The 2022 Nobel Prize for economics has been awarded for studying the banking system and crises. In this regard, the award is timely given the ongoing digitalisation of money, banking, and financial services. A few days prior to the award, the Reserve Bank of India (RBI) released a concept note on the central bank digital currencies (CBDC). The note discusses the RBI’s views on issuing a CBDC, and how this can change the banking and payment system.
A CBDC is a digital version of the physical currency issued by a central bank. Worldwide, most central banks are at different levels of engaging in a CBDC. The Central Bank of The Bahamas and the Bank of Jamaica have issued CBDCs, the European Central Bank has started a consultation process, and the United States Federal Reserve has issued a discussion paper on the topic.
Let’s look at the impact of CBDCs on banks, and financial stability.
How will introduction of a CBDC impact the existing banking, and payments system? The RBI note points to two ways in which public could switch to the CBDC.
The first is switch from cash to a CBDC where public swaps physical currency notes with a CBDC. Digital technology enables central banks to provide a CBDC directly to the people. If the central bank adopts the direct route, banks’ role as a payments provider will become limited.
The second switch is from deposits to a CBDC. Such a switch is similar to withdrawal of banknotes from an ATM or bank branch. It could result in loss of deposits for the banking system, and it might become more reliant on borrowings. The loss of deposits will also lead to lower reserves. If the banks need to maintain reserves for supervisory purposes, it might lead to acquiring more reserves from the central bank.
The second switch is slightly tricky for another reason. Central banks also have an option to introduce interest-bearing CBDCs. If central banks offer interest-bearing CBDCs, customers are likely to prefer such CBDCs over bank deposits. The problem will become even more acute in case of a crisis, leading to possible run on the banking system. The RBI note says that an ‘easy switch to CBDC can potentially speed up a bank run’.
The two switches shows that if certain choices are made, the banks could come under pressure as a provider of payment services, and deposit services. Banks are also under pressure from fintechs across financial services.
How do we connect the two switches with the 2022 Nobel Prize, and the future of banking?
In case of the first switch from currency notes to CBDCs, banks will lose one of their major functions of payments. The Nobel citation suggests that one of the major roles of banks is to provide payment facilities to the public. The public park their savings as deposits with the banks, and the banks provide various payments services against these deposits. In earlier times, people made payments mainly via currencies or via issuing cheques and demand drafts. Today, payments are made via cards and mobile apps as well.
The banks were already under pressure in this segment. The banks once had monopoly in this payment services space, and payments were a stable source of income for banks. However, in recent years, banks have been facing significant competition from telecom and technology players. With a CBDC, they will have to rework, and rethink their payments strategy on a high-priority basis.
In case of the second switch, while it is unlikely that the central bank will allow the public to open accounts with itself. The RBI recently started a pilot CBDC project in the wholesale segment, and not the retail segment. However, it is still an interesting exercise to think of bank runs due to the central banks. The central banks which also work as banking regulators help resolve bank runs, and now due to new technologies they could be the reason for bank runs. The digital environment also poses challenges for regulators as rumours about weak health of banks can spread much easily leading to rise in bank runs.
Apart from the CBDC challenge, banks are facing other challenges too. As per the Nobel citation, the core purpose of banks is to act as an intermediary between surplus units and deficit units industry. The surplus units are typically households who have extra savings, and will like to earn interest by lending the savings. The firms are deficit units will like to receive these extra funds for their investment projects. If banks do not exist, then both deficit and surplus units will have to find ways to find each other which is very difficult. The banks help in this regard, and they first intermediate deposits and then give loans. The banks also have the capabilities to monitor the loan seekers and provide payment services.
While these core banking functions remain intact in the digital space, we are seeing changes in the way core banking services are being provided. Some countries have allowed telecom and technology entities to provide banking services such as credit and deposits too. These entities do not necessarily follow the conventional collateral based lending, but rely on data analytics and behavioural patterns to give loans. These new ways of doing banking and competition for payments also requires rethink of the Nobel laureate models on banking.
To sum up, the Economics Nobel Prize for 2022 is not just about work done in the past. In fact the prize has been awarded at the right time given the ongoing sweeping changes in money and banking. The intersection of ideas between the Nobel Prize and the RBI concept note cannot just help understand today’s banking challenges, but also be in reckoning for future Nobel prizes as well.
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