The likely impact of central bank digital currencies on quantitative easing
Many central banks are considering launching digital currencies. Far from being a mere technological innovation, central bank digital currencies (CBDCs) could persistently alter the size and composition of central bank balance sheets. Martina Fraschini, Luciano Somoza and Tammaro Terracciano analyze the equilibrium effects of the introduction of a CBDC and its interaction with current monetary policies. They show how and when the issuance of a CBDC could make expansionist policies almost permanent.
Major central banks are studying retail central bank (CBDC) digital currencies and considering their introduction in the near future (BIS, 2020). A retail CBDC is defined as a digital payment instrument, denominated in the national unit of account, which is a direct commitment of the central bank (BIS, 2020). Or, roughly speaking, it’s a retail version of bank reserves.
Yet how a CBDC would interact with existing monetary policy and whether it could push the central bank towards riskier assets remain open questions (BOE, 2020). Allowing retailers to hold deposits with the central bank could dramatically increase the size of the central bank’s balance sheet and pose the problem of assets to be held against them. These questions are particularly relevant as central bank balance sheets, already at record levels after the global financial crisis, are pushed into further expansions by asset purchase programs aimed at mitigating the impact of COVID-19 ( for example, the ECB’s Emergency Pandemic Pandemic Program (PEPP)). While it is certainly possible to use a CBDC to perform helicopter-like operations, the current working assumption for most CBDC projects is to hold assets against these new deposits. In this regard, the European Central Bank, in the report on the digital euro published in October 2020, explicitly states that
… issuing a digital euro would change the composition and most likely the size of the Eurosystem’s balance sheet, and therefore affect its profitability and risk exposure […] the Eurosystem should acquire assets (loans or securities) to be held against the digital euro; (iii) unlike cash, a digital euro could be remunerated, which would affect seigniorage income – European Central Bank, Digital Euro Report, page 18, October 2020
In a recent article, we present a model that addresses the issues raised by the ECB (2020) with an emphasis on the consequences on the balance of holding different assets versus CBDC deposits, in the context of standard monetary policy regimes and quantitative easing.
Effects of the introduction of a CBDC
We study a stylized economy in which the central bank uses the deposits of the CBDC either to hold government bonds or to acquire risky securities, given pre-existing political regimes. The main mechanism behind our results is the reduction in bank deposits following the introduction of a CBDC and its impact on bank financing and lending. Policy makers clearly identify this mechanism as one of the main concerns regarding the introduction of a digital currency (ECB, 2020; BOE, 2020).
If the central bank holds treasury bills against CBDC deposits, it indirectly passes CBDC funds to banks, influencing interbank financing through open market operations (i.e. by changing the floating amount of treasury bills in the economy). Leaving aside liquidity needs and quantitative easing, the introduction of a CBCD does not affect the total amount of loans to the real economy, nor the size of the banking sector because the reduction in deposits is entirely compensated by interbank financing. These results are consistent with the equivalence theorem of Brunnermeier and Niepelt (2019), according to which the central bank lends directly to banks to compensate them for the lack of financing of deposits. As in our context, the structure of banks’ balance sheet liabilities changes, but not its assets.
Nonetheless, the introduction of a CBDC is not neutral when considering an economy with liquidity requirements, quantitative easing policies, or the ability to hold risky assets against CBDC deposits. These characteristics determine changes in bank size, lending to the economy, seigniorage income, and bankruptcy costs, showing that the equilibrium effects of issuing a CBDC are dependent on both the interaction with the pre-existing monetary policy regime and assets held against deposits. In particular, the introduction of a CBDC as part of a quantitative easing regime has non-linear effects. This finding is all the more important given that most discussions on the design of CBDCs focus either on the technological aspect of the latter, or on the risks of disintermediation.
Can the CBDC make current QE policies quasi-permanent?
QE is about swapping newly created reserves for risky assets. As a result, the amount of reserves in the banking sector has increased sharply over the past decade and liquidity requirements are no longer binding. For example, in August 2020, the amount of excess reserves in the US banking sector was $ 2.8 trillion. Once economic conditions improve, central banks are committed to reversing these expansionary policies, and excess reserves are expected to be reabsorbed as assets held by central banks are sold.
Introducing a CBDC in this context could hinder such a reduction phase, as commercial banks could use their excess reserves to allow depositors to switch from bank deposits to CBDC deposits. This would make (part of) QE programs quasi-permanent.
When customers wish to convert a unit of bank deposits to CBDC deposits, the commercial bank must transfer one unit of resources to the central bank to settle the transaction. How can he do it? There are two options. The first is to transfer a unit of assets to the central bank. In this case, the commercial bank would lose one unit of deposits and one unit of assets and the central bank would have an additional unit of CBDC deposits backed by assets held on its balance sheet. The second is that the commercial bank reduces its excess reserves with the central bank by one unit. Therefore, the commercial bank loses one unit of deposits and one unit of reserves, and the central bank simply credits one unit to the CBDC deposit and charges one unit to the bank’s reserve account, without any change to the asset from its balance. leaf.
Which of the two mechanisms is more plausible depends on the amount of excess reserves held by the banking sector. If the liquidity requirement is onerous, the commercial bank is forced to liquidate a unit of assets, but if it has excess reserves, it may choose to reduce them. However, given the size of the excess reserves held by the banking sector as a result of quantitative easing programs, it is plausible that banks would prefer to reduce their reserves rather than buy and transfer assets, especially when the interest rates on these reserves are less than zero.
It should be noted that the larger the amounts of bank deposits to be converted into CBDC deposits with this mechanism, the more difficult it is for the central bank to reverse its expansionary policies. In this context, issuing a CBDC could crystallize the central bank’s balance sheet and prevent it from emerging from its expansionist policies. This has significant political implications as it can be seen as a tool for permanent engagement, thus deviating from the official position which sees QE policies as temporary.
Our analysis leads to two main conclusions. The first is that at equilibrium, the impact of a CBDC depends on the monetary policy conducted by the central bank and against which the asset is held. Second, the introduction of a CBDC could make quantitative easing a near-permanent policy, as commercial banks could use their excess reserves to allow depositors to switch from bank deposits to CBDC deposits. We argue that these aspects should be carefully considered when deciding whether or not to issue a CBDC.
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To note: The post office gives the point of view of its authors, do not the position USAPP – American Politics and Policy, nor the London School of Economics.
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About the authors
Martina Fraschini – University of Lausanne
Martina Fraschini is a doctoral candidate in economics with a specialization in finance at the Swiss Finance Institute and at HEC Lausanne, University of Lausanne. His research interests focus on venture capital investments, CBDCs and financial regulation.
Luciano Somoza – University of Lausanne
Luciano Somoza is a doctoral candidate in economics with a specialization in finance at the Swiss Finance Institute and at HEC Lausanne, University of Lausanne. His research interests focus on banking, financial regulation and fintech. More information can be found here: www.lucianosomoza.com.
Tammaro Terracciano – University of Geneva
Tammaro Terracciano is a doctoral candidate in economics with a specialization in finance at the Swiss Finance Institute and at the Geneva Finance Research Institute – University of Geneva. More information can be found here: www.tammaroterracciano.com.