Central bank digital currency, loan supply, and bank failure risk: a microeconomic approach

Abstract

Central bank digital currencies (CBDCs), which are legal tenders in digital form, are expected to reduce currency issuance and circulation costs and broaden the scope of monetary policy. In addition, these currencies may also reduce consumers' need for conventional demand deposits, which, in turn, increases banks' loan provision costs because deposits require higher rates of return. We use a microeconomic banking model to investigate the effects of introducing an economy-wide, account-type CBDC on a bank's loan supply and its failure risk. Given that a CBDC is expected to lower the cost of liquidity circulation and become a strong substitute for demand deposits, both the loan supply and the bank failure risk increase. These increases are countered by subsequent increases in the rates of return on term deposits and loans, which, in turn, reduce the loan supply and thus bank failure risk. These offsetting forces lead to no significant change in banking, as long as the rate of return on loans is below a certain threshold. However, once the rate is above the threshold, bank failure risk increases, thereby undermining banking stability. The problem is more pronounced when the degree of pass-through of funding costs to the loan rate is high and the profitability of a successful project is low. Our results imply that central banks wishing to introduce an economy-wide, account-type CBDC should first monitor yields on bank loans and consider policy measures that induce banks to maintain adequate liquidity reserve levels.