DR ASGERDUR PETURSDOTTIR, DR CYRIL MONNET AND DR MARIANA ROJAS-BREU – WRITTEN EVIDENCE (CDC0020)
CENTRAL BANK DIGITAL CURRENCIES INQUIRY
This submission has been prepared by Dr Asgerdur Petursdottir, Dr Cyril Monnet and Dr Mariana Rojas-Breu (brief introduction of authors can be found below).
We are currently working on academic research that focuses on the effect implementing central bank digital currency (CBDC) may have on the financial sector. We would like to share our current results with policymakers as well as engage with policymakers on our future CBDC research.
- We find that an interest-bearing central bank digital currency (CBDC) does not lead to disintermediation of the banking sector if the interest rate on CBDC is kept at a low to moderate level and if banks have some market power.
- Banks adjust to the existence of CBDC as an outside option to bank deposits. Introducing CBDC encourages banks to increase the value of their bank deposits, and to alter the composition of their balance sheet, including making more prudent investment decisions to retain their deposit base. These results are irrespective of the level of CBDC adoption.
- Depending on the level of market power that banks have and the level of risk on banks’ balance sheets, the introduction of CBDC can increase bank profits. Furthermore, using the interest rate on CBDC as a monetary policy tool can ensure a quick pass-through from policy interest rates to the interest rates private banks offer to their customers.
- Generally, it is optimal for the central bank to offer the same interest rate on CBDC and reserves.
- This evidence is based on theoretical work we have conducted, using mathematical models as the analytical framework.
CBDC and bank disintermediation and profitability
- An important concern that has been raised regarding the implementation of CBDC, is the potential negative effect that CBDC could have on financial stability and financial intermediation. Specifically, the fear is that there could be a significant substitution away from bank deposits, a core source of funding for banks, into CBDC. This could affect aggregate bank lending and the profitability of banks, with negative consequences for the banking sector and the real economy.
- In our theoretical analysis we explore the consequences of a CBDC that has been designed as a risk-free substitute to bank deposits. Hence, we assume that CBDC is a liability of the central bank, account-based (people hold accounts directly at the central bank), can be interest-bearing and uses the same payment technology as bank deposits. As such, CBDC is a cash-like payment instrument that can be used to make digital payments. Cash already exists as a substitute to bank deposits. However, notice that during normal times we do not observe large shifts from bank deposits into cash.
- When we make investment decisions, we usually trade-off the risk in the asset return and the expected return. Thus, we tend to prefer assets with low risk but high expected return. Similarly, households are indifferent between using bank deposits or CBDC as means of payment or store of value, if the risk adjusted remuneration is the same across both instruments. Therefore, banks must respond to the introduction of an interest-bearing CBDC by adjusting the value of their deposits. For instance, if the remuneration of CBDC increases, banks will need to respond by increasing the remuneration on bank deposits. This can promote intermediation since higher interest rate on deposits attracts more deposits. Given there are enough profitable investment and lending opportunities for banks, they will increase their lending activity in line with the increased deposit issuance.
- However, for this theoretical result to hold, banks need to have a degree of market power so they can buffer the increased funding costs. A perfectly competitive banking sector does not have the same margins as a banking sector with market power. Therefore, unless banks can increase the cost of borrowing substantially, it is costly for banks to honour the higher deposit interest rate resulting from the increased remuneration of CBDC. Hence, under perfect competition, banks would respond by reducing lending, leading to disintermediation.
- On the other hand, if banks have a degree of market power, introducing CBDC and increasing the remuneration on CBDC can increase intermediation and promote investment. Furthermore, setting the correct interest rate on CBDC can allow banks to attain the socially efficient level of investment. However, any increase in the CBDC interest rate beyond that threshold makes further investing too costly and would lead to disintermediation. Due to the consolidation that has occurred in the banking sector in the past decade, banks in the UK are likely to have a degree of market power. Therefore, implementing and offering a low interest rate on CBDC can promote intermediation in the UK.
- The higher interest rate on bank deposits and the increased volume of lending does not necessarily lead to a reduction in profits for banks. That is because banks are issuing more deposits and thus investing more. However, the effect on profitability depends on the degree of market power. The more market power a bank has, the more likely it is that CBDC can increase bank profits up to a certain point.
- Even though we have not observed large shifts from bank deposits into cash during normal times, we have witnessed those scenarios during times of financial distress. Therefore, some policymakers have feared that outflow of deposits could be exacerbated during financial distress if depositors can easily transfer their funds into CBDC. Therefore, we also consider specifically the threat of disintermediation under bank risk. Our premise is a banking sector that relies on deposits as its core source of funding and banks can invest in high-risk, high return assets. To the extent that the realised return on a bank’s investments is below the expected return, the bank may be unable to honour regular withdrawals.
- We find that banking sector risk does not induce bank disintermediation given the existence of CBDC. In fact, theoretically, disintermediation occurs for a higher threshold of the CBDC interest rate when banks can make risky investments than when they can only invest safely. When there is risk, the bank needs to compensate for the risk by further increasing the remuneration on bank deposits. At the same time, it will encourage banks to invest more in safe assets to attract depositors.
- As mentioned above, the central bank needs to set the level of interest rate it offers on CBDC with care. In addition to leading to disintermediation, if the CBDC interest rate is set too high, it can have a negative effect and result in banking sector risk. More specifically, banks need to increase the remuneration on their deposits when the interest rate on CBDC is raised. If a negative shock occurs, it could be that the bank cannot honour regular deposit withdrawals because it has to offer a high interest rate to match the CBDC remuneration rate. Therefore, central banks should aim for low to moderate level of interest on CBDC.
- We find that introducing an interest-bearing CBDC can be beneficial and promote economic activity for low to moderate levels of the CBDC interest rate. Furthermore, we find that CBDC can discipline banks. Because banks need to ensure that bank deposits are as valuable to depositors as CBDC, they need to match increases in remunerations of CBDC.
- In that regards, CBDC as a monetary policy tool can ensure that the banking sector passes on any interest rate change that the central bank implements, quickly and effectively to its customers. Additionally, if there is risk on the banks’ balance sheet, the remuneration on CBDC can induce banks to adjust their portfolio and increase their investment in risk-free assets to retain deposits. CBDC does not need to have a wide scale of adoption for these effects to hold. The mere existence of CBDC, and thus the threat of this outside option is enough to affect bank behaviour.
CBDC and reserves
- The Bank of England already issues digital money to banks in the form of interest-bearing reserves. The volume of reserves and the remuneration of reserves are important monetary policy tools. As we have discussed, the interest rate on CBDC can be used as a monetary policy tool to ensure quick pass-through from central bank rates to commercial bank rates. Furthermore, it can promote efficient investment levels. Central banks need to consider whether they want to expand their reserve offering to everyone or if they want to keep reserves and CBDC as separate liabilities and thus what interest rate to offer on each.
- Interest rate paid on CBDC is the opportunity cost of holding bank deposits for consumers and affects banks’ cost of issuing deposits. On the other hand, interest rates paid on reserves is the opportunity cost of bank lending for banks. Therefore, if the interest rate on reserves is high, it becomes attractive as an investment opportunity for banks and can crowd out lending and other investments. It is generally optimal for central banks to set the same level of interest on reserves and CBDC. An exception to this recommendation is if there is risk in the banking sector and banks are lacking access to relatively cheap risk-free assets. Under those circumstances raising the interest rate on reserves above the interest rate paid on CBDC can be optimal. Even though it leads to disintermediation, it is beneficial for the economy as it reduces bad investment and helps reduce risk in the banking sector.
- Therefore, we find that reserves and CBDC should be kept as separate liabilities of the central bank. Reserves should continue to only be available to eligible financial institutions, whereas everyone should be granted access to CBDC. This will allow the central bank to offer the same level of interest on both reserves and CBDC, while having the flexibility to create a spread between the two rates when needed.
Brief introduction of submitting academics:
Dr Asgerdur Petursdottir is an Assistant Professor of Economics at the University of Bath. She has previously been an Economist at the Central Bank of Iceland and a visiting researcher at Sveriges Riksbank. Asgerdur’s main field of research is in monetary economics, with special interest on monetary policy, central bank digital currency and financial markets. Asgerdur received her PhD in Economics at the University of New South Wales (UNSW Sydney), Australia in 2015.
Dr Cyril Monnet is a Professor of Economics at the University of Bern and at the Study Center Gerzensee, Switzerland. He has previously been a Senior Economic Advisor at the Federal Reserve Bank of Philadelphia, and a Senior Economist at the European Central Bank. Cyril’s research focuses on monetary theory and the design of financial markets. He holds a Ph.D. in Economics from the University of Minnesota.
Dr Mariana Rojas-Breu is a Professor of Economics at Université Paris II Panthéon-Assas. She has previously been an Associate Professor at Université Paris Dauphine and a Senior Economist at the Banque de France. Mariana’s main fields of research are monetary and financial economics. Mariana received her PhD in economics from Université Paris Nanterre (France) and University of Basel (Switzerland) in 2009 and obtained her HDR (French habilitation) in 2016.
15 October 2021