Correct design can ensure CBDCs don’t destabilise banks

There is a concern on whether a central bank digital currency could destabilise the banking sector. This stems from the sector’s crucial role in financial intermediation

The Budget confirmed that the Reserve Bank of India (RBI) is going to introduce a central bank digital currency (CBDC) in India this year. There is, however, a significant concern on whether CBDCs can potentially have a destabilising effect on the banking sector. In a recent interview, former RBI governor D Subbarao, while sceptical of it actually taking place, highlighted this as a pertinent issue for India. What is the nature of this concern and how can it be mitigated? The concern stems from the banking sector’s crucial role in financial intermediation. Banks borrow money in the form of deposits and use a portion of it to allocate credit to various parts of the economy, fuelling economic activity. They retain another portion in the form of reserves to preserve some liquidity to service their liabilities. Banks also facilitate payments, and even online digital payments using e-wallets require bank accounts.

CBDCs could impair the stability of this system if people shift their funds from bank deposits to CBDCs on a large scale. This can happen if people want to shift to a safer form of digital money. (FILE PHOTO)

In the current setup, central banks don’t perform these roles themselves because the commercial banks are considered more efficient at innovating and allocating resources. Central banks, instead, provide safety and finality to all transactions in the economy through cash and reserves. All digital payments are ultimately settled through interbank transfers of these reserves. This fosters trust in the financial system. Central banks also pursue monetary policy by charging interest rates on the reserves. Banks take their cue from this to set their borrowing and lending rates. When RBI offers a higher interest rate, banks may choose to keep the money with RBI than lend them, and vice versa, thereby impacting the overall supply of credit and money in the economy. This division of labour is called a two-tier architecture of monetary and payments system.

CBDCs could impair the stability of this system if people shift their funds from bank deposits to CBDCs on a large scale. This can happen if people want to shift to a safer form of digital money. Since CBDCs will have an implicit guarantee by RBI while bank deposits are only partially insured, this possibility cannot be ruled out. A shift can also happen if CBDCs are interest-bearing. Similar shifts occur now as well, during financial stress or uncertainty, leading to flight of deposits to cash. CBDCs could, however, accentuate such bank-runs much more, as they are far easier to access and use compared to cash.

The implications are serious. Banks would lose a cheap source of funds. They may hike interest rates to lure customers back or seek alternative sources, increasing their cost of funding. Banks’ overall balance sheet would also diminish since they must debit both the deposit accounts (liabilities) and their reserves with RBI (assets) simultaneously, so RBI can credit the amount into CBDC accounts maintained with RBI. This leads to disintermediation. It would not only reduce the overall volume of credit but also increase the cost of credit since banks may charge higher interest on loans to offset their increased funding costs.

Large scale shifts to CBDCs could be a problem for banking sectors with insolvency issues as well. This is due to the fact that while liquidity and insolvency are distinctly different problems, in practice, they are known to reinforce each other. Thus, if the Indian banking sector continues to have large non-performing assets, any disintermediation and liquidity constraints could reinforce this weakness, thereby leading to a solvency problem too. If CBDC holders transact directly through their individual accounts, then the banking sector’s role in providing payments services would also be reduced. Similarly, their role in monetary policy transmission will diminish, as central banks would directly deal with households and businesses.

How can these problems be controlled or minimised? Possible solutions may lie in designing CBDCs appropriately. CBDCs could be non-interest-bearing to avoid competing with deposits. Interest-bearing features are attractive primarily to impose negative interest rates. But as Subbarao notes, negative interest rates are not necessary for India, unlike for developed countries. Ceilings on CBDCs holdings and transactions could minimise the propensity to accentuate bank-runs. Central banks could reroute funds gained from CBDC deposits to banks to address disintermediation. This would, however, depend on whether they choose to do so, and whether banks can offer requisite security to receive these funds.

The institutional arrangements around CBDCs can also be designed to preserve the two-tier architecture mentioned here. This architecture is designed to leverage the relative advantages of the public and private sector. There are two alternatives possible here. First, a synthetic CBDC that allows banks and others to issue the payment instruments, representing their personal liabilities, and back the same with central bank reserves. This is, however, not considered a genuine CBDC as it is not a direct central bank liability such as cash. The other is a hybrid CBDC where the CBDC is a direct claim on the central bank, but the private sector continues to offer customer-facing services such as KYC (Know Your Customer). Banks would thus broadly continue to play their role of financial intermediation. Finally, any potential problem of solvency reinforced by liquidity constraints at banks due to CBDCs could be addressed by RBI and the government providing greater support.

Sabyasachi Kar is RBI Chair Professor, Institute of Economic Growth.

Priyadarshini D is an associate fellow, Carnegie Endowment for International Peace India. The views are personal

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