U.S. federal researchers say digital dollar may improve rather than worsen financial stability

One of the primary worries raised concerning a central bank digital currency (CBDC) is the possibility that it might increase the frequency of run on banks and other financial intermediaries.

However, a new working paper by two U.S. federal researchers for the Office of Financial Research (OFR), an arm of the U.S. Treasury Department, published on July 12, suggests two ways in which a CBDC can strengthen financial stability rather than damage it.

The research investigated how the stability of the banking system will be impacted by the introduction of a CBDC, and the authors stated, “our results suggest that a well-designed CBDC may decrease rather than increase financial fragility and a “CBDC may tend to improve rather than worsen financial stability.”

How was the research conducted?

The authors also provided a model that accounts for a worry that is often brought up in policy debates, namely that the possibility of holding CBDC might make depositors more likely to move their money out of failing institutions.

For instance, a recent report by the European Central Bank states, “in crisis situations, when savers have less confidence in the whole banking sector, liquid assets might be shifted very rapidly from commercial bank deposits to the digital euro.” Similarly, another report from the Federal Reserve worries that “CBDC could make runs on financial firms more likely or more severe.”

However, the authors noted that “our model highlights two countervailing effects.”

First, when depositors have access to CBDC, banks reduce the amount of maturity transformation they do, which lowers their vulnerability to runs on deposits. 

“Introducing a CBDC decreases the amount of maturity transformation performed by banks in the constrained-efficient allocation. Intuitively, having access to CBDC makes experiencing a liquidity shock less costly for depositors in our model, which leads banks to provide less insurance against this risk.”

The professors added:

“When banks perform less maturity transformation, they are less exposed to the possibility of a run. In this way, the adjustments in private financial arrangements in response to a CBDC may tend to stabilize rather than destabilize the financial system.”

Keeping track on the inflow and outflow

Second, keeping track of the inflow and outflow of money into and out of CBDC makes it possible for policymakers to respond more rapidly to times of strain, which reduces the incentive for depositors and other short-term creditors to withdraw assets

Observing the flow of funds into a CBDC enables officials to infer whether a run by a bank’s depositors is in progress and to resolve distressed institutions faster.

“When depositors anticipate this faster policy reaction, their incentive to join the run decreases. In other words, 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.”

Finally, using a CBDC can transform depositors’ withdrawal choices into strategic substitutes, so doing away with the multiplicity of equilibria that is often seen in models belonging to this class.

In situations like these, the incorporation of a CBDC for these reasons they believe unquestionably makes the banking system more stable.