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Banks are only as special as central banks make them

Published January, 2018 |

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Banks have long played a special role in the financial system. But banks are only as special as central banks make them, and, since the crisis, central banks have taken steps to make them less so. In the future, banks might not be special at all. If governments were to introduce central bank digital currencies, these would not only replace cash; they might also displace deposits. That would have significant effects on banks, the financial system and the economy at large – and the effects may not all be positive.

The pre-crisis financial system

Prior to the crisis banks were seen as the foundation for stability in the financial system and the economy at large. Individuals and institutions had to use banks to access the payment system. Banks lent to non-banks and provided the economy at large with a liquidity back-stop.

Central banks aligned their functions to this framework. They restricted access to payment systems to banks. They transmitted monetary policy to the economy at large via banks. They provided liquidity to banks, and they played a significant role in the regulation and supervision of banks. Banks were special.

The crisis has made banks less special

The crisis demonstrated the frailty of this framework. Banks collapsed, and so would have the financial system and the economy at large, had the authorities not intervened. In response to the crisis, authorities have taken steps to strengthen the resilience and resolvability of banks. In addition, policymakers have also reduced the economy’s dependence on banks.

Authorities have made payment systems and other financial market infrastructures more robust, and shifted activity away from banks toward such infrastructures. Although banks will continue to be the point of entry to the payment system, customers can now use third-party providers rather than banks to initiate transactions. Under “open banking,” a customer can shift his or her relationship to such a provider, and the bank has to give such a provider a conduit to the payment system.1

In addition, central banks have broadened the transmission mechanism for monetary policy beyond banks. Although banks remain the most important channel, they may no longer be the predominant one. Under quantitative easing, central banks have expanded beyond banks and governments to the range of entities to whom they extend credit. They have bought corporate bonds and asset-backed securities outright.

Central banks have adapted their policy framework accordingly. Via eligibility easing they have expanded the range of institutions with access to ordinary central bank liquidity facilities beyond banks to other financial institutions. Similarly, central banks have expanded their supervisory remit beyond banks. Macro-prudential supervision encompasses the financial system as a whole. Banks have become “semi-special.”

The choice facing policymakers and the economy at large

Where should policymakers go from here? Stay with the current approach, revert to the pre-crisis system or try something entirely new?

The case for staying with the current approach is strong. It works in practice. It has arrested the recession and fostered recovery. It is also consistent with theory, namely that the transmission mechanism for monetary policy works through total credit – not just bank credit or bank money.

In contrast, the case for reverting to the pre-crisis system is weak. It failed to avert the crisis, and might do so again, even though post-crisis reforms have made banks less likely to fail and easier to resolve. Banks’ share of total credit is diminishing, and the role of nonbanks – including shadow banks – is growing. These new entities don’t necessarily depend on banks for their own financing, particularly during the upswing of the business cycle.

Consequently, trying to turn back the clock is likely to be ineffective. So, at this stage, is an attempt to try something entirely new. In theory, a central bank could interact directly with the individuals and institutions that constitute the “real” economy rather than indirectly through banks and financial institutions. The means by which central banks might do so is a central bank digital currency (CBDC). This is essentially today’s currency in digital form.

Central banks are currently exploring how digitization could enhance the current role of central bank money in clearing and settlement infrastructures, as well as the pros and cons of issuing digital currency more broadly to the general public. At its broadest extent, anyone could have a CBDC account at the central bank, in the same way that anyone could own a note from the Federal Reserve, the ECB or the Bank of England.

Starting with the pros, a CBDC would be far superior to alternative digital currencies (ADCs) such as Bitcoin. ADCs do not function well as a store of value: prices are too volatile, defenses against hacking are too weak and their backing is non-existent. By contrast, central bank money is the quintessential store of value. The distributed ledger technology is the current key competitive advantage ADCs have, and it’s something central banks can and will acquire.

Macroeconomists see additional benefits from a CBDC. It would expand the policy toolkit. It would eliminate the zero lower bound to interest rates and allow central banks to employ negative interest rates. It would also facilitate the distribution of “helicopter money” and/or the introduction of basic income. Finally, by eliminating cash, a CBDC might contribute to the battle against financial crime.

For the moment, however, the cons of a CBDC predominate. A freely available CBDC poses significant technology, security, privacy and legal challenges. A CBDC would have to be universally and continuously available to eligible participants as well as being able to handle a vast volume of transactions at speed and with accuracy. In addition, the CBDC would have to be robust against the cyber attacks it would undoubtedly attract as a single point of failure for its jurisdiction’s economy. Furthermore, introducing a CBDC would have serious privacy implications for the entities with whom (and the procedures by which) the central bank might manage detailed information about the transactions, finances and even possibly the location of participants.

A freely available CBDC would also pose policy challenges for central banks. A CBDC would be a direct senior obligation of the central bank, effectively backed by the government. They would not be subject to bail-in, and would have lower risk than bank deposits, particularly uninsured ones. This could lead to a significant shift of funds from banks to CBDC accounts, particularly if the central bank paid interest on funds held in CBDC accounts.

If such a shift were to occur, the central bank could well become the largest single source of credit to the economy and to specific institutions. This prospect would intensify the debate over the type of assets that central banks should acquire, and the impact that a central bank should have on the financial markets. This would require decisions regarding to whom the central bank could lend, whether it should originate credit directly or restrict itself to buying securities in the secondary market and refinancing credit originated by others. Central banks would also have to decide the terms on which they would lend and the degree of forbearance they should extend to borrowers who fall into arrears.

Could central banks take on such a task? Probably, yes. They already collect, collate and calibrate credit information on the obligors issuing the instruments that the central bank purchases outright or accepts as collateral. This enables them to assess the risks incurred, as well as to monitor overall credit conditions.

Should central banks take on such a task? Here, the answer is not so clear-cut. This course of action politicizes the extension of credit. Lawmakers are likely to set criteria for the central bank along both political and economic lines. This could easily lead to credit allocation toward favored sectors as well as to forbearance for troubled creditors within these sectors. Neither of those outcomes would be good for efficiency or growth – or for central bank independence.

Small wonder, then, that no central bank has yet been ready to stake its reputation, its citizens’ wealth and its nation’s fortunes upon a CBDC. As Vitor Constâncio, Vice-President of the European Central Bank, recently remarked:

  • “[T]he use of the blockchain by central banks to create digital currency open to all citizens without limits would be really disruptive. This would be a radical political choice that could end banking as we know it and is therefore unlikely to happen.”2

While this is undoubtedly true for the immediate future, it may not always be the case. Over the next five to ten years, technology will continue to advance and this may enable central banks to satisfy their security, privacy and legal concerns. In other words, nothing would stand in the way of a central bank issuing a CBDC. Will they always refrain from doing so? Even if another crisis were to occur, and cries were to arise that banking is too important to be left to bankers?

In the EU banks are required to grant such access from January 2018 under the terms of the Second Payments Services Directive. 

Constâncio, V. (2017). The future of finance and the outlook for regulation. Retrieved from https://www.ecb.europa.eu/press/key/date/2017/html/ecb.sp171109.en.html