The introduction of a central bank digital currency (CBDC) may increase the stability of a banking system, according to a paper released Tuesday by the United States Treasury Office of Financial Research.
This finding counters concerns that a CBDC may encourage runs on weaker banks.
According to the July 12 paper, researchers often claim that the public may in times of financial stress “pull funds out of banks and other financial institutions” meaning that a “CBDC could make runs on financial firms more likely or more severe.”
The authors however argued that a well-designed CBDC can mitigate that risk, and also offered two arguments that favored the role of CBDCs in increasing financial stability.
First, the authors created a mathematical model in which banks performed maturity transformation, that is, they borrowed money for shorter periods than they made loans for, to insure against liquidity risk. This could create financial fragility in case of an adverse event, and that could lead to a bank run.
In the authors’ model, however, access to a CBDC “intuitively” makes “experiencing a liquidity shock” less costly to depositors, so banks can provide less insurance against this risk. Thus, a CBDC leads to greater stability of the financial system.
“In this way, the adjustments in private financial arrangements in response to a CBDC may tend to stabilize rather than destabilize the financial system.”
The second argument was based on a so-called information effect. Banks in weak positions may try to hide that fact from regulators to avoid intervention. Hiding unfavorable information could also make the crisis worse because of delayed response.
Related: BIS: 90% of Central Banks are researching the utility of CBDCs
However, the nature of CBDCs will allow policymakers the ability to identify situations where funds are being converted, and not simply withdrawn from a bank — thus spotting problems sooner which can lead to a faster resolution.
“By allowing a quicker policy reaction to a crisis, this information effect is another channel through which CBDC may tend to improve rather than worsen financial stability.”
The authors point out that other researchers have suggested imposing caps, fees or other restrictions on CBDC during crises. The authors argue against this approach, noting:
“Policies that limit the use or attractiveness of CBDC risk losing many of its potential benefits as well.”
They also argue that the benefits of the greater information available to policymakers in the presence of a CBDC may have a variety of beneficial uses.
