Balancing Innovation and Stability: How CBDCs Could Reshape Banking Systems

The IMF paper explores how Central Bank Digital Currencies (CBDCs) could impact financial stability, highlighting potential risks like disruptions to bank funding, profitability, and lending. It suggests policy options, including careful CBDC design, to mitigate these risks and balance the benefits with financial stability.

The IMF Working Paper authored by Romain Bouis, Gaston Gelos, Paavo Miettinen, Fumitaka Nakamura, Erlend Nier, and Gabriel Soderberg, from the International Monetary Fund’s Monetary and Capital Markets department, examines the implications of retail Central Bank Digital Currencies (CBDCs) on financial stability. This detailed study looks at how the issuance of a CBDC to the general public could impact the balance sheets of both central banks and commercial banks, with a particular focus on the risks and opportunities this transition might present. The authors highlight that the financial stability effects of CBDCs depend on several key factors, including the size of the issuance, the initial conditions of the financial system, and how both banks and central banks react. Through scenario analysis, the paper explores how balance sheets might change in different environments, whether under normal conditions or during crises, and the potential impacts on financial stability.

Risks to Financial Intermediation

One of the central concerns raised in the paper is that the issuance of CBDCs could lead to disruptions in the traditional banking system, particularly in terms of financial intermediation. The scenarios outlined in the study suggest that if CBDCs replace a significant portion of commercial bank deposits, the banking system could face challenges in maintaining stable and low-cost funding. This is particularly true when commercial banks do not have excess reserves to absorb the demand for CBDCs, forcing central banks to expand their balance sheets by providing more reserves. In such cases, banks may need to rely on more costly or volatile wholesale funding, which could lead to higher lending costs and reduce the overall availability of credit to businesses and consumers. Additionally, during periods of financial stress, there is a risk of "digital bank runs," where depositors rapidly move their funds from traditional banks into CBDCs, exacerbating liquidity crises.

Impact on Bank Profitability and Lending

The paper also discusses the potential consequences of CBDC adoption on banks' profitability. As banks lose cheaper deposit funding and are forced to replace it with more expensive central bank or wholesale funding, their profitability could decline. This, in turn, could lead to increased risk-taking as banks try to maintain profit margins, or it could prompt a reduction in lending to the private sector, which would have negative implications for economic growth. The authors argue that these risks are particularly pronounced when CBDC adoption is rapid or occurs during a financial crisis, as banks may struggle to adjust to the new environment in which deposits are being diverted into digital currencies.

Macroprudential Policies and Central Bank Lending

In exploring potential policy responses to these challenges, the paper suggests several options that central banks and regulators might consider. One possibility is to adjust macroprudential policies to account for the new risks introduced by CBDCs, such as tightening capital and liquidity requirements for banks. However, the authors note that macroprudential policies alone are unlikely to be sufficient to fully mitigate the risks associated with CBDC issuance. Another potential solution is to expand central bank lending to the commercial banking system, particularly during times of stress. By providing additional liquidity through mechanisms such as longer-term refinancing operations, central banks could help ensure that banks have the necessary funding to continue lending, even if they face significant deposit outflows due to CBDC adoption.

Designing CBDCs to Mitigate Risks

Nevertheless, the most promising approach, according to the study, is to carefully design CBDCs in a way that limits their potential to disrupt the banking system. Specifically, the authors advocate for CBDC designs that encourage their use as a means of payment rather than as a store of value. This could be achieved through features such as imposing limits on the amount of CBDC individuals can hold or offering zero or negative interest rates on CBDC balances. These design choices would help prevent large-scale shifts of deposits from commercial banks into CBDCs, thereby reducing the risk of financial instability. Moreover, ensuring interoperability between CBDCs and traditional bank-operated payment systems could further mitigate these risks by allowing for a smoother integration of CBDCs into the existing financial system.

Balancing Benefits with Financial Stability

The paper concludes by emphasizing that while CBDCs offer several potential benefits such as reducing the costs of producing and handling cash, improving financial inclusion, and enhancing the efficiency of payment systems these benefits must be weighed against the potential risks to financial stability. The authors argue that without careful consideration of these risks, CBDCs could lead to significant disruptions in the banking system, particularly if they are widely adopted in a short period of time or during times of economic stress. Therefore, central banks must carefully design CBDCs and consider a range of policy tools to ensure that their introduction does not inadvertently harm the broader financial system.