Research from the Bank of Canada suggests that the introduction of a digital dollar may pose a risk to the banking sector and overall financial stability.

Is a Digital Dollar a Risk to the Banking Sector and Financial Stability?

The introduction of a digital dollar may pose a risk to the banking sector and overall financial stability, according to research from the Bank of Canada (BoC). A central bank digital currency (CBDC) could potentially reduce deposits held at commercial banks, increasing their costs of doing business. Additionally, there is concern that a CBDC could raise the likelihood of bank runs, which would be a risk to financial stability.

The BoC suggests that a CBDC would directly compete with bank deposits in the market for digital money. This competition could lead to a substantial crowding out of bank deposits, which would undermine financial stability by raising funding costs and reducing profitability for the banking sector. Steve Ambler, a professor emeritus of economics at Université du Québec à Montréal, explains that if a CBDC were designed as a good substitute for private bank deposits, financial market stress could cause individuals to try to move their deposits from banks to the central bank all at once. This could potentially lead to a run on the banks, which is a rare occurrence in Canada but happens frequently in the United States.

The Office of the Superintendent of Financial Institutions (OSFI), the federal bank regulator, acknowledges that without knowing the design and features of a potential CBDC, it is difficult to assess the possible impacts on commercial banks. However, at a conceptual level, OSFI suggests that these impacts could include higher financial stability risks due to banks losing deposits to the CBDC and being less able to extend loans due to loss of revenue and changing distribution channels for money.

Privacy concerns have long been an obstacle for CBDCs, and recent events in Canada have only heightened these worries. The freezing of bank accounts for individuals who donated to the Freedom Convoy truckers has raised concerns about privacy and surveillance. James Hickman, co-founder of Schiff Sovereign LLC, warns that with CBDCs, governments can simply deactivate a person’s funds with a click of a mouse, without having to instruct banks. This raises concerns about the potential for abuse of power and diminished financial privacy.

Despite these concerns, over 90 percent of the world’s central banks are exploring digital currencies. Canada and the United States are currently in the development phase with CBDCs, while digital currencies are being piloted or launched in various countries, including China, Russia, India, and Japan.

The BoC suggests that the design features of a CBDC could increase its adoption. For example, if the CBDC had a network of branches like commercial banks and paid a sufficiently high interest rate, it would likely see greater uptake. However, it is expected that commercial banks, especially larger ones, would respond to the introduction of a CBDC by raising deposit rates and losing fewer deposits.

The Canadian Bankers Association (CBA) has expressed the view that CBDCs, like hard cash, should not earn interest. They argue that this would mitigate adverse financial stability consequences that might arise if banks needed to resort to more expensive and fragile forms of funding. Analyst Atul Bhatia raises concern over the risk of something going wrong with CBDC software in a centralized system, creating a single point of failure in critical payments infrastructure.

CBDC adoption would greatly benefit from having service locations, according to the BoC research. If Canada Post offices were used as service locations, adoption rates would be similar to those seen with cash. Rural customers, who often have poor access to bank branches, would benefit more from a CBDC than urban residents.

The BoC has trademarked terms like “digital dollar” and “central bank digital currency,” indicating their interest in exploring these options. However, a survey conducted by the BoC revealed that a majority of respondents believed that the central bank should not even be researching digital currencies. Additionally, many respondents expressed concerns about privacy and the potential compromise of that right with a digital dollar.

The added benefits of a CBDC to Canadians remain unclear, according to the Canadian Bankers Association. As central banks around the world continue to explore digital currencies, it is crucial to carefully consider the potential risks and benefits to the banking sector and overall financial stability.