Earlier this month, the Federal Reserve published a thought-provoking paper exploring the impact on monetary policy of a central bank digital currency (CBDC), stablecoins and narrow banks.
The latter are banks that compete directly with commercial banks for deposits but don’t provide any lending. Hence, they aren’t subject to the same run risk as conventional banks.
On the face of it, all three seem highly disruptive to the current system. However, the paper opens with a reminder that the Federal Reserve has fundamentally changed how it conducts monetary policy in the recent past.
Changes in monetary policy: 2007 to date
Until the Great Financial Crisis, the Fed didn’t pay interest on reserves deposited by banks. As a result, banks were not incentivized to keep money at the central bank and held a minimal level of reserves, averaging around $10 billion during 2007. In September 2023, the figure was $3.1 trillion, an increase of 30,900%.
Until 2008 the central bank controlled the interest rate through open market operations – by buying and selling Treasuries. Today it influences the interest rate through the rate it offers on central bank reserves and the reverse repo (repurchase) rate.
The latter has a similar effect on nonbanks, such as money market funds and primary dealers with access to reverse repos. The central bank sells Treasuries to these nonbanks in return for their cash. It agrees to buy back the Treasuries at a future date, at a slightly higher price, with the difference representing interest.
This significant change matters because the potential for CBDCs, stablecoins and other changes could disrupt how interest rates are set. It could also impact the size of the Fed’s balance sheet. In 2007 it was less than $1 trillion. It peaked during 2022 at almost $9 trillion and is now around $7.6 trillion.
While the situation currently appears stable, the paper doesn’t mention that a fair few people are concerned about the current Fed balance sheet size and composition.
Difference between a retail CBDC and stablecoin
While a retail CBDC (rCBDC) and stablecoin might be quite different instruments, the impact of the two is similar from a monetary policy perspective. However, much depends on assumptions. For example, the author started by assuming that a retail CBDC is a substitute for cash rather than bank deposits and doesn’t pay interest. In that scenario, the impact is minimal.
However, when you drop these two assumptions and assume that households switch some deposits into an interest-bearing CBDC, then there’s a far greater impact. The result is banks raise their lending rates and reduce the volume of new loans. However, the higher lending rates incentivize nonbanks to make up for most of the lending shortfall.
Given the central bank doesn’t want lending to fall, it could lower the policy rate in response. However, this will reduce the equilibrium interest rate closer to zero, which gives the central bank less room for maneuvering in a crisis.
An interesting takeaway is the analysis that stablecoins are very similar to a retail CBDC. The higher the interest rate offered, the greater the attraction of the stablecoins, luring away depositors and impacting lending volumes. Again, the central bank can lower rates in response.
Narrow banks have the biggest impact
Another scenario was the case of narrow banks. A key assumption here is that consumers view narrow banks as direct competitors to commercial banks, which is not the case for stablecoins.
Hence, if narrow banks offer better rates, consumers are happy to switch to them. Given that narrow banks are simpler with fewer overheads, they will likely offer more competitive deposit rates. We saw last year, with rising interest rates, how commercial banks failed to pass on the increase.
The shift of deposits from commercial banks to narrow banks lowers the capacity of commercial banks to lend. And lending volumes become quite sensitive to changes in interest rates. While nonbanks expand their lending, there’s a notable overall decline in aggregate loans.
The central bank’s balance sheet expands in all three of these scenarios.
However, the author emphasized that assumptions heavily impact the conclusions. So, if stablecoins are considered more of a perfect substitute for bank deposits, the impact might be more extreme and closer to the narrow bank scenario.
