This chapter develops further the role of a central bank and its interplay with commercial banks. Together, the two ensure the provision of liquidity to the economy, such that the real sectors are shielded from flows of funds originating from household and investors. We also disaggregate the banking system into two banks to represent deposit flows between banks and their impact on the central bank’s balance sheet, and to distinguish between what we call “relative” and “absolute” central bank intermediation. We then integrate deposit money creation by commercial banks into our system of financial accounts, and revisit some old debates, such as the limits of bank money creation and the role of related parameters that the central bank can set (not only the reserve requirement ratio, but also the collateral framework). Finally, we explain the concepts of “plain money” and “full reserve banking” within the financial accounts, and also discuss in this framework the recent proposals regarding central bank digital currency (CBDC).

2.1 Central Banks in a Paper Standard

Since their origins (Bindseil 2019), central banks have evolved considerably. Today, they have most of the time the following set of common characteristics: (i) monopoly over the issue of the legal means of payment; (ii) public control and in most cases state ownership; (iii) a clear public mandate; (iv) possibility to create the legal means of payment without any liquidity risk or risk of default; (v) deal only with banks and the government and not with corporates and households.

Table 2.1 summarises the financial relationships of a modern central bank with the other sectors. Practices changed over time: modern central banks withdrew from accepting deposits from corporates and households, and they normally do not provide directly credit to governments.

Table 2.1 Counterparties for financial operations for central banks
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A paper standard is a monetary arrangement in which the central bank does not promise convertibility of its monetary liabilities into precious metal coins. Issuance of monetary liabilities is therefore less constrained, and the central bank cannot default on a convertibility promise, as there is none. In a pure paper standard, the central bank does not need to hold gold nor silver. If it also does not need to stabilise its exchange rate to any other currencies, then its assets may consist only in domestic financial claims, such as  loans to banks and domestic securities.

Table 2.2 provides a stylized representation of the balance sheets of the different economic sectors. It does not distinguish between financial equity and debt. However, it distinguishes between financial equity and real equity (equity that is the financial asset of no-one).

Table 2.3 shows an alternative representation of the financial accounts shown in Table 2.2. It avoids the redundancy inherent in financial accounts shown in balance sheet format as it shows every financial position only once in a matrix, and not twice, i.e. not separately as a financial claim and as a financial liability. The first column shows the economic sectors from which to see each row a list of assets. The row with the list of financial sectors shows, in each column below the sectors, the liabilities. Besides the matrix of financial claims and liabilities, there is one column showing all the real assets of the sectors (second column) and one row showing the real equity positions of the sectors, i.e. the equity not being a liability to any other sector (second but last row). Some positions will be zero by definition: for example F(5,1) should be zero, because the central bank should never have any direct claims towards households.    

Table 2.2 Financial accounts in a paper standard
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Table 2.3 Parsimonious financial accounts representation through financial exposure matrix
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We should always remember that the following equalities hold:

  • Σ real assets = Σ real equity, i.e. total real assets of economy are equal to total real equity

  • Σ Σ financial assets = Σ Σ financial liabilities (sum of all financial assets across all sectors equals sum of all financial liabilities across all sectors)

  • Σ assets of one sector = Σ liabilities of one sector.

2.2 Changes to the Demand of Financial Assets in a Paper Standard

In this section we will review what happens if households adjust their demand for financial assets in a paper standard. Two of the sectors shown in Tables 2.2 and 2.3 are assumed to make choices: first the household chooses to diversify its real assets into financial assets and determines the extent of this diversification, as well as the reliance on each of the three types of financial assets: bonds, deposits, banknotes; second the central bank decides on the split up of its monetary policy operations between outright (i.e. direct) securities holdings SCB and credit provision to banks (as residual, B − SCB). All other balance sheet positions are expressed in terms of these four choice variables, plus the initial household endowment EH.

The household demand for specific financial assets is potentially unstable, as households may want to reduce their exposition to a debtor whose solvency they no longer trust by holding more liquid and safe assets. In the following representation gold is merged into real assets. Households could refuse to roll over debt securities and reduce their related positions (which we will identify in the subsequent financial account tables as flow s) and hold more deposit. Alternatively, households may withdraw deposits from banks (which we will identify as flow d) and hold more banknotes if they fear banks may be insolvent.

The effects of these flows will depend on the reaction of the banks and the central bank. If the financial sector is ready to provide the necessary elasticity, then the financial flows related to changing financial asset demand of household can be absorbed without damage. If however the financial sectors do not provide the necessary elasticity, then the financial flows triggered by the households can cause economic damage.

2.2.1 If Financial Sectors not Ready to Compensate Missing Demand for Securities

Table 2.4 assumes that households want to reduce their corporate bond holdings by s, and that the rest of the financial sector is however not available to play any role to shield the corporate sector from this. For simplicity, we assume that the household wants to hold again more real assets. If neither the commercial banks nor the central bank want to react to a de-investment of the households from corporate bonds, then the corporates are threatened by illiquidity. Corporate (and government) assets are illiquid and specific to some extent, i.e. they have been made specific to the uses by the corporates (in the sense of Williamson 1985). For instance, a machine that has a certain value if used in a specific production will likely have lower value outside this production. In the worst case, the machine could have no value for other companies apart from the value of the raw materials it is made of. Therefore, when sold, it creates a revenue that is lower than the value the asset has in the balance sheet. In the short term to produce the liquidity needed to pay off the corporate debt that cannot be rolled over, they lose value and create financial losses, as captured below. The letter “f” stands for fire-sale losses. To capture the effects, we need to introduce a positive equity of the corporate sector, held by households. The financial accounts of the financial system (bank and central bank) in this example are not affected. They would be if the equity of corporates were insufficient to buffer fire-sale losses, and the fixed income liabilities of corporates towards banks would suffer losses.

Society now suffers from asset fire-sale losses of f. If s is the funding gap of the corporate created by the declining willingness of the household to hold securities, then the corporate needs to sell not only assets of a value s, but of a value s + f, to generate a liquidity of s. These losses reduce the corporate’s equity, and eventually the household equity (as the household holds the corporate equity). This is a first example of how liquidity and solvency interact, and how illiquidity can cause damages to society.

Table 2.4 Real sector when fire sales are inevitable
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2.2.2 Commercial Banks Absorb Security Flow

Now we assume that households want to substitute corporate bond holdings by deposits with banks and that banks are ready to use the related funding inflows to close the funding gaps of the corporate. Table 2.5 shows this case. The banking system acts as lender of last resort for the corporate sector by recycling the deposit inflow to provide more credit to the corporates as illustrated in Table 2.5.

Table 2.5 Flow of funds if financial system absorbs flows and shields real sectors
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The system of accounts in Table 2.5 assumes that the banking system is fully effective in extending its balance sheet to finance the corporate sector such as to avoid any economic damage. However, in reality, quick adaptation of the balance sheet of banks will come at extra cost: (i) e.g. the staff has to get extra pay for “night shift work”; (ii) additional resources may be needed in the form of expensive consultants and external lawyers; (iii) the additional risk taking associated with the rapid acceptance of extra exposure needs to be compensated, etc. The banks will charge these extra costs to the corporate at the expense of the profits (or, in stock terms, of the equity) of the corporate. Moreover, if the households were also to have doubt on the solvency of banks, they could convert their securities into banknotes. In such a case only the intervention of the central bank can avoid a financial crisis.

2.2.3 The Central Bank Absorb Flows and Acts as Market Maker of Last Resort

Table 2.6 shows the case in which households want to shift exposures from corporate bonds into deposits with banks (flow s) but at the same time want to convert deposits with banks into banknotes (flow d) and the central bank provides elasticity and acts as market maker of last resort in the bond market. 

Table 2.6 Flow of funds if central bank absorbs all shocks
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The central bank issues banknotes demanded by households and purchases debt securities as needed. None of the financial shocks relating to the instability of the household demand for financial assets reaches the corporate/government sector in the sense that fire sales can be avoided.

Funding shocks reaching the real sector imply forced deleveraging (like in Sect. 2.2.1) or defaults, both of which are costly for society. A total shielding of the government and corporate sector from funding risks, however, would also be costly in the long run as it would undermine market discipline and incentives to improve productivity. An indefinite softening of the budget constraint is credited to be one of the main sources of inefficiencies in planned economies and of the reason for the ultimate prevalence of market economies in the twentieth century. At the same time an excessively hard budget constraint prevents long run investment (Dewatripont and Maskin 1995). The intervention of the central bank should aim at finding the optimal compromise between these two opposite risks, allowing for an appropriate amount of “creative destruction” for maximising social welfare in the medium and long run. From this point of view the central bank can be seen as a solvency regulator of the economic system (Brancaccio and Fontana 2013).

2.3 Interbank Flows

So far, we have assumed that every economic sector (households, corporates, the government, the banks, the central bank) is in itself homogenous and can be aggregated without losing anything. This also implies that shocks (liquidity and solvency) would affect all individual households and firms equally within each sector. In reality, all sectors—except the central bank and the government, each of which are constituted by a single entity—are internally heterogeneous. In the case of households: some have taken loans and are thus leveraged, while others are not. Moreover, households have different asset compositions. Some own real estate (as the typical largest real asset position of households) while others have almost only financial assets. Finally, some households may have a lot of equity (are rich) while others may have almost none or even a negative equity (are poor). Corporates and banks have different liability structures, i.e. different shares of credit, bond issuance, and equity. Bank credit and bonds may have different maturity structures, etc.

Today’s banking crises are typically not about shifts of deposits into banknotes, but about shifts of deposits between banks. We therefore need to adjust the previous financial account systems by introducing two separate banks—we obtain Table 2.7 as a result. This will also allow us in Table 2.7 to include an interbank market. We assume that the banks are identical ex-ante, and each represent one half of the banking system. The interbank market position between the two types of banks is set initially to Y, with bank 1 lending to bank 2. This could be the case because bank 1 has comparative advantages in deposit collection, while bank 2 has comparative advantages in originating and managing loans to corporates. We simplify the model above in the sense that we no longer consider securities issuance as a funding source for corporates, but introduce two new flows to the model. Flow d>0 reflects a deposit shift between banks initiated by households. The flow may be triggered by one bank suddenly offering a higher remuneration rate, or by rumours about one bank having solvency problems. Flow y>0 reflects a shrinkage of interbank lending, and may result from a change of business strategy by the lending bank, or that the lending bank believes that the borrowing bank is in trouble and that therefore credit riskiness of loans to it is perceived as too high. Flows d and y both imply funding losses for bank 2, which consequently has to extend its central bank borrowing. Note that if d + y > B/2, bank 1 will be in excess liquidity, i.e. without any recourse to central bank credit, bank 1 will have a claim on the central bank of d + y − B/2. In this case, the central bank balance sheet expands by the latter amount (Table 2.7).

Table 2.7 Household deposit and interbank lending shifts—with two separate banks
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These accounts allow us to define three important concepts.

  • By allowing liquidity flows d and y to be compensated by heterogeneous changes of the recourse by individual banks to central bank credit, without lengthening the central bank balance sheet (as long as B/2 − d − y ≥ 0), the central bank provides relative intermediation to the banking system.

  • Once liquidity flows are such that some banks deposit excess funds with the central bank, thereby lengthening the central bank balance sheet (which happens in the above financial accounts when B/2 − d − y < 0), while other banks are particularly dependent on the central bank, we speak of absolute central bank intermediation of the banking system. Normally absolute central bank intermediation can be avoided by setting a sufficient spread between the (higher) rate at which banks can borrow from the central bank and the (lower) rate of remuneration of excess deposits. Interbank lending allows the banks to collectively avoid the costs associated with this spread.

  • By choosing to conduct its credit operations as “full allotment” operations, i.e. providing at a given rate whatever the banks ask for, the central bank can provide these intermediation services passively, i.e. it does not need to take any particular initiative for it. The limit to intermediation despite full allotment is central bank collateral availability. Widening the collateral set in a crisis specifically for the sake of allowing for more intermediation, or for providing confidence to markets that banks have large liquidity buffers, would be examples of active intermediation measures.

Finally, note that interbank lending can be either positively or negatively correlated with household deposit shifts, whereby the former case is detrimental, and the latter case supportive to financial stability. A positive correlation is likely if the main underlying factors are public news on a poor performance of the bank and possible related solvency problems. A negative correlation will occur if household deposit shifts are driven by factors which are independent of the actual credit quality of the bank and if the banks have no mutual credit risk concerns such that the interbank market can serve as an elastic buffer compensating exogenous liquidity flows. For example, a negative correlation generally prevailed in the euro area between 1999 and 2007, and a positive correlation was experienced particularly during the sovereign debt crisis, in which Greek, Spanish, Portuguese and Irish banks experienced both a cut-off of interbank lending and deposit outflows.

2.4 Role of Commercial Banks in Money Creation

2.4.1 Credit Money Created by Banks

To represent credit money creation in our system of financial accounts, we start from the simplest case of a financial account system with two banks and with all financing to the real economy being done through the banking system. Werner (2014, 1), one of the promoters of plain money (see Sect. 2.7 below), summarises the old question and the three schools in monetary economics about the ability of banks to create money as follows:

According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit. (the credit creation theory of banking)

Werner (2014) also presents an empirical test to conclude that the third school is right (“money supply is created as fairy dust produced by the banks individually, out of thin air”, p. 1). Table 2.8 provides financial accounts to understand the issue. Denote by C1 (C2) the credit money creation by bank 1 (bank 2) to the households. We assume that households keep the money in the form of deposits with banks, but not necessarily with the same bank. Concretely, we assume that the household would split up its additional credit money holdings equally across the two banks, regardless of which bank provided the credit. Moreover, we assume that the central bank imposes a reserve ratio of r on the banks, i.e. banks need to hold a ratio of the non-bank deposits with them in the form of required reserves with the central bank. This duty implies an increased reliance of banks on central bank credit. For simplicity, we also assume that the banks have not issued any equity.

Table 2.8 Financial accounts with two banks and credit money creation (assuming │C2 – C1│ < B)
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What could be the possible limits to credit money creation by banks on the basis of these accounts? Assume that credit claims of banks on firms and households are eligible central bank collateral, but that they are subject to a haircut h. The following collateral constraint applies for bank 1 if it is the only bank that expands credit (i.e. C2 = 0). On the left-hand side of the inequality is the available central bank collateral after applying the haircut h, while on the right-hand side figures the recourse to central bank credit.

$$\begin{array}{*{20}c} {\left( {1 - h} \right)\left( {\frac{D}{2} + \frac{B}{2} + C_{1} } \right) \ge \frac{B}{2} + \frac{{C_{1} }}{2} + \frac{{r\left( {D + C_{1} } \right)}}{2}} \\ { \Leftrightarrow \ldots \Leftrightarrow \left( {1 - {\text{h}} - {\text{r}}} \right) \cdot D - hB \ge C_{1} \left( {r + 2h - 1)} \right)} \\ { \Leftrightarrow \frac{{\left( {1 - h - r} \right)D - hB}}{r + 2h - 1} \ge C_{1} } \\ \end{array}$$

In the case of the euro area, r = 0.01 and h is approximately around 0.8. It is therefore plausible that r + 2h − 1 > 0. If r + 2h − 1 < 0, then the inequality would change direction when dividing by this term, and C1 would be unconstrained. Therefore, to make reserve requirements and the collateral framework effective as a tool to prevent uncontrolled credit expansion by a single bank, the central bank must ensure that r + 2h > 1. Under this assumption, the maximum value of C1 declines with increasing reserve ratio r and increasing haircut h. For example, if D = 10, B = 1, h = 0.8 and r = 0.01 (relative values broadly corresponding to the euro area), then the maximum value of C1 is 1.8.

What happens if instead C1= C2= C/2, i.e., if the banks engage in parallel credit money creation? In this case, the constraint of the bank becomes:

$$\begin{array}{*{20}c} {\left( {1 - h} \right)\left( {\frac{D}{2} + \frac{B}{2} + \frac{C}{2}} \right) \ge \frac{B}{2} + \frac{{r\left( {D + C} \right)}}{2}} \\ { \Leftrightarrow \ldots \Leftrightarrow \left( {1 - {\text{h}} - {\text{r}}} \right)D - hB \ge C\left( {h + r - 1} \right) } \\ { \Leftrightarrow \frac{{\left( {1 - h - r} \right)D - hB}}{r + h - 1} \ge C } \\ \end{array}$$

If r + h − 1 is negative, as one should expect (and as it is certainly the case for the euro area), this equation is not constraining on C, as the direction of the inequality changes direction when dividing by this term. Only if the central bank imposes higher than usual reserve ratios in addition to high haircuts (say h = 0.8 and r = 0.4) does a constraint materialise. But, then, the bank would be collateral constrained even before providing any credit to households. In sum: even in combination, haircuts and reserve ratios are not a suitable tool for controlling credit expansion if banks expand credit simultaneously and proportionally.

However, limits to credit money creation arise anyway out of the preferences of the household. Bank credit money creation is costly in the sense that the banks will require a higher remuneration rate for the claims towards the households than what they offer in terms of remuneration rate of deposits (banks have to cover their operations costs and compensate their financial risk taking). Therefore, households will have a demand for credit money only to the extent that they see a particular utility attached to it justifying the costs. Extending credit to corporates would mean that corporates would use the extra funds for additional investments in real goods, which assumes that the productivity of these investments is sufficiently high. Extending credit to corporates for the sake of corporates purchasing financial assets is again limited by the requirement of this allowing the corporate to generate positive carry at sufficiently low risk. Therefore, again, this should not be sustainable and be relevant only in phases of speculative exuberance.

It is important to note that the credit money expansion by the bank has no impact on the central bank balance sheet in the financial accounts system above as long as the difference in the pace of additional credit provision by the two banks is not too large, i.e. as long as │C2 − C1│ < B. Once this condition is violated, the length of the central bank balance sheet would expand because the bank with the more limited credit expansion would hold excess reserves.

The size of credit money expansion in any case affects the scale of possible deposit shifts, and hence the scale of possible recourse to the central bank to compensate for resulting funding gaps. Therefore, the length of the banks’ balance sheets, and their ballooning through credit money creation, are relevant in financial crisis situations.

2.4.2 “Sovereign Money” and “Full Reserve Banking”

A number of monetary economists claim that deposit money creation by banks is one of the major causes of monetary and financial instability and recurring crises. Werner (2016) argues that by not understanding the problematic implications of deposit money creation, “the economics profession has failed over most of the past century to make any progress concerning knowledge of the monetary system”. Some of these economists conclude that all money creation should be undertaken by the central bank. Banks would need to refinance through the central bank and through capital markets, but no longer through sight deposits (i.e. deposits that can be withdrawn any time without notice period). Two variants may be distinguished: First, Beneš and Kumhof (2012) return to Irving Fisher’s Chicago Plan, which foresees essentially that banks have to hold the funds obtained through sight deposit issuance fully in the form of required reserves with the central bank (a sort of full reserve banking proposal). Second, Huber (1999, 5–6) explains the “plain” or “sovereign money” proposal, in which sight deposits with banks would be substituted by central bank money, i.e. banks would no longer have monetary liabilities. Huber (1999, 18) also explains the financial account implications of plain money:

the credit claims of a bank on the loan-taking clients remain; the cash liabilities of a bank to the account-maintaining clients disappear, and the cash claims of the account-maintaining clients on the bank disappear equally; in exchange for the latter a credit claim of the central bank on the bank appears. These credit claims would be part of the assets on the balance sheet of the central bank, corresponding to the sums of non-cash money being registered on the liability side. (neither of which are the case today)

Also KPMG (2016) studied sovereign money (or as they call it the “sovereign money system”) in a report commissioned by the Icelandic Prime Minister’s Office. In this report, financial account representations are shown, and a survey is provided of political initiatives (e.g. in Switzerland, Iceland, UK, US) to study and possibly introduce plain money, and of academic literature.

In the financial accounts shown in Table 2.9, we interpret “plain money” as meaning that sight deposits need to be held at the central bank and we use a basic numerical example. The numbers are broadly representative of the euro area in 2018, if denominated in trillions of EUR (however with strong simplifications necessary to map the statistical financial accounts of the euro area as provided by the ECB into our simplified accounts, as well as rounding). The switch to a sovereign monetary system implies, in the stylised accounts of Table 2.9, a migration of 6 trillion of sight deposits from banks to the central bank. 

Table 2.9 Plain money in financial accounts with illustrative numbers
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The central bank becomes a much more important financier of the commercial banks, i.e. it becomes an intermediary between depositors and banks. The central bank balance sheet will lengthen, and central bank eligible collateral will become even more important for banks.

If instead we interpret sovereign money as full reserve money, as in the Chicago Plan, the financial accounts in Table 2.10 would be obtained.

Table 2.10 Full reserve money/Chicago plan financial accounts with illustrative numbers
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The implications on the central bank balance sheet are similar to sovereign money: the central bank balance sheet lengthens and credit risk-taking of the central bank and collateral constraints are likely to become more relevant, unless the central bank expands its outright holdings of low-risk securities, as we will discuss further below for the case in which central bank digital currency would move the financial system in the direction of “sovereign” money.

2.4.3 “Central Bank Digital Currency” (CBDC) Accessible to Non-Banks

The idea of Central Bank Digital Currencies goes partially in the same direction as plain money but would be voluntary and is motivated from the perspective of efficiency of the means of payment, and not out of scepticism regarding the stability properties of bank money creation. CBDC would be brought into circulation in the same way as banknotes: on demand by households and corporate users, who could freely convert bank deposits into CBDC. Indeed, the internet and the use of mobile devices have transformed the possibilities how money can be stored and exchanged. Already today, a large share of money transfers is undertaken electronically, via internet banking, card payments or the use of e-money. Furthermore, new technologies for digital currencies have become available. Normally, electronic money transfers are based on commercial bank money, i.e., money is transferred from one commercial bank account to another. Only central bank account holders, i.e., commercial banks and a few other institutions (e.g. market infrastructures, governments), can hold and transfer central bank money electronically. Non-banks can currently do so only in the form of banknotes. CBDC would be, like banknotes, a direct claim on the central bank.

The literature in favour of CBDC argues: (i) It is more convenient and efficient to hold central bank money in digital form than in the form of cash. (ii) CBDC is more secure than commercial bank money, from a credit and settlement risk perspective. (iii) People’s preference for money in digital form could lead to an undesired increase in the usage of virtual currencies (e.g. “stablecoins”) in the absence of CBDC. Virtual currencies may create risks to price and financial stability. (iv) The provision of CBDC is cheaper for the central bank than the provision of cash. (v) Promoters of plain money argue that increased reliance on central bank money has various macroeconomic advantages, such as higher fiscal income for the state and a more stable financial system.

CBDC could be implemented in two forms: First, offering deposit accounts with the central bank to all households and corporates. From a technological perspective, this would not be very innovative, but just a matter of scaling the number of accounts offered. Second, the central bank could offer a digital token currency that would circulate in a decentralized way without central ledger, i.e., without the central bank knowing who currently holds the issued tokens. This would be more innovative, and would require more complex cryptographic techniques.

If households substitute banknotes with CBDC, then central bank and commercial bank balance sheets do not really change. However, if households substitute commercial bank deposits with CBDC, then this would imply a funding loss for commercial banks, i.e., lead to “disintermediation” of the banking sector. Sight deposits largely used for payment purposes could shift to some extent into riskless CBDC, leading to a loss of commercial banks’ funding of equal size. Banks would have to try to offer better conditions on their deposits in order to protect their deposit base as much as possible—but this would imply higher funding costs for banks and a loss of commercial bank “seignorage”. The central bank could aim at limiting the attractiveness of CBDC, through fees, or through a lower remuneration rate than the short-term market rate. In addition to the structural loss of funding for banks, there is also a financial stability issue. CBDC makes it significantly easier for non-banks to shift funds out of banks in the case of emerging general credit risk fears towards the banking system (although already today customers can easily shift their funds from one bank to the next). Contradicting this, some authors have perceived the occurrence of CBDC as positive for financial stability. For example, Dyson and Hodgson (2016) argue that CBDC

can make the financial system safer: Allowing individuals, private sector companies, and non-bank financial institutions to settle directly in central bank money (rather than bank deposits) significantly reduces the concentration of liquidity and credit risk in payment systems. This in turn reduces the systemic importance of large banks. In addition, by providing a genuinely risk-free alternative to bank deposits, a shift from bank deposits to digital cash reduces the need for government guarantees on deposits, eliminating a source of moral hazard from the financial system.

Table 2.11 shows the creation of CBDC in a financial account system. The creation of CBDC has been split into two parts: CBDC1 which substitute banknotes and CBDC2 which substitute deposits with banks. The accounts also reflect that the central bank would, instead of increasing only its lending to banks, also increase its outright security holdings. In theory, one could imagine that the central bank would, for example, absorb corporate and government bonds from existing stocks of investors, and that this will make it possible for banks to issue new bonds that investors will happily take to close the gaps created by central bank purchases. This case is captured by the bond purchase flow S below. Then, if S = CBDC2, the eventual difference for banks would consist in being funded more through capital markets than through deposits (due to the introduction of CBDC). Such purchases of bonds by the central bank would mitigate the risk that large-scale CBDC2 would make the central bank collateral framework a crucial allocation mechanism of the financial system and that central banks would need to accept almost the entire assets of banks as eligible and impose only moderate haircuts. In the case of large scale CBDC2, preventing the central bank from becoming involved in credit risk and credit allocation despite the lengthening of its balance sheet will thus depend on the availability of low-credit risk bonds, such as in particular central government bonds. If these are abundantly available such as to fully match CBDC2 in the central bank balance sheet, then arguably the central bank would not increase its credit risks, the banks would not become more dependent on central bank credit, the collateral framework would not become a more pervasive factor, and the consolidated state balance sheet (i.e., consolidating the government and the central bank) would not increase. All this, however, does not imply that banks would continue to play an unchanged role in the credit allocation process. The more expensive and maybe less stable refinancing through capital markets makes banks less competitive relative to a direct capital market access of corporates, i.e., will tend to reduce the role of banking in the financing of the economy. This is further discussed in Bindseil (2020), who also proposes to address the risk of large scale CBDC2 through a tiered remuneration of CBDC, such that large holdings of CBDCs are subject to unattractive remuneration.

Table 2.11 Financial accounts with central bank digital currencies
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Large CBDC2 could also undermine bank profitability: (i) Central bank lending tends to be more expensive than deposits, which normally can be funded at less than the short-term risk-free interest rate. Therefore, bank profitability could suffer, and banks would have to deleverage to some extent. (ii) If the central bank decides to address this issue through purchases of securities, this does not help either: capital market funding is even more expensive than central bank credit.

To compensate for the implied tightening of monetary conditions, the central bank may have to lower its policy rate, for a given inflation target and for a given growth rate. This would reduce the positive effects on central bank income. Another issue, also arising under the “plain money” proposal, is collateral scarcity of banks, because central bank credit has to be substantially increased. In this case, central banks that have so far had a narrow collateral framework may have to broaden their framework to also accept non-government securities and loans to NFCs as collateral to secure the enlarged structural credit provision. Recently, central banks have devoted growing efforts to analyse central bank digital currency, as documented by e.g. CPMI & MC (2018), Sveriges Riksbank (2020), the Bank of England (2020b), Bindseil (2020), ECB (2020e), Auer, Cornelli, and Frost (2020), BIS (2020). The implications of CBDC on the financial system and the economy have been assessed from a macroeconomic perspective in e.g. Grasselli and Lipton (2019), Niepelt (2020) and Keister and Sanches (2020).