How CBDCs can offers financial stability in banking systems

If central bank digital currencies (CBDCs) are implemented across the world, we might see more stability in the global banking systems according to a report from the United States Treasury Office of Financial Research.

The paper, released by the Treasury Office, suggests that a CBDC that is well-designed stands to mitigate the risk of making financial firms volatile, instead saying that the financial technology can increase stability in economics.

To investigate how a CBDC might impact banking, the researchers created a model  to explore how banks would respond. To conduct the research, they borrowed money for time-frames shorter than they had made loans (in order to insure against the risk of liquidity). This would create financial fragility, and might lead to a bank run. In the model, the access to a CBDC would create less chance of a liquidity “shock” which would help the banking systems provide less need to offer insurance against liquidity risks.

“In this way, the adjustments in private financial arrangements in response to a CBDC may tend to stabilize rather than destabilize the financial system.”

The authors also consider the ability for banks to display a lack of transparency in the current systems, noting that banks without strong positions might hide that from regulators to avoid the risk of financial and legal intervention. A CBDC would mitigate this, given the transparent nature of a digital currency which would enable lawmakers to have more comprehensive oversight which would protect users.

“By allowing a quicker policy reaction to a crisis, this information effect is another channel through which CBDC may tend to improve rather than worsen financial stability.”

Offering other factors to back up the argument, the authors of the paper designed a model to showcase how a CBDC can help stablise a financial model. From the model, the authors found two prevalent effects:

• The maturity of banks

According to the paper, “banks do less maturity transformation when depositors have access to CBDC. Which leaves them less exposed to runs.”

• Monitoring funds

As per the paper, “monitoring the flow of funds into CBDC allows policymakers to identify and resolve weak banks sooner, which also decreases depositors’ incentive to run.”

With both of these in mind, the results of the model showed that a well-designed CBDC is set to decrease financial fragility – rather than increase it – and add stability to economics.