The Impact of Evolving Central Bank Digital Currencies on Banks and Risk Management

Central bank digital currencies (CBDCs) are on the horizon and risk managers need to pay closer attention to them. While CBDCs are still in their infancy and their adoption in major markets like the U.S. is yet to gain momentum, their potential impact on risk management at banks is undeniable.

The question is no longer whether CBDCs will become a reality, but when and how they will shape the future of banking.

From Analog to Digital

Cryptocurrencies such as Bitcoin and Ether, free from government control and manipulation, have been touted as the future of finance, promising privacy, stability and independence. However, the reality has been far from ideal. Several companies supporting cryptocurrency transactions and storage have been hacked, so their record on privacy has been spotty, to say the least.

Moreover, high-profile incidents, such as the Colonial Pipeline ransomware attack, have revealed that public blockchains may make it more difficult –  but not impossible –  for authorities to track transactions.

Widespread adoption of cryptocurrencies for everyday transactions is unlikely. Their prices have tended to track equities (especially technology stocks), making them much more volatile than traditional fiat currencies such as the U.S. dollar or the Euro. The industry also faces several regulatory headwinds in the wake of FTX and other headline-grabbing scandals.

Cristian deRitis

Despite these challenges, it would be a mistake to dismiss cryptocurrencies as simply a passing fad. Even if their use as everyday transactional money is questionable, their potential as "digital gold" is worth considering, given investor interest.

If nothing else, the rise of cryptocurrencies has sparked a global movement among central banks to develop their own digital currencies. We may think that the transition to CBDCs is a giant leap, but the fact is that “commercial bank digital currencies” already dominate the financial system.

According to the Federal Reserve, nearly 90% of the $21 trillion U.S. money supply is held in digital form as entries on bank ledgers. The preference for digital over physical currency by businesses and households is already overwhelmingly clear.

Significant Obstacles to Entry

Privacy concerns are one of the most significant barriers to moving from commercial to central bank digital currencies. The public fears that CBDCs would allow their private transactions to be easily traced by government officials.

While this is a legitimate fear that needs to be addressed, it is not as though the current system is anonymous. Online bank accounts, credit cards and other forms of digital payment are already highly traceable. Even physical banknotes have serial numbers allowing for some degree of traceability. It may take some time, but privacy concerns are likely to be overcome.

The second challenge to rolling out CBDCs is the potential harm and disruption that disintermediation could do to both the financial system and the broader economy. If consumers and businesses were to start holding large quantities of their savings directly with central banks, the deposit base of financial institutions would be sharply reduced.

Banks and credit unions would be unable to originate as many loans as they do today, cutting off a primary source of capital for businesses — especially small businesses— and households. The resulting drop in spending, investment and employment could push economies into recession and restrict future growth.

A third consideration is whether governments can afford to issue CBDCs. This is not a question about paying for the computer servers and other technology needed to support a digital currency. Rather, government officials will need to consider the effect of lost revenue derived through seigniorage. 

Assuming a 5% annual interest rate, the holders of the $2.3 trillion in outstanding U.S. banknotes are effectively subsidizing the U.S. government by over $100 billion per year. Given that lower income households hold a disproportionate share of their savings in cash, reducing the level of seigniorage may be socially beneficial – but it will come at a cost.

In Search of a More Perfect System

Faced with these challenges, central banks will aim to issue CBDCs that complement the existing system, rather than replacing it entirely. They will likely seek to engage with commercial banks as partners that can function as independent custodians of individual CBDC accounts.

Introducing this fiduciary layer between central bank, households and business should address privacy concerns while preserving the crucial role that commercial banks have in the provision of credit.

Central banks will take a slow, phased approach to introducing CBDCs, given the need to build trust and avoid the catastrophic consequences of a poorly executed transition. They will likely place limits on the amount of CBDC individuals and businesses can hold, and, to reduce the amount of capital flight from commercial banks, refrain from paying interest on deposits.

How Should Risk Managers Respond?

The gradual approach to CBDC adoption will buy commercial banks some time, but risk managers need to start adjusting their strategies today to avoid getting left behind. The banking crisis earlier this year underscored the speed at which bank customers may move their assets based on perceptions of risk.

High-income households are already choosing to deposit a growing share of their wealth in money market funds (MMFs) rather than commercial bank accounts, partly because of MMFs’ higher interest rates and partly because of customers’ fears that bank failures could cause them to lose their non-insured deposits. Considering their direct relationship with the Federal Reserve, MMFs, in fact, already share many of the characteristics of CBDC.

Risk managers can respond to these competitive threats by adopting best-in-class controls and security measures to allay their customers’ privacy and safety concerns. They need to continuously adapt to their customers’ evolving demands, rather than fighting against them.

The shift to MMFs provides an informative example. Instead of standing idly by while deposits continue to flee, banks can react by increasing interest rates or by offering their own MMFs to retain a relationship with their customers.

Emphasizing the customer experience will enable banks and credit unions to demonstrate their value to lawmakers and regulators, ensuring that they are not cut out of the financial system. Rather than resisting CBDC adoption entirely, successful banks and risk managers will embrace it and develop ways to provide additional services that enhance both customer service and their own bottom lines.

Simultaneously, risk managers will need to consider how CBDCs may be used to improve the efficiency of their own back office and Treasury functions. For example, the collection, sorting and transporting of physical banknotes tends to be a highly manual and costly process for many banks today. Adoption of CBDCs may reduce or even eliminate this expense for many institutions.

Parting Thoughts

The question of whether central banks should issue digital currencies should be left up to the public. In the current system, households and businesses have voted for commercial bank digital currency over physical currency in overwhelming numbers. CBDCs are the next logical step in this evolution that promises greater transparency, safety and financial inclusion.

As with all financial innovations, CBDCs present both a challenge and an opportunity for banks. They are a potential threat to traditional banking, but banks already must compete with physical currency, money market mutual funds, cryptocurrencies and a growing number of fintechs and alternative providers of private capital. Financial institutions will need to evolve their business practices and offerings with or without the introduction of CBDCs.

Predictions that CBDCs are going to take over and drive all commercial banks out of business are overstated. But so is the assumption that CBDCs are a passing fad. They are a reality that is fast approaching.

Risk managers must adapt to this reality and innovate quickly to shape the future, rather than reacting passively.

Cristian deRitis is the Deputy Chief Economist at Moody's Analytics. As the head of model research and development, he specializes in the analysis of current and future economic conditions, consumer credit markets and housing. Before joining Moody's Analytics, he worked for Fannie Mae. In addition to his published research, Cristian is named on two U.S. patents for credit modeling techniques. Cristian is also a cohost on the popular Inside Economics Podcast. He can be reached at cristian.deritis@moodys.com.