Relieve banks’ fears about losing deposits

February 19, 2024

By Ulrich Bindseil, Piero Cipollone and Jürgen Schaaf

On 18 October 2023, the ECB’s Governing Council outlined the scope and key features of a digital euro. The ECB also decided to continue with the “preparatory phase” of the digital euro project. The actual decision on issuing a digital euro will be taken at a later stage, but not before the legal framework is in place and all functional features are specified.

Based on the specifications for a digital euro put forward by the ECB and the European Commission, we can expect the digital euro’s features to include pan-European reach, legal tender status and a high level of privacy. A digital euro will combine all the features of a modern digital payment solution. This will fill the gap left by the absence of a European electronic payment solution freely available and accepted throughout Europe, thus strengthening the monetary sovereignty and resilience of the currency.

To preserve the economic function of commercial banks, individual digital euro holdings will be limited. Merchants will be able to receive and process digital euros, but will not be able to hold them at all ‒ to protect the corporate deposit base of the banking system. Additionally, digital euro holdings will not accrue interest. Users will be able to seamlessly link their digital euro account to a payment account at their bank, enabling a “reverse waterfall” mechanism. This eliminates the need to pre-fund the digital euro account for online payments, as any shortfall will be covered immediately from the linked commercial bank account, provided it has sufficient funds available.

Addressing concerns about bank disintermediation

From the beginning, questions about the risk to bank funding have been at the center of discussions about central bank digital currencies (CBDCs). In theory, CBDCs could influence financial institutions, as depositors could choose to move money from bank deposits to the central bank. This can reduce the traditional banking system’s ability to provide credit. However, central banks have analyzed this issue and devised ways to pre-empt such risks. In the case of a digital euro, the combination of the reverse waterfall, a holding limit and no compensation will greatly reduce incentives to hold large sums of money in a digital euro wallet. Users will rely on digital euros as a means of payment rather than using them for investment, especially in light of the tendency of money holders to consolidate their liquidity pool. Moreover, banks can always offer higher compensation to keep deposits.

But despite the explicit inclusion of mitigation measures in CBDC design, banking associations, bank-sponsored think tanks and scholars have continued to publish studies highlighting the risks associated with eliminating financial intermediaries from transactions – known as bank disintermediation – through the potential issuance of CBDCs in general and of a digital euro in particular.

Given the persistence of such criticisms, it is worth taking a closer look at the arguments.

Some critics say that in an acute economy-wide banking crisis, a digital euro could accelerate bank runs, exacerbating the crisis. However, this is not very plausible for the following reasons:

As a limit would be applied to digital euro holdings, the ability of customers to withdraw unlimited amounts of cash would pose much more of a threat to banks. Indeed, the downside of holding cash as a short-term store of value due to security concerns will become less important in a crisis of this magnitude. Even in severe banking crises, many banks are still considered safe (also because central banks act as a system-wide lender of last resort). For example, during the great financial crisis in 2008 as well as in the recent crisis that hit US regional banks, safe banks continued to benefit from inflows. In recent decades, bank runs have generally not been caused by large numbers of retail customers withdrawing small deposits, but by incidents in the wholesale market or the withdrawal of very large individual amounts above the thresholds covered by deposit guarantee schemes.

Other critics say that the attractiveness of safe central bank money could lead to banks losing long-term deposits as a source of refinancing. This could put a strain on loans to companies and private households. According to the Association of German Banks, significant amounts of central bank money could be withdrawn from the banking system, which would limit the ability of commercial banks to refinance against customer deposits. However, the combination of a holding limit, no compensation, the reverse waterfall and the absence of corporate ownership of digital euros will mean that overall levels of digital euro ownership will remain quite low.

Comprehensive analysis should include banknotes

What matters most to banks is the total amount of central bank money in circulation. The focus on digital euros alone ignores banknotes in circulation. This is misleading, as the way they both affect the financial accounts of the economy is identical. Banks experienced increased demand for euro banknotes during periods of financial stress and low interest rates, but did not raise this as an issue at the time. Between 2007 and 2021, euro banknotes in circulation increased from €628 billion to €1.572 billion, far exceeding the amount expected to be issued in the form of digital euros.

The declining use of banknotes for day-to-day transactions will also eventually reduce the structural demand for banknotes. The point of a “store of value” is that it must be spent, but not immediately. Moreover, the usefulness of a store of value rests on the ease with which money can ultimately be spent. Therefore, the decline in the use of banknotes also risks reducing their attractiveness as a long-term store of value.

Indeed, in 2023 the value of euro banknotes in circulation fell by around €5 billion in nominal terms for the first time since 2002. Although only 20% of banknote demand can be attributed to domestic payments – and this trend reversal is likely mainly a reflection of higher interest rates – the digitization of payments is also a factor.

Digitization in general is likely to lead to lower real growth in central bank money in circulation, or even to a decline. From this perspective, the persistent complaints regarding future digital euro volumes in studies sponsored by the banking system do not look at the right variable (which is central bank money in circulation) and are outdated (since they ignore the digital euro blueprint).

Closure

As the ECB advances its work on developing a digital euro, it will continue to refine design choices, address potential risks and optimize benefits. The ECB has presented innovative design features that will limit the circulation of digital euros while providing benefits to users. The concerns about bank financing were taken seriously by proposing holding limits, access restrictions, no compensation and the reverse waterfall. The holding limits will be calibrated based on a comprehensive analysis taking into account all relevant factors.

In terms of the interaction between central bank money and commercial bank financing, it is the total volume of central bank money in circulation that really matters. Amid the declining use of banknotes, it is likely that nominal growth in banknotes in circulation will decrease or even turn negative. This could lead to a scenario in which there is a decrease in central bank money in circulation relative to GDP.

Additionally, new players may pose a greater risk to bank financing than CBDCs. Stablecoins, e-money institutions and other narrow banking constructs, some sponsored by large technology companies with large customer bases, do not care about the role of banks in the economy. Non-banks have no obvious incentive to limit the use of their stablecoins or the services they offer, and the use of stablecoins can become significant.

Banks are barking up the wrong tree when they rely on studies that overlook the detailed design features of a digital euro. In doing so, they ignore the many other challenges they must address to ensure stable funding through deposits. Banks must offer attractive products and services that encourage customers to keep their deposits with them instead of migrating to new and powerful private competitors.

A longer version of this ECB Blog post was published on VoxEU.

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