According to a recent working paper published by the Office of Financial Research (OFR), banking sector stability may suffer, yet household welfare may improve should a digital currency be fully integrated into the financial system.
In the paper, Digital Currency and Banking Sector Stability, the authors modeled a financial sector where digital currencies coexist with bank deposits, and households hold both forms of liquidity. This model allowed the authors to identify the financial stability consequences of digital currency should it become fully integrated into the financial sector.
The theoretical results suggest that financial frictions may limit the potential benefits of digital currencies, whether issued publicly as a central bank digital currency (CBDC) or privately as stablecoins. In addition, the authors found that financial system volatility decreases when digital currencies are fully integrated, and household welfare improves, yet banking-sector stability suffers.
Specifically, with the full integration of digital currency: The probability of a banking sector crisis increases – A decline in deposit spreads is the primary reason a crisis’s probability increases with digital currency issuance. A fully-integrated digital currency depresses bank deposit spreads, particularly during crises, which limits banks’ ability to recapitalize following losses.
In addition, because banks are less able to rebuild equity after adverse shocks, banks, on average, have lower equity. Accordingly, bank valuations decrease significantly. As a result, the probability the banking sector is in crisis or a distressed state can grow significantly.
Household welfare can improve: Fully integrating digital currency into the financial sector would increase household welfare, and these welfare consequences are potentially large. For example, household welfare could increase by 2% in terms of consumption, even though at this level of digital currency, the probability of crises doubles.
System volatility decreases: Financial system volatility declines with the full integration of digital currency. This decline is primarily reflected in a decrease in the volatility of asset prices. While financial markets improve with lower volatility and higher prices, the financial sector suffers because the banking sector is at greater risk of insufficient capital levels.
As interest in these emerging technologies grows, the threat to financial stability posed by integrating digital currencies into the traditional financial system needs to be examined from multiple angles, considering potential effects on bank equity levels and consequences for runs. The authors’ financial stability focus for this working paper is on the risk that banks have insufficient equity capital following losses from their investments. Investment losses, not runs per se, create instability in this context.
Other analyses, which considered whether the benefits of creating a central bank digital currency (CBDC) outweighed the risks, found that at least one risk — bank runs — is not as big as initially feared. Authors of this complementary analysis concluded that the threat of investors running to a CBDC leads banks to do less maturity transformation, and policymakers can use information flows from the CBDC to react quickly.
Digital currencies have the potential to become an alternative to traditional money. Imperfections in financial markets nevertheless limit their potential benefits. At some point, there may be a robust range of digital currency issuance in which the welfare-stability trade-off is in favor of digital currency, even when digital currency is costly to issue in a competitive environment.