trending
Central bank digital currencies like the digital euro still spark enthusiasm, at least among some central bankers, not least of all the European Central Bank.
The potential financial impact of a digital Euro
After two years of studying how a digital euro would work, the ECB is planning its implementation. This “preparation phase” should take two years from November 1, 2023.
The ECB maintains that current bank financial models will be little changed. Others see problems ahead.
Banks could see profit decline by up to 20%, according to one analysis. The hit to fees will have a significant impact, according to Mediobanca Research.
The digital euro’s underlying infrastructure would remove European payments from the current patchwork of costly national systems. Savings on payments would follow.
If around half of debit payments and bank transfers switched, the hit to EU bank profits would be about 3%.
Digital Euro Deposits
CBDC payments would also suck deposits from the banking system.
As banks are the envisioned institutions for the distribution of the digital euro, this means that those banks need to perform the conversion function from commercial bank money into Digital Euro.
In layman terms, this means that consumers will have to withdraw money from their payment, savings or deposit accounts to obtain digital euros.
Or, in other words this actually means that every digital euro that is being distributed, the deposit outflow causes that commercial bank holdings are reduced with the same amount, and hence banks’ balances sheets are reduced accordingly.
We acknowledge that holdings in digital euros can also be converted back into accounts held at banks, however, this still allows for (capped) amounts to be held outside the banking system.
It is that holdings in digital euro that is of particular concern.
Central bankers are proposing a cap on CBDC account size, likely to be about €3,000. Even so, full uptake would still mean significant pain.
The digital euro could draw almost €1 trillion of deposits out of the European system or equal to 10% of retail deposits.
Banks could be forced to make up any shortfall by drawing down excess reserves. That worst-case scenario would sap net interest income and shave another 9% from bank profitability.
Fee income would also fall. Banks would have to find new ways to exploit technology and find growth.
CBDC’s likely use of a digital ledger will open the door to further sources of fees such as smart contracts for financial products.
There is a counter argument, of course. Banks could reduce deposit flight with higher rates for short-term money. And it is always unwise to underestimate the lethargy of bank customers.
Economic Effects?
The economy could also face negative consequences in the form of a reduction of mortgage financing, consumer loans or SME financing (either because the reduction in savings and retail banks’ balance sheets imply less capability to provide credit or because the increase in funding costs translates in higher prices of loans).
Besides, possible negative impact of a deposit outflow is expected on banks liquidity management, notably on two ratios that are important: on the Liquidity Coverage Ratio (LCR) and on the Net Stable Funding Ratio (NSFR). Banks always have to comply with these ratios.
Both will be changed by the introduction of a digital euro on an incremental basis: based on our calculation, the introduction of a digital euro will cause the decline of both LCR and NSFR on average, the higher the amount of digital euro holdings will be allowed, the stronger the decline of both LCR and NSFR.
Lower LCR levels may require banks resorting to other, usually more expensive, funding sources, whilst lower NSFR levels may require banks to involve the use of capital market instruments, to which some intuitions have little to no access.
Both options are expensive, if possible at all, and will negatively impact banks bottom lines.
Both reasons, the impact on the balance sheet as well as the impact on liquidity, call for a low cap on holdings.
Comments