Martina Fraschini, Luciano Somoza and Tammaro Terracciano are doctoral students at the Swiss Finance Institute. Here, they explain why the implications of central bank digital currencies on the balance sheets of monetary custodians merit further examination.
Since the great financial crisis of 2008, central bankers have become technocrats of reassuring power. Whether it’s market turmoil, a pandemic, or even climate change and inequality, they always seem to be trying to do something about it.
This omnipotence is made possible by their special power to create money out of nothing.
The effect of these interventions on the institutions themselves is quite evident in view of the swelling of the balance sheets of the European Central Bank and the Federal Reserve over the past 15 years:
It has not gone unnoticed. Questions are being asked. Who decides which assets to target? What do persistently low interest rates mean for public policies? Does the central bank monetize debt? It is difficult not to conclude then that, the larger the balance sheet, the more the central bank is politicized.
Soon the size could increase further.
The introduction of a central bank digital currency (CBDC) seems a question of when not if. Its supporters point to the technological advantages and argue that it could foster financial inclusion and smooth cross-border payments. While this is debatable, what we want to focus on here is the impact that CBDCs would have on the balance sheet.
A CBDC would be the digital equivalent of cash and would work the same from an accounting point of view. When a depositor withdraws $ 1,000 in cash, his bank must purchase the notes from the central bank. To settle the transaction, the commercial bank pays the central bank its reserves, which are reduced by $ 1,000. From the point of view of the central bank, this operation is neutral because one type of liability (reserves) is simply transformed into another (cash).
Things would be the same if, instead of cash, the depositor wanted to buy the CBDC. The bank would reduce its reserves, while the central bank would credit the depositor to their personal CBDC account. So far, so good.
The main distinction between cash and CBDC is the size of your pockets. The demand for cash is of little concern; it is impractical and dangerous to accumulate large amounts of banknotes. However, the physical limits do not apply to digital dollars. If a significant fraction of deposits were converted to CBDCs and banks did not have enough reserves, any additional digital dollars created would imply an increase in the size of the central bank’s balance sheet.
Let’s do some math at the bottom of the envelope.
In the United States, there are $ 17.2 billion in bank deposits. The Fed, for its part, possesses $ 8 billion in liabilities, including 3.9 billion in bank reserves and 2.2 billion in banknotes. It is reasonable to assume that banks will always want to hold some reserves and that liquidity would remain in circulation. So suppose the system can handle up to $ 4.5 billion in CBDC deposits (or just over 25 percent of bank deposits) without a major impact on the size of the balance sheet.
If the CBDC demand is less than 25% of bank deposits, we would only see a transfer of bank reserves and banknotes into the CBDC. Commercial banks might even be in favor of such a transfer, as deposits are expensive to manage and reserves earn very little interest. However, this changes the type and number of counterparties the central bank would have to deal with, as the millions of retail depositors are quite different from a handful of banks. If the central bank decided to reverse its expansionary policies and reduce its balance sheet, it would face millions of inelastic small retailers. That would complicate things a bit. The design of a CBDC could reduce, but not substantially change, the described mechanism. Even with commercial banks distributing the CBDC, there would be millions of retailers with claims on the central bank.
If the demand for CBDC is more than 25% of bank deposits, the situation would be different. Once reserves and banknotes were absorbed, the banking sector would be under pressure as it would have to liquidate other assets to transfer deposits. At this point, the size of the Fed’s balance sheet would increase with each additional unit of CBDC. In the extreme scenario where all deposits end up in the CBDC, the Fed’s balance sheet would more than double in size. The central bank should also decide what to hold against these deposits. Treasury bills and corporate bonds? This would lower interest rates further and make the government even more dependent on Fed funding. Bank debt? The idea of returning money to banks may be appealing, but who would decide which banks to finance? Under what conditions? The central bank would inevitably end up picking winners and losers.
Either way, monetary policy would change drastically. The central bank would have a closer connection to people’s wallets, with less intermediation by the private banking sector than there is currently. He could easily implement all kinds of monetary experiments like helicopter money or deep negative rates straight to the people. In other words, the central bank would acquire even greater monetary superpowers.
And, like Spiderman, they should be aware that with great power comes great responsibility.
The CBDCs call for a fundamental rethink of the mandates, independence and ultimately accountability of the central bank. In his 1968 essay on central banks, The role of monetary policy, Milton Friedman underlined the risks of splitting macroeconomic policy between several decision-makers, because this would lead to a “dispersion of responsibilities, which favors the evasion of responsibility in times of uncertainty and difficulty…”. This concern is very real. It is perhaps not surprising that in this environment, the most recent former ECB and Fed leaders, Mario Draghi and Janet Yellen, are now both in political office. A strong and proactive central bank is the perfect alibi for the government. In difficult times, the government can avoid taking responsibility because the central bank steps in and saves the day. In good times, the government has no pressure to reform, and nothing is done. The long-term effect is undoubtedly over-indebtedness, inequality, dependence on asset prices and a constant search for new and more powerful monetary tools.
With great power, should come great responsibility. A central bank with monetary superpowers that directly guarantees citizens’ savings, targets climate change and social justice, and whose former leaders are involved in active politics, is no longer a boring technocratic body. Enthusiasm for new technologies should not deflect the debate on CBDCs; there are serious implications for financial stability and social welfare in taking such a step. In such circumstances, it is essential that we consider whether the launch of the officially approved digital currency is truly compatible with the independence of the central bank and the general public interest.