the nemesis of fractional reserve banking?
8 June 2020
A year after their 2019 paper "Understanding Central Bank Digital Currencies" (CBDC), the Cashless Society
Working Party is revisiting the topic with a blog series. This time, Sabrina Rochemont investigates the impact
of a retail CBDC on the fractional reserve banking system.
A major block stands against all the drivers towards the launch of retail (general
purpose) Central Bank Digital Currencies (CBDC): the risk facing the current
lending process. In other words, there is a concern that the impact of such CBDC
as a new payment instrument on fractional reserve banking is too big a risk for
financial stability. Why such a concern?
With fractional reserve banking, only a fraction of bank deposits is backed by actual
cash in hand and available for withdrawal. The balance is available for lending.
This is the opposite of a full reserve system, also referred to as narrow banking,
where banks’ deposit accounts are separate from all their other activities, preventing the banks from creating
money. Narrow banking attracts many proponents, notably during or just after major economic crises, such as
the Great Depression, that led to the Chicago Plan in the 1930s. The plan for banking reforms, including the
abolition of the fractional reserve system, was never implemented, but the concepts keep resurfacing. In
2018, the Swiss voted against returning to a full reserve system.
The deployment of a retail CBDC could change this. The plans from the People’s Bank of China for their
Digital Currency (DC/EP) CBDC, as well as the Bank of England’s illustrative model for a Sterling CBDC, both
function on a two-tier intermediation model, whereby Payment Interface Providers (PIPs) would keep all
CBDC reserves at the Central Bank. These PIPs may be pure payment intermediaries or may be commercial
banks processing transactions. But these CBDC deposits would not be used for lending.
This is a major change: a CBDC will compete for commercial bank deposits, depending on other aspects of
the design, such as its interest-bearing status. One result of the withdrawal of funding to commercial banks
would be the growth of the Central Bank’s balance sheet in times of stability, that would increase further at
times of crisis. Commercial banks would therefore lose stable low-cost funding and might also have to align
their deposit rates above that of an interest-bearing CBDC to attract deposits. This would grant more power to
the Central Bank’s monetary policy. Digital-only PIPs would also benefit from lower operating costs, so could
compete with commercial banks on interest rates. If PIPs are able to attract savings and use these for
lending, they could partially or wholly compete with banks.