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(Kitco News) - As the global banking system deals with its worst crisis since 2008, a recent study by the Office of Financial Research (OFR) has found that the integration of a digital currency into the financial system could exacerbate the struggles currently facing the banking industry.
The OFR, an independent bureau reporting to the U.S. Department of the Treasury, published a working paper titled "Digital Currency and Banking-Sector Stability" that looked at a model where digital currencies coexist with bank deposits. Households would hold both forms of liquidity.
The authors of the study write that the “banking-sector stability may suffer, yet household welfare may improve should a digital currency be fully integrated into the financial system.”
The study also found that the volatility experienced in the financial system decreases when digital currencies are fully integrated. However, the integration of a central bank digital currency (CBDC) increases the probability of a banking crisis due to a decline in deposit spreads, which limits banks’ ability to recapitalize following losses, resulting in a significant decrease in bank valuations.
“A fully-integrated digital currency depresses bank deposit spreads, particularly during crises, which limits banks’ ability to recapitalize following losses,” the authors wrote. “In addition, because banks are less able to rebuild equity after adverse shocks, banks, on average, have lower equity.”
Despite the threat to financial stability posed by integrating digital currencies, the average household welfare could increase by up to 2% in terms of consumption.
“Fully integrating digital currency into the financial sector would increase household welfare, and these welfare consequences are potentially large,” the report said. “For example, household welfare could increase by 2% in terms of consumption, even though at this level of digital currency, the probability of crises doubles.”
Additionally, CBDC integration would also decrease the level of volatility in the overall financial system by decreasing the volatility of asset prices. “While financial markets improve with lower volatility and higher prices, the financial sector suffers because the banking sector is at greater risk of insufficient capital levels,” the report cautioned.
The theoretical results indicate “that financial frictions may limit the potential benefits of digital currencies, whether issued publicly as a central bank digital currency (CBDC) or privately as stablecoins.”
The OFR called for further examination “from multiple angles” into the threat to financial stability posed by integrating digital currencies into the traditional financial system as interest in blockchain technology grows, with a specific focus on the “potential effects on bank equity levels and consequences for runs.”
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The focus of this working paper was on the risk that banks have insufficient equity capital following losses from their investments. “Investment losses, not runs per se, create instability in this context.”
While this study found that CBDCs pose a risk to bank runs, other studies conducted by the OFR found that this concern “is not as big as initially feared.” This complementary analysis concluded that “the threat of investors running to a CBDC leads banks to do less maturity transformation, and policymakers can use information flows from the CBDC to react quickly.”
As the Fed moves forward with its digital dollar trials, the OFR recommends keeping a vigilant eye on the effects its integration has on the wider financial ecosystem.
“Digital currencies have the potential to become an alternative to traditional money,” the OFR wrote. “Imperfections in financial markets nevertheless limit their potential benefits. At some point, there may be a robust range of digital currency issuance in which the welfare-stability trade-off is in favor of digital currency, even when digital currency is costly to issue in a competitive environment.”
