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Digital currencies may pose risks to banking sector stability, says US gov researchers

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According to a recent paper by the Treasury’s Office of Financial Research (OFR), the integration of digital currencies into the financial system could increase household welfare but spell danger for the stability of the banking sector. The resulting financial frictions, the authors note, could limit the potential benefits of new digital currencies, whether issued by central banks (CBDCs) or private entities (stablecoins).

The study modeled a theoretical financial sector in which bank deposits and digital currencies coexist and households can hold both. Its aim was to determine the implications of full digital currency integration for financial stability by looking at the effect of CBDCs and stablecoins on bank profitability and household consumption.

The findings suggest that the full integration of digital currencies would make banks less profitable. That’s because it leads to a decrease in the spread of bank deposits – the difference between what banks charge customers for loans and what they pay other customers for their deposits. By offering a potential substitute, digital currencies would force banks to raise deposit rates in order to attract customers, thereby reducing their spreads, hurting their overall profitability, and decreasing their financial valuations.

This effect would be particularly acute during economic crises, when people tend to move to safer assets (in this case CBDCs or stablecoins), and banks need to recapitalize quickly. With fewer deposits, banks would have to find alternative, more expensive ways to rebuild their balance sheet following exceptional losses.

On the other hand, the integration of digital currencies could lead to potentially significant increases in household welfare, depending on the level of substitutability. For example, if digital currencies were introduced as near-perfect substitutes for bank deposits, household welfare could increase by over 2% in terms of consumption. However, because of the mechanism described above, this would also decrease financial stability, potentially doubling the probability of a banking crisis. 

The study concludes that “while financial frictions do not completely overturn the potential welfare gains from digital currency, they do affect the social optimum.” Digital currencies, whether CBDCs or stablecoins, will significantly reshape the financial sector, with potentially large consequences for financial stability and household welfare. Costlier equity issuance may harm banks’ ability to recapitalize following losses and increase the likelihood of future crises. Still, the increased competition could also improve household welfare and boost private consumption, with potential net positive effects for the overall system volatility.

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