Central banks around the world either have issued or are considering the issuance of a central bank digital currency (CBDC). While most modern transactions take place digitally, a CBDC differs from existing digital money such as bank deposits because a CBDC is a direct liability of the central bank, rather than of a commercial bank. Several policy issues and risks surround the creation of a CBDC. In our paper, we consider one of the most important: Does a CBDC draw deposits away from banks and does this disintermediation restrict lending?
As noted in a report from the Federal Reserve, disintermediation is an issue because “a widely available CBDC […] could reduce the aggregate amount of deposits in the banking system, which could in turn increase bank funding expenses, and reduce credit availability or raise credit costs for households and businesses.” In a 2021 article in Business Reporter, Greg Baer, the President and CEO of the Bank Policy Institute, writes that “given that the average loan-to-deposit ratio for banks is generally around 1:1, every dollar that migrates from commercial bank deposits to CBDC is one less dollar of lending.” However, deposits are not the only source of funding for banks, as many banks, especially large ones, can fund deposit shortfalls using wholesale funding. More fundamentally, the assumption that bank lending must be funded by deposits rests upon the basic question of whether loan origination is necessarily dependent on deposit creation.
We start our investigation of the effects of a CBDC on bank lending with the following observation: Deposit creation and loan origination need not be linked to each other, although this decoupling occurs only under two stringent conditions. First, loan rates are set in a market that ensures the participation of both borrowers and lenders. In other words, banks find these loans profitable. Second, loans remain profitable even if banks lose cheap deposits if banks can replace those deposits with wholesale funding at the same cost. These two conditions imply that CBDC will not affect bank lending because the two sides of banks’ balance sheets are independent. While banks do not operate under these conditions, this baseline allows us to isolate the various features of the banking system that allow a CBDC to affect lending.
The bulk of our analysis involves estimating the parameters of a model of banks, depositors, borrowers, and a central bank, and then examining the behavior of loans in the model when we counterfactually add a CBDC. As the model is disciplined tightly by data, these counterfactual experiments offer quantitative rather than just qualitative conclusions. In our model, banks compete with one another by setting loan and deposit rates, making loans, and taking deposits. Bank default is the main realistic feature of the model that links lending to deposits. Since bank wholesale funding is not insured, default risk and funding costs rise when banks use more wholesale funding. Thus, any shrinkage in cheap deposits cannot be covered fully by this alternative funding source. Nor can deposit shrinkage be covered by equity issuance. Banks only tap this market infrequently because of information frictions and issuance costs.
We model the deposit and lending markets by using what is called a characteristic-based demand approach, in which the demand for products such as deposits or loans depends on features such as convenience, maturity, and the relevant interest rate. In other words, we get data estimates of the value of specific features of financial products. We then introduce a CBDC as a new product. This approach is conducive to studying different policy proposals concerning a CBDC because we have already estimated the value of the characteristics that can be attributed to a CBDC.
In the model with all parameters estimated from our data, we introduce a CBDC as a direct central bank liability that households can hold, with the interest rate determined by the central bank. Facing competition from the CBDC, banks can increase deposit rates, replace deposits with wholesale funding, or cut lending. The exact quantitative margins that banks use to accommodate the introduction of CBDC depend on the links between deposit taking and loan origination.