Digital Dollar May Prevent Runs, but Banks Fear Lost Profits

A new Treasury Department report argues that banks’ fears that a digital dollar would lead to the loss of depositors and even bank runs is overblown.

A U.S. central bank digital currency (CBDC) could strengthen financial stability, according to a research paper issued on Tuesday (July 12) by the Treasury Department’s Office of Financial Research (OFR).

One of the biggest concerns banks have about a digital dollar is that it would “make it more attractive for short-term creditors to pull funds out of banks and other financial institutions in periods of financial stress,” researchers Todd Keister and Cyril Monnet noted in the report. While calling the logic of these arguments “compelling,” they argue that a properly designed digital dollar would “stabilize rather than destabilize the financial system.”

For one thing, a digital dollar would provide regulators with an early warning system, allowing them to identify weak banks before a run begins, they said. So when regulators see a bank’s depositors moving funds into a CBDC rather than competing institutions or other investments, it will raise a red flag.

That is important, they added, because “a bank in a weak position will often have an incentive to hide this fact from regulators, at least for a while, to avoid triggering supervisory actions. The fact that this information remains hidden delays policymakers’ response to an incipient financial crisis, making the crisis more severe.”

In addition, that faster response will relieve depositors’ concerns enough to prevent them from joining the run, the report argued.

Beyond that, struggling banks would be dissuaded from attempting to use “maturity transformation” — a disconnect between short-term assets and long-term liabilities — that can make banks more exposed to runs.

A Steep Hill

Regardless of the argument’s merits, the government will have a tough time convincing banks.

In a recent comment on the Federal Reserve’s initial digital dollar policy paper, “Money and Payments: The U.S. Dollar in the Age of Digital Transformation, the Bank Policy Institute said it would “undermine the commercial banking system in the United States and severely constrict the availability of credit to the economy” while offering “few, if any, benefits” to offset those risks.

Read more: Fed’s Vice Chair Tells Banks: Digital Dollar Won’t Cut You Out

Among other things, banks are a lot less concerned about regulators’ ability to spot banks so damaged that they are at risk of a run than they are of strong banks being weakened by fleeing depositors during a financial downturn.

And there are two problems here that Keister and Monnet’s arguments do not address, at least for strong banks.

First, depositors shifting funds into digital dollars — even if they are stored at the same institution — will leave banks with less money to lend. That’s because most CBDC proposals would require institutions to maintain 100% reserves for those deposits — the government is on the hook after all, and not just for the Federal Deposit Insurance Corp.’s $250,000 limit — rather than the fractional reserve requirements of standard cash deposits.

That all means banks will face diminished profits down the road, and financial downturns will be lengthened and worsened as banks will have less capital to deploy to get people spending again.

Second, banks have expressed concerns that once depositors flee into CBDC accounts, they won’t have much incentive to return.

While a number of CBDC proponents — including those in the U.S. and EU — have recommended making CBDC accounts interest free, the reality is that deposit interest rates are so low that anyone without a huge account doesn’t really make enough of a return for that to be a big incentive to abandon a safer deposit.

In its response to the Fed’s request for comments on its “Money and Payments” paper — which did not advocate for or against a digital dollar — the American Banking Association added that a better solution would be to “leverage novel developments in private money, like real-time payments systems and well-regulated stablecoins.”

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