The collapse of Silicon Valley Bank (SVB), the closing of Signature Bank, and the takeover of Credit Suisse, are all recent events that suggest that deposit insurance schemes and tight regulations are not always sufficient to prevent bank runs.
Of course, unlimited deposit insurance has the potential to prevent bank runs, but most deposit insurance schemes are limited — for instance, up to US$250,000 in the U.S. and $100,000 in Canada. And individual deposits at SVB were mostly over $250,000 and thus uninsured, so depositors ran to withdraw their money when their trust in the bank waned.
Though too late to save SVB, the U.S. government moved swiftly and eliminated the upper insurance limit to prevent contagion and a banking crisis. Additionally, the Fed announced an emergency lending program to all banks to assure depositors that they could access their accounts whenever needed.
While necessary given the circumstances, emergency-response programs tend to create a moral hazard situation: They encourage banks to take greater risks in good times under the expectation that they will be bailed out in bad times: Heads, they win; tails, taxpayers lose.
Therefore, tight government regulations that prevent banks from taking excessive risks are also needed to preserve the stability of the sector. In this regard, Canadian pundits and politicians often praise the strength of our regulatory system at the time of the 2008 world financial crisis.
Of course, these cheerleaders forget to mention two important points. One, the Harper government was pushing for the deregulation of the financial sector in the months prior to the onset of the crisis. And two, once the crisis materialized, the government provided a $114-billion bailout to the banks — although, as economist David Macdonald reminds us, the government was careful to call it “liquidity support” and not a “bailout.”
In any case, while necessary, financial regulation is not a panacea for three main reasons. Firstly, regulations do not always work because crashes continue even when banks comply with the rules. Secondly, more often than not, most financial innovations are aimed at evading regulations. And thirdly, governments are continually under pressure to relax the rules since they reduce banks’ short-run profitability.
So, definitely, deposits insurance and tight regulations are not sufficient to guarantee the stability of the financial sector. Does it mean that we should be resigned to face bank crashes every now and then?
Well, not necessarily.
As Jan Eeckhout of Barcelona’s Pompeu Fabra University points out, we now have a technological solution that could end bank runs forever: We can introduce a central bank digital currency (CBDC), providing all depositors with interest-bearing accounts at the central bank. And this is something the Bank of Canada is already considering, although not necessarily with the same objective in mind.
How would a CBDC system work?
Let’s first consider the main functions of commercial banks. Commercial banks take deposits from some customers and make loans to other customers. But contrary to the popular belief, banks are not intermediaries between savers (depositors) and borrowers. Indeed, banks do not need a previous deposit to make a loan; rather, the loan itself creates an additional deposit — where deposits are money, digital currency. That is, loans create money. So, banks are not financial intermediaries after all … they are money creators — that is, commercial banks create digital currency.
These main functions of commercial banks would continue with a CBDC system, but with an important twist: Now commercial banks would become intermediaries between their customers and the Bank of Canada.
On the one hand, when customers make deposits at commercial banks, they would be actually depositing in their CBDC accounts at the Bank of Canada. Hence, “with an interest-bearing CBDC, a bank run is impossible,” says Eeckhout. “As the lender of last resort, the central bank could issue as much money as needed if depositors wanted to withdraw their money simultaneously.” Therefore, bank runs would become a thing of the past.
On the other hand, when a bank gives a loan to a customer, it needs to have the required amount of CBDC. If not, then it would have to borrow it from the Bank of Canada — and the bank would profit from the difference between the interest paid and the interest received from its customer. Consequently, since commercial banks cannot create CBDC, banks cannot create money now. Instead, the Bank of Canada creates money now when it lends CBDC to commercial banks — and the latter thus become mere intermediaries between their customers and the Bank of Canada.
In a CBDC system the role of commercial banks would remain “crucial for the financial system,” notes Eeckhout. “They monitor whether households that apply for mortgages are solvent, and whether business loans will be used for profitable investments.”
But now, the Bank of Canada could also monitor more easily whether banks are complying with risk management regulations, and whether they are providing loans to finance mostly GDP-enhancing transactions. Therefore, the introduction of a CBDC would put the Bank of Canada in a better position to ensure that fewer loans are extended to finance speculative asset-transactions, thus helping to prevent the development of asset-bubbles and financial crises.
Unlimited deposit insurance and stringent bank regulations do not appear as a foolproof combination to prevent banking crises. A CBDC system, however, appears to have the potential to make bank crises a thing of the past — and for two main reasons. On the one hand, customers’ deposits would remain bulletproof. On the other, a bad loan would reduce the profits of the bank in question, without affecting the stability of the sector. And even if a bank becomes insolvent, another bank would just purchase its loan portfolio without affecting the financial well-being of any customer, thus preventing the possibility of contagion and a banking crisis.
The time for the adoption of CBDC appears to have come. The Bank of Canada is building the capability of issuing CBDC, and it appears ready. However, the decision to adopt a CBDC system is political and not technical — that is, it’s up to Parliament and the Government of Canada, and not to the Bank of Canada.