Consumers can hold funds in the form of cash or deposits in commercial banks. Both cash and bank deposits can be used as a means of payment and storage of value. In this sense, for consumers, there is “competition” between cash and bank deposits.
We expect the central bank’s digital currency (CBDC) to compete with bank deposits. Even if CBDC is not designed to create competition (such as limiting the size of transactions or not earning interest), this may be true. This competition will intensify because CBDC is a new type of safe asset that can be used as a means of storing value and as a means of payment for transactions like cash.
For banks, bank deposits are a relatively cheap and stable source of capital. Increased competition for deposits could prompt banks to consider other sources of funding. Net income and liquidity (net cash inflows) are likely to decline, while business models may change over time to reflect the new normal. Other things being equal, these changes may affect financial stability by shortening the maturity of funds and reducing the ability of banks to generate capital.
To study this possibility, we used regulatory data from 2018 and 2019 (before COVID-19) to conduct sensitivity analyses to assess how the introduction of CBDC would affect net income and liquidity as competition intensifies. We found that Canada’s six largest banks  may absorb the potential impact on net income and liquidity, but there will be a temporary decline in profitability.
For analysis, we consider three hypothetical scenarios using CBDC and assume that CBDC is designed to have similar characteristics to cash. Using these adoption scenarios, we analyze why:
Increasing the cost of capital will affect profitability, and.
The decrease in the stability of funds (short-term funds) will affect the liquidity of funds.
To separate the specific impact on income and liquidity, let’s make the following assumptions:
Banks maintain their loan or fee income.
Banks maintain their business model.
Banks can replace deposit funds with other sources of funds.
The cost of capital is not sensitive to deposit demand.
CBDC will compete with retail bank deposits.
As an emergency measure, Bank of Canada is creating the ability to issue cash-like retail CBDC (Bank of Canada 2020). CBDC will be denominated in Canadian dollars, will not earn interest, and will be open to retail customers (individuals and small businesses).
The adoption of CBDC will depend on design, how the banking sector responds to CBDC competition, how consumers react, and how the financial system evolves with the introduction of new technologies. Under the current design assumptions, the most sensitive deposits to the introduction of CBDC seem to be Canadian dollar-denominated retail deposits (such as checking deposits).
Canadian dollar-denominated checking deposits account for about 5% of the bank’s total assets (figure 1). To consider the potential spillover effects, we also consider some options, including non-cheque retail deposits (savings) that may be sensitive to CBDC, assuming that bank customers use them as a store of value. Deposits in checking deposits and savings accounts account for slightly more than 10% of the bank’s total assets.
Figure 1: CBDC-sensitive retail deposits account for 5%-10% of bank assets.
Use the ratio to determine the amount of deposits at risk.
In order to explore the possible impact of CBDC on bank funds, we considered the use of three levels of scenarios, including the current demand for paper money, the balance of individual bank deposits and comparable payment methods (Table 1), to explore the potential impact on banks, but this does not imply a forecast of adoption.
Table 1: adoption scenarios based on cash and deposit balances (as of April 2019).
- including retail, small business and wholesale deposits.
Source: deposit liability Supervision filing document (K4).
The following is the adoption scenario we are considering :
Scenario An assumes that the amount of deposits vulnerable to CBDC competition is roughly the same as the amount of outstanding cash: C $90 billion . For example, if outstanding cash is still circulating at current levels and an additional C $90 billion of CBDC, is issued, a decrease in bank deposits may occur. Given that cash accounts for only about 2 per cent of bank assets and 5 per cent of Canadian dollar deposits, this is unlikely to have a significant impact on bank funds.
Scenario B assumes that all Canadian dollar-denominated retail checking deposits will face competition from CBDC. This is equivalent to 280 billion Canadian dollars. Although these deposits are the traditional source of bank funds, they account for a relatively small proportion of assets (5 per cent), with Canadian dollar deposits accounting for 16 per cent. So for D-SIBs, the competition between CBDC and checking deposits seems manageable. This happens if CBDC has all the features, convenience, and trustworthiness of a checking account.
Scenario C speculates that all retail cheques and savings deposits in Canadian dollars are vulnerable to CBDC (C $585 billion). This could happen when consumers lose confidence in the Canadian banking system and choose to give up savings interest and instead seek the safety of CBDC endorsed by the central bank.
Debit cards, checks and cash are the most similar payment methods for CBDC. In 2018, consumers paid C $243 billion, C $65 billion and C $93 billion in brick-and-mortar stores and online, respectively (see appendix, TSI 2019) . Another broad category of payments (“other”) includes pre-authorized bill payments, wire transfers and other bank transfers. The total value of these “other” payment methods is C $264 billion, and if these payment methods are included in the CBDC design, some of them can be replaced. The total value of debit cards, checks and “other” payment methods is A $571 billion.
Profitability and liquidity may be adversely affected.
In order to reduce the outflow of deposits, banks can increase the interest paid to depositors with high demand price elasticity. Banks also need to use other higher-cost and more volatile sources of capital to make up for lost deposits. Other things being equal, these actions may lead to a decline in bank profitability (see also Chiu et al. 2019).
In order to evaluate the sensitivity of net income to CBDC, we analyzed the impact on deposits when the effective interest rate in each scenario increased by 25 basis points (bps), 50 basis points and 184bp respectively. The biggest increase was the effective wholesale time deposit rate as of the fourth quarter of 2018 . Table 2 reports the impact of domestic systemically important banks on net interest margin, net profit before tax and (ROE) of return on equity. We assume that there is no opportunity for bank customers to adopt CBDC, Bank within a quarter to pass on the increased cost of capital to borrowers.
Table 2: average impact of Canada’s six largest banks on interest income.
Note: the impact on the rate of return on net assets is measured on an annual basis; other effects are calculated on a quarterly basis.
Source: regulatory documents for the balance sheet (M4) and income statement (P3) of the Bank of Canada in the fourth quarter of 2018.
In scenario A, net income before tax will be reduced by 0.6% to 3.0%. In 3 of the 9 cases, the net income decreased by only more than 5%, mainly in the case of high adoption rate and significant increase in interest rates (scenario BMagol / 184bp; scenario C / Magi / 50 bps or higher). These results show that the impact of the increase in deposit cost on net income is greater than that of CBDC adoption on net income. Even in the most extreme cases, the net income of domestic systemically important banks will fall sharply, and other conditions are the same, domestic systemically important banks will still maintain high profits, and the average ROE will drop by less than one percentage point. In the past two years (2018-19), the average ROE of systemically important banks in China was about 15 per cent.
Although we are focused on interest income, fees may also be affected, as customers may have fewer bank accounts, thus reducing related income. Checking account is also an important banking product, which can help banks obtain customers and lead to cross-selling of other products. If a customer cancels a bank checking account, the impact on earnings may be wider than rising interest costs and reduced fee income. However, cross-subsidies for other products can maintain demand for trading accounts and reduce outflows to CBDC. Higher interest rates will also reduce the outflow of deposits, but will have a negative impact on net income, as we have shown.
The glimmer of hope for a decline in deposit activity is to reduce the costs associated with maintaining outlets. These costs may be fixed in the short term, but a reduction in the number of depositors may lead to fewer branches of banks, thereby reducing costs in the long run. .
The liquidity of banks depends to a certain extent on the stability of their capital sources. Stable funds are usually long-term, price fluctuations are small, and withdrawals are unlikely. Stable funding ensures that cash inflows continue to exceed cash outflows, enabling banks to meet their funding needs over an extended period of time, even in times of high financial constraints.
Retail deposits have been a stable source of funding in recent years. If banks need to replace retail deposits with unstable, short-term sources of funding, the number of months in which cash inflows exceed outflows are expected to fall during stressful times. For this part of our analysis, we use net cumulative cash flow (NCCF) regulatory filings to assess the liquidity impact of an CBDC on the expected number of positive cash flow months . We use three scenarios to roughly estimate the amount of deposits that can be replaced by unstable sources of funding. We then assume that these deposits will be replaced by three dwindling stable deposit products: uninsured deposits and two wholesale demand deposits (Table 3). The stability of deposits is measured by the runoff rate, which is the rate at which deposits can be withdrawn during stress events . An increase in the runoff rate will reduce the number of months in which bank cash inflows exceed outflows in the future. What this measure means is that the greater the number of months of net positive cash flow, the more time banks have to cope with unexpected liquidity shocks.
Table 3: banks can withstand the liquidity shocks of CBDC in most cases.
Source: April 2019 Canadian banking regulatory filings (net cumulative cash flow).
In the case of low CBDC adoption (for example, the impact of A), on bank liquidity is either zero or minimal. If scenario B is used, there is little or no impact when the runoff rate is 1, while the expected number of positive cash flow months with a runoff rate of 3 will only be reduced by two months. It is only when scenario C is combined with a decline in financial stability that cash flow is expected to fall significantly. These results show that, other things being equal, in most cases, banks can withstand short-term liquidity shocks caused by the introduction of CBDC due to the introduction of domestic systemically important CBDC.
Based on the sensitivity analysis and the hypothetical design of CBDC, we find that the domestic systemically important banks can well absorb the potential temporary negative impact on profitability and liquidity caused by the introduction of CBDC. Banks have a high return on equity ((ROE)) and liquidity levels, so they can absorb shocks under reasonable options. We have only observed a huge impact on net income in extreme cases, that is, all checking deposits have been affected and interest payments have increased sharply. This is unlikely to happen, given the current cost of deposit funds and the fact that the CBDC design does not bear interest. A small rise in interest rates and similar demand for cash will not pose a threat to the stability of the financial system or the competitiveness of banks’ ROE. When we look at liquidity, the results are similar: banks will maintain healthy levels of liquidity, and liquidity will become a concern only in the most extreme cases.