Researchers at the Federal Reserve Bank of Philadelphia recently published a paper exploring the potential impact of a Central Bank Digital Currency on our financial system.
The report noted that in addition to eliminating the need for cash, a CBDC should prevent future bank runs by giving the US Federal Reserve a monopoly on deposits.
The paper states that a CBDC should, therefore, reduce risks posed by the investments of commercial banks, and render our financial system more secure. At the same time, it hypothesized that a CBDC may carry negative consequences for our monetary order by hindering the ability of banks to finance productive projects.
In fact, the report predicted stark economic consequences should a CBDC be issued. In a fractional reserve banking system, commercial banks deploy demand deposits to finance long term projects. However, a digital currency issued by a central bank could hinder the commercial banks’ ability to engage in credit formation by eliminating demand deposits as a source of bank loans.
Credit would be less widely available to the public should commercial banks lose their natural comparative advantage in loan origination.
Interestingly, the paper’s authors believe that a CBDC would not necessarily result in reduced credit formation. The researchers cited historical examples of central banks extending loans to individuals and small businesses. For example, the Bank of England actively engaged in commercial activities in the 1600s taking deposits and lending for mortgages.
The model developed by the Federal Reserve Bank of Philadelphia made the assumption that the central bank will not be able to gain access to the same investment opportunities as commercial banks to engage in lending because it has not developed “expertise in screening, monitoring, and liquidating productive projects.” However, it noted that a central bank may contract with commercial banks in order to extend loans on CBDC deposits.
The U.S currently lags behind China which is actively developing a CBDC. Research conducted by Federal Reserve shows that the United States is not too far behind.