the banks for their deposits of reserves, i.e. Bank Rate, currently 0.1%. Given that the banks currently have large stocks of reserves – acquired as a result of the BoE’s asset purchases – Bank Rate is their marginal opportunity-cost of short term funding, and this drives their choices of short-term retail lending and deposit rates. Even after the CBDC has caused the banks to lose a portion of their reserves as discussed above, the LCD rules ensure that there will remain enough reserves to maintain the connection between Bank Rate and retail rates, although the margins between these rates will be adjusted, with some lending rates moving higher as discussed.

17.              With the introduction of a CBDC, the BoE would have an additional choice, over the interest rate to pay on the CBDC. But this is not an additional instrument of monetary policy.

18.              The interest rate on CBDC would never be set higher than Bank Rate. If it were, the banks would shift all their reserves into CBDC, either directly if this was permitted, or through some intermediary that had a CBDC account. The CBDC rate must therefore be set equal to or below Bank Rate; thus Bank Rate remains as the BoE’s monetary instrument, with the transmission to the banks’ retail rates as already described. The relevance of the CBDC rate is in its influence on the attractiveness of CBDC (paragraph 3, above), and in its effect on BoE profits.

19.              The other instrument of monetary policy which has been much used in recent years is the BoE’s asset purchases. Quantitative easing, QE, is believed mainly to exert stimulus by reducing market yields. This channel of transmission would be unaltered by the introduction of a CBDC.

20.              The presence of CBDC would not impair the Bank of England’s ability to apply monetary policy.

 

29 October 2021

 

 

 


[1] Central Bank Digital Currency: Opportunities, challenges and design, Bank of England Discussion Paper, March 2020.

[2] New forms of digital money, Bank of England Discussion Paper, June 2021, is mainly concerned with the effects of private digital money such as stablecoins

[3] A small amount of CBDC, perhaps £10bn, will be demanded in exchange for cash (banknotes), which will have no effect on the banks as the BoE just substitutes one liability for another. All further inflows into CBDC are at the expense of deposits in banks.

[4] See, for instance, Central bank digital currencies: foundational principles and core features, Bank for International Settlements, 2020.

[5] Similar consequences of a large issue of private digital currency (stablecoins) are discussed in section 3.2 of Bank of England, June 2021, op cit. Note 3, and by the Bank of England governor in Innovation to serve the public interest - speech by Andrew Bailey, June 2021. In the opinion of the Bank, the rise in interest rates would be small but with large uncertainty.

[6] The run-off rate for central bank funding under the LCR rules would also need to be reduced to zero, to avoid penalising the banks.

[7] Op cit. Note 1.

[8] A deeper discussion of this scenario in the context of US Federal Reserve is in Kimberly Houser and Collen Baker, Sovereign Digital Currencies: Parachute Pants or the Continuing Evolution of Money   part IV.C, NYU Journal of Law & Business (Forthcoming), September 2021.

[9] There is a precedent for this: the BoE bought a small amount of corporate debt in its first QE programme in 2009. In the US, around half of all assets bought under the Fed’s QE programmes have been mortgage-backed securities.

[10] See, for instance, Christopher J Waller  CBDC - A Solution in Search of a Problem? BIS, Central bank speech, August 2021.

[11] The European Central Bank has talked of an upper limit of 3,000 euros per holder In its discussion of a eurozone CBDC: ECB’s Panetta Floats 3,000-Euro Limit on Digital Cash , Bloomberg, 9 February 2021.