Financial stability aspects of the introduction of a central bank digital currency

VII. Financial stability aspects of the introduction of a central bank digital currency

Zénó Fülöp – János Szakács – Péter Szomorjai – Balázs Varga – Márton Zsigó

The introduction of a central bank digital currency can positively impact financial stability among other central bank objectives, including by maintaining the competitiveness of the financial system and making a quasi-risk-free digital payment instrument available to participants in the real economy. At the same time, this new technology can significantly transform banking business models depending on its objectives and the range of payment, saving and possibly lending services taken over by the central bank from commercial banks. This may entail new banking and systemic risks. For the potential introduction of central bank digital currency, it is necessary to start assessing these risks and preparing regulatory and supervisory tools for their mitigation and for the uncertainties of a new setup.

1. Introduction

Central banks are increasingly using digital solutions to fulfil their functions. New solutions can not only increase operational efficiency but can also bring about fundamental changes in the activities of the financial system and central banks. One notable example would be the introduction of central bank digital currency (CBDC). In our study, we deal with the effects of this on financial stability objectives.

First we examine the potential benefits of introducing central bank digital currency in terms of financial stability. These advantages arise mainly through improvements to the functioning of the payment system. The achievement of financial stability objectives can be supported by the diversification of payment systems, the emergence of new digital services, and increased competition and efficiency in the banking system. In addition to the benefits, we will review in detail how CBDC would affect the balance sheet and risks of the banking system. Given that the vast majority of central banks have not committed themselves to certain specific variants of CBDC implementation, we examine the effects in general and look into the particular cases of three different alternatives of design: the model of the digital central bank cash substitute, the deposit-taking central bank and the creditor central bank.

In addition to disintermediation (a narrowing of the role of the banking system in financial intermediation), the introduction of CBDC can also induce changes that give rise to unprecedented risks. In the study, we will discuss the transformation of the mechanism of bank runs and examine system-critical central bank activities that may occur in parallel with the spread of CBDC use. Finally, we also mention which directions of the renewal of the financial and prudential regulation introduced in recent years tailored to the current setup of banking operations should be reevaluated in the future with regard to the systemic changes brought about by central bank digital currency and the support for the spread of CBDC.

2. The possible contribution of central bank digital currency to the stable and efficient functioning of the financial system

The introduction of CBDC has various potentials and can also be an effective tool for achieving financial stability objectives, depending on technological implementation and the new framework. These advantages are mainly due to the impact of central bank digital currency on payment systems and payment habits (Figure 1). However, in order to exploit the benefits, CBDC must be reliable, resilient and secure, and also a fast, simple, efficient and easily accessible tool for users. Below we look at some of the key benefits of central bank digital currency for financial stability.52 The introduction of a new payment instrument will result in diversification and increased competition in the market for payment services. Payment systems have evolved at an extraordinary pace in recent years, driven by increased market demand and the spread of electronic (cashless) payments. The launching of instant payment systems around the world (including the instant payments introduced by the MNB) seen in recent years also fits well into the tendency. With the introduction of CBDC, a new alternative is emerging, reducing the criticality of existing payment systems, potentially making them even more secure and resilient, thereby increasing financial stability. The CBDC would provide an additional, potentially widely available substitute payment method in case the operations of other critical parts of the payment system were under distress or shut down. Barrdear and Kumhof (2016) emphasise that the increasing number of payment options brings about an increase in competition. Increased competition has a positive impact on the economy through safer, cheaper payment alternatives, which can also lead to a more stable financial system that is better adapted to shocks.

52 The possibility of introducing CBDC has been addressed in a number of studies, including by the Bank of England (2020).

Figure 1: Potential financial stability benefits of CBDC through its impact on payment systems and habits

Supporting a more resilient payment system

Improving the availability and usability of central bank money Addressing the decline in cash use

Supporting innovation and competition in payments CBDC

Supporting cross-border payments

Meeting future payment needs

Mitigating the risks of excessive spread of private digital currencies Decreasing counterparty risk

Source: Authors’ compilation based on Bank of England (2020).

The emergence of digital payment solutions from the private sector is difficult to control, and their uptake on a broad scale may therefore pose a risk to financial stability. The introduction of a CBDC may reduce the prominence of less controlled technologies, thus preventing the development of risks. Numerous digital currencies are currently available on the market, but their uncontrolled spreading could lead to an increase in financial stability risks. Unlike commercial bank money, digital currency may escape the scope of financial regulation and supervision; customers are not protected in the event of a potential default or

devaluation (volatile exchange rate), and the various e-currencies also do not ensure interoperability. Wierts and Boven (2020) also address the issue of how CBDC offers an alternative to other digital currencies. With the introduction of CBDC, the popularity of these currencies can be reduced and the market for innovative currencies can be controlled, whereby financial stability is increased. CBDC is a reliable and secure payment service compared to digital money substitutes issued by other financial enterprises, institutions or developers (e.g. cryptocurrencies, stablecoins and other virtual currencies). Depending on its design and definition, CBDC may have a cash-substitute function in response to future payment needs, supporting the benefits of electronic payment systems. Currently, central bank money is only available in the form of cash for households and companies. Central bank digital currency would provide an opportunity to store it and use it electronically. Central bank money has a key role in maintaining monetary policy and financial stability objectives by ensuring, in its capacity as riskfree money, final payments in legal tender in the economy. Appearing as an electronic form of cash, it would provide this feature in a more widely available form, ideally under appropriate infrastructural conditions.

Payment systems must also keep pace with the development of the digital economy. The coronavirus pandemic has given the latest boost to digitalisation. The CBDC could potentially move forward the adaptation to these needs which have come to the fore recently. These new solutions can strengthen digitalization by strengthening competition in the banking sector, improving efficiency and sustainable income-generating capacity. Direct settlement within the central bank may reduce the role of loan collateral. Another argument in favour of the introduction of CBDC concerns the efficiency gains in financial transaction

settlement systems, whereby operational and counterparty risk, liquidity risk and loan collateral can be reduced. The underlying risks of current multi-level payment systems include counterparty risk, i.e. the risk that the counterparty becomes insolvent, and fails to meet its obligations. In addition to counterparty risk, another mean of managing liquidity risk is to request loan collateral, which typically comprises high-quality instruments such as sovereign debt. With the introduction of central bank digital currency, payments can also be settled directly between the counterparties in the books of central banks. According to Barrdear and Kumhof (2016), this helps to avoid counterparty risk and thus to reduce the role of loan collateral. The volume of unencumbered, high-quality assets available would increase as collateralized transactions could be substituted by direct payments settled with CBDC which could entail significant macroeconomic and stability benefits, for example through potentially widening borrowing opportunities. The introduction of CBDC can also improve the efficiency of crossborder payments in the long run. Cross-border payment options are currently relatively costly and comparatively slow. Although many new payment service providers (e.g. TransferWise, Revolut) offer solutions in this regard, their operation is much less secure and mature compared to the banking system, which is subject to strong regulatory and supervisory and consumer protection expectations. According to Codruta-Henry-Amber (2020), increasing the efficiency of cross-border payments can be one of the main motivations for introducing central bank digital currency. One of the roles of central bank digital currency in the longer term may be to offer a solution to cross-border payments, i.e. a faster, cheaper and safer alternative to the technology currently available. Depending on the chosen solution, the introduction of CBDC may make available settlement processes where payment in one currency is finalized only by payment in the other currency (Payment-versus-Payment, PvP) or when delivery (e.g. on the

securities market) is made at the same time as payment (Deliveryversus-Payment, DvP), thereby eliminating settlement risk and open positions. Ousméne (2020) highlights in his study that the introduction of the technology can also have a significant positive impact on the foreign exchange trading market. At the same time, central banks would have a greater role to play in operating the payment system, which carries a potential operational risk. In order to exploit the positive effects, it is necessary to develop communication and cooperation between the central banks, as well as to create interoperability between the systems, which may be a longer-term step following the deployment of each national CBDC.

To summarise, the successful introduction of central bank digital currency can help to create a more competitive and innovative financial environment, bringing efficiency improvements in payments and strengthening financial stability. Depending on the technological realisation, it may open up new possibilities, and its introduction may address several risks that may arise in the near future. These include the shift of payment flows and savings to unregulated cryptocurrency markets or the spread of uncontrolled payment service providers. The introduction of CBDC can contribute to the improvement of the innovative capacity of the banking system and to strengthening the level of competition, which is the basis for the development of the financial system, ultimately improving the customer experience that can be potentially achieved (security, new technological solutions, convenience). In some markets where the stability of the banking system poses a risk to depositors (for example due to the lack of deposit insurance), CBDC may offer a safer alternative.

3. Potential financial stability risks in introducing CBDC

The advantages of introducing central bank digital currency shown so far can be properly exploited if the risks involved in its introduction can be successfully identified and managed either through the development of a CBDC operating framework or through regulatory solutions. Kiff et al (2020) identifies three main categories of risks that may arise from the operation of CBDC (Figure 2), which comprises the types of strategy and political risks (financial payment system, consumer protection, price stability, financial stability, financial integrity, financial inclusion, economic growth), financial market risks (liquidity, credit, exchange rate) and operational risk (fraud, legal risk, IT, consumer behaviour, third party, process). The risks included in the three groups may also affect the reputational risk of the central bank and the entire banking system. How and to what extent the above risks arise will be significantly influenced by the technological designs under which CBDC will be implemented, the possible limitations and conditions under which it will be available to users and the extent of its uptake among users. Certain risks may increase at the start of implementation, given the possibility for errors to surface during the transition period that cannot be completely eliminated during pilot tests. With the introduction of the CBDC, cyber risks and operational risks cropping out, and critical system failures may also compromise financial stability. During the transition period potential risks (e.g. liquidity risk) may also increase on the side of the banking system in the event of a shock-like transition. A gradual and carefully managed introduction, as well as the prior use of detailed pilot projects, are therefore critical. Of these risks, we will focus on the potential evolution of risks to financial stability following the introduction of CBDC.

Figure 2: Risks of introducing CBDC

Strategy and policy risks

• Payments Systems • Consumer protection • Price stability • Financial stability • Financial integrity • Financial inclusion • Economic growth

Operational Risks

• Fraud and security, cyber risk • Legal risk • IT infrastructure • Culture, consumer behaviour • Third party risk • Process management

Reputational Risks

Source: Kiff et al (2020), authors’ compilation.

Financial Risks

• Liquidity • Market • Credit

3.1. Potential narrowing of the role of the banking system in financial intermediation

A major part of the financial risks and financial stability issues associated with the introduction of the CBDC stem from the fact that the central bank can take over different financial intermediary functions from commercial banks depending on the objectives pursued through CBDC. The transformation and sustainability of commercial banks’ business models may be significantly affected by the decline in banking activities, the so-called banking system disintermediation. Given that the vast majority of the central banks addressing the issue have not yet committed themselves to the specifics of CBDC design and have not decided on the detailed objectives to be achieved, we will endeavour to examine, in a general and broad approach, the risks that the introduction

of CBDC in different forms could entail for the functioning of the banking system. Examined in this general framework, the degree of stability risks associated with disintermediation can best be determined by (1) the level of demand for central bank digital currency; (2) the extent to which this demand causes a change in the balance sheet of the banking system; and (3) the extent to which the profitability of the sector is affected. For example, if the CBDC is designed to have such features that it is an attractive alternative to cash transactions the functioning of the banking system may be less affected by its introduction, and financial stability risks may remain moderate. However, if the introduction of CBDC represents serious competition for bank deposits and related payment services, the refinancing of deposit withdrawals from commercial banks, as well as the declining profitability of the banking system as a result of the loss of fee income and increased cost of funds, will be the main source of stability risks. The outflow of bank deposits in the event of the introduction of central bank digital currency may take one of two extreme values. If the CBDC design is primarily aimed at reducing cash holdings (which is the liabilities of the central bank), there may not be a meaningful transfer of deposits from the banking system to the new central bank currency. Conversely, the entire holding of bank deposits could get substituted by a CBDC that is similar to current account deposits but more attractive in its parameters. However, this latter scenario would run into obvious funding and liquidity constraints in terms of the current business model of the banking system; accordingly, in our analysis we will also try to take into account the regulatory framework reflecting the current form of operation.

Meanwhile, in the event of a larger deposit outflow, the central bank would also be forced to adjust significantly, since in such a situation the banking system would rely on permanent central bank financing to an extent that goes beyond the possibilities of the “peacetime” central bank policy instruments. Another decision point is by what means the central bank is willing to mitigate the possible impact of changing balance sheet structures on the financing of the private sector. The central bank may increase its exposures to commercial banks (whether secured or unsecured) or may even finance private sector actors directly (in the form of bond purchases or even direct lending). Accordingly, in this study we also aim to provide a brief outline of the possibilities of central bank adjustment. Examining the stability effects of introducing CBDC, the primary criterion is therefore whether, with the introduction of the CBDC, the central bank opens only the liability side of its balance sheet to non-financial actors (deposit-taking central bank) or offers access to its asset side in addition to the liability side deposits, which means that it provides loans to non-financial actors (creditor central bank). While the liquidity risks posed by deposit withdrawals from the banking system may dominate in the case of the deposit-taking central bank, in the case of the creditor central bank, the loss of revenue due to the market lost by the commercial banks may increase the stability risks, while the central bank also faces new risks in its balance sheet, profit and loss, and operations. In view of the above, the financial stability effects of the introduction of CBDC are presented in our analysis through possible changes in the balance sheet of the central bank and the banking system along the following scenarios.

I. Financial stability aspects of introducing cash substitute CBDC. II. Impact of introducing CBDC on financial stability in the case of a deposit-taking central bank.

III. Impact of introducing CBDC on financial stability in the case of a creditor central bank.

If a specific design of the CBDC is introduced, it may not be purely one of the above scenarios, but rather a partial realisation or a combination of these scenarios; nevertheless these cases are discussed separately for a simpler presentation of the stability effects. While individual chapters focus primarily on the stability risks to the banking system, we also highlight the possibilities of central bank adjustment, and draw attention to the risks of stronger participation by the central bank.53

3.1.1. Financial stability aspects of introducing cash substitute CBDC From a banking system perspective, the simplest case is when the newly introduced central bank digital currency is aimed only at replacing cash holdings. In this case, assuming that the introduction of “digital cash” does not affect the willingness of economic agents to hold bank deposits, only the central bank’s liabilities will be reorganised. In this case, CBDC holdings will increase to the same extent as cash holdings decrease, while the balance sheet of the banking system will remain unchanged (Figure 3). In this case, financial stability risks to the banking system do not arise either in terms of financing or in terms of profitability.

53 At the same time, our analysis is static in that we present a hypothetical equilibrium after introducing CBDC and do not address the changes in balance sheets over time after introduction. It is also assumed that the demand for CBDC is continuously controlled by the central bank by defining and fine-tuning the design criteria, therefore the states presented can be achieved according to the intention of the central bank.

Figure 3: Impact of cash substitute CBDC on the simplified balance sheet of the central bank and the banking system

Central Bank Assets Liabilities

Banks' deposits

Reserves

Cash ↓ CBDC↑

Banking System Assets Liabilities

Deposits at CB

Liquid securities

Loans

Retail and corporate deposits

Source: MNB.

Equity

3.1.2. Impact of introducing CBDC on financial stability in the case of a deposit-taking central bank Adjustment without loss of lending activity If the introduction of CBDC leads to a transfer of bank deposits into the new central bank money, the banking system has several options to adjust. If banks can easily find funds to replace outflowing deposits, then it can be assumed that the balance sheet of the banking system does not decrease substantially, and the amount of loans in the balance sheet of the banking system remains unchanged. If deposit outflows are replaced by unsecured wholesale funds (e.g. an interbank deposits or funds raised from bond issuance), the liquid assets of the banking system do not change either (Figure 4). Accordingly, in this case, the balance sheet of the banking system is only reorganised on the liabilities side, while the balance sheet of the central bank increases by the amount of CBDC issued.

Figure 4: Effect of CBDC with deposit outflows and unsecured wholesale funding

Central Bank Assets Liabilities

Banks' deposits

Banking System Assets Liabilities

Deposits at CB

Reserves ↑

Source: MNB

Cash

CBDC↑

Liquid securities

Loans

Retail and corporate deposits ↓

Wholesale funds↑ Equity

However, reorganisation may require a sacrifice in profitability. The price of unsecured wholesale funds may substantially exceed the cost of funds associated with deposit outflows. Revenues from payment services lost as deposits decrease may impair the profitability of the sector to a greater extent than the increase in the cost of funds, which can also greatly contribute to an increase in institutional concentration, for example through the exit of certain players from the market or through mergers. As a result of all these factors, the profitability of the banking system decreases, which may direct its lending activities towards more risky transactions with higher returns. At the same time, decreasing margins and the competition for deposits can also be seen as a positive development in a less competitive banking system. The wholesale funds raised may also lead to an increase in stability risks as those funds may vary significantly in maturity, concentration and denomination compared to customer deposits. Shorter maturities and higher concentration may lead to an increase

in renewal risks and maturity mismatch stretching in the balance sheet of the banking system. Finally, if wholesale funding is carried out through foreign currency borrowing, it may, in addition to the aforementioned risks, lead to an increase in short-term external debt and an increasing imbalance in the currency structure of the balance sheet. However, it is important to note that macroprudential regulation can contribute to the management of these risks, setting limits to in the balance sheet adjustment explained here. For example, in the Hungarian regulations, the requirement on the foreign exchange coverage ratio (FECR) limits the mismatch between foreign exchange assets and liabilities to 15 per cent of the balance sheet total, while the regulation on the interbank funding ratio (IFR) limits the liabilities from financial corporations to 30 per cent of the balance sheet total. The maturity match of foreign currency liabilities is currently ensured by the foreign exchange funding adequacy ratio (FFAR) requirement, while by 2021 banks will have to comply with the NFSR regulation at European level. Overall, these rules can limit both how and to what extent the banking system adjusts on the liabilities side.

Figure 5: Effect of CBDC with deposit outflows and secured central bank refinancing

Central Bank Assets Liabilities

Reserves

Loans to banks↑ Banks' deposits Cash CBDC↑ Liquid assets of the banking system Regulatory requirement for liquid assets

Banking System Assets Liabilities

Deposits at CB Liquid securities↓ Encumbered sec.↑

Retail and corporate deposits

Loans

Loans from CB↑ Wholesale funds↑ Equity

Source: MNB

If, due to the above constraints or for other reasons (for example, excessive cost to raise funds from the market), outflows of deposits could no longer be made up by wholesale funds, banks could also finance the missing funds through secured central bank loans (Figure 5). However, apart from a further increase in the cost of funds, this also leads to encumbrance of securities, which reduces free liquidity in the banking system. the balance sheet adjustment financed from secured central bank loans can only be sustained within the scope of assets available as collateral in the banking system.54 What would this mean for the Hungarian banking system? In the case of the Hungarian banking system, the liquidity surplus above the regulatory minimum within which balance sheet adjustment can take place without violating the LCR rules has fluctuated around 15–20 percent of household and corporate deposits at sector level in the last two years. Given that the volume of these deposits amounted to HUF 21 000 billion at the end of August 2020, this maximum adjustment is already very significant. It can be assumed that until the liquidity of the banking system does not fall close to the regulatory minimum, the banking system will not be forced to reduce its lending activity drastically. However, the lower liquidity generated by the adaptation reduces the shock resilience of the banking system, and permanent central bank financing may require the expansion of the central bank’s policy instruments to include long-term secured loans that are commonly used, also outside crisis episodes. As a next step in the analysis, consideration may be given to the extent to which the central bank is able to neutralise the negative consequences of financing available to the banking system in decreasing volumes and at relatively higher prices as the demand for CBDC increases in line with its monetary policy objectives by lowering interest rate levels. The impact on central bank room to manoeuvre and on bank profitability may also vary considerably

54 Until liquidity falls close to the regulatory minimum, which is currently defined in the LCR regulations at the European level.

depending on the specificities of the banking and financial system. For example, as Bindseil (2020) demonstrates, monetary policy space may come under stronger constraints due to a relatively higher proportion of capital markets in the financing of the real economy, while the response of interest rate margins to changes in the level of interest rates will also be shaped by the complex effects of the structure of the banking market (see, for example, Ennisetal [2016]).

Adjustment with the contraction of the balance sheet of the banking system When the banking system’s liquidity approximates the regulatory minimum, the central bank may consider extending eligible assets (for example to corporate loans) to increase the banking system’s liquidity. This slightly increases the banking system’s scope for adjustment, but the excess outflow of deposits already leads to a contraction of the balance sheet of the banking system (Figure 6). Indeed, when the possibilities of raising wholesale funds are exhausted and reserves in liquid assets are used up, the banking system will also be forced to reduce its other assets, such as its loan portfolio. This causes a contraction of the sector’s balance sheet, which can, ceteris paribus, also lead to sacrifices in terms of economic growth.55 At this point, however, the role of the central bank also changes noticeably, as the risk of the sector taking loans from commercial banks, albeit indirectly, is also reflected in its balance sheet by the wider inclusion of corporate loans in the scope of eligible assets. Moreover, due to the information asymmetry, there is a moral hazard on the part of commercial banks, which could drive institutions with already deteriorating profitability even

55 The relationship between financial intermediation and economic growth is discussed in detail by Levine (1997).

more towards riskier credit transactions.56 The fact that a bank is increasingly indebted to a state-owned institution also points in the same direction, so its decisions are more likely to be characterised by a soft budget constraint. Furthermore, if they are completely excluded from the operating framework of CBDC, banks are also forced to rely on a narrower range of information for their credit approval and monitoring, as they may observe fewer deposit movements in the case of those customers who are primarily transacting or saving using CBDC.

Figure 6: Effect of CBDC with deposit outflows, broadening of eligible assets and decreasing lending activity

Central Bank Assets Liabilities

Reserves

Loans to banks ↑ Liquid assets of the banking system Banking System Assets

Regulatory requirement for liquid assets

Liabilities Banks' deposits Cash CBDC ↑

Deposits at CB Liquid securities↓ Encumbered sec. and / or loans ↑ Loans from CB ↑

Retail and corporate deposits ↓ Loans

Wholesale funds↑ Equity

Source: MNB

56 Expectations for CBDC to appear as a risk-free instrument typically anticipate an increase in risk. However, Wierts and Boven (2020: 23) note that it is possible, at least theoretically, that in risk competition, some institutions may, by contrast, compete with the alternative of quasi-risk-free CBDC by reducing their risk.

Adjustment with “automatic” unsecured central bank refinancing The central bank also has the theoretical possibility to automatically finance the banking system with uncovered loans to a virtually unlimited extent (Figure 7). With such automatic refinancing, even an extreme case could be envisaged in which banking system deposits would get transferred entirely into CBDC. However, this scheme carries a number of risks, regardless of difficulties with legal feasibility.57 Indeed, in this case, the default risk of the banking system would be largely transferred to the central bank’s balance sheet, which would further strengthen the above-mentioned moral hazard. As a consequence, and given the increasing information asymmetry between the central bank and the banking system, the efficiency of financial intermediation would deteriorate significantly, which would not be desirable for economic growth either.

Figure 7: Effect of CBDC with unsecured central bank refinancing

Central Bank Assets Liabilities

Banks' deposits

Reserves

Cash

Loans to banks (unsecured) ↑ CBDC ↑ Liquid assets of the banking system

Banking System Assets Liabilities

Deposits at CB Liquid securities Retail and corporate deposits ↓

Loans Loans from CB (unsecured) ↑ Equity

Regulatory requirement for liquid assets

Source: MNB

57 This solution contravenes the prohibition of monetary financing under the current EU rules and is therefore not feasible under the current regulatory framework.

3.1.3. Impact of introducing CBDC on financial stability in the case of a creditor central bank Although it can be seen from the previous chapter that the credit risks of the banking system gradually appear in the balance sheet of the central bank also in the case of the deposit-taking central bank as the demand for central bank digital currency increases, a CBDC scheme is also possible where the primary objective is for the central bank to lend directly to certain economic agents. Central banks are already involved in the financing of the private sector, for example through the purchase of corporate bonds. However, this option could be a solution primarily for large or medium-sized enterprises, while for small and micro enterprises or households, the introduction of a significant volume of depositside central bank digital currency would leave a significant part of the potential credit demand that would be excluded from the commercial bank balance sheet unsatisfied.58

However, the extension of central bank digital currency may also allow the central bank to lend directly to companies or households.59 In this case, the volume of transactions financed by the central bank will increase as the credit portfolio of the banking system decreases (Figure 8).

58 Ultimately, this is due to the fact that the composition of the assets of a commercial bank differs significantly from the composition of the asset side of the central bank balance sheet – even after the unconventional measures of the central bank in recent years. Thus, if the central bank “invests” the funds obtained through CBDC along its previous balance sheet structure, many sectors will face financing shortages. 59 Direct lending by the central bank can obviously be introduced not only as an “extension” of liabilities-side central bank digital currency, but also independently.

Figure 8: Effect of CBDC in the case of a creditor central bank

Central Bank Assets Liabilities

Banks' deposits

Reserves

Cash

Loans to households↑ Loans to corporates ↑ CBDC ↑ Liquid assets of the banking system

Banking System Assets Liabilities

Deposits at CB Liquid securities

Retail and corporate deposits ↓

Loans↓

Equity

Source: MNB

Regulator requirement for liquid assets

As the CBDC introduced for lending purposes may exclude certain credit segments from the banking system even in their entirety, the diversity of the banking product portfolio will also be reduced and a narrower range of activities and lower profitability may lead to increased competition and, in this context, concentration of the sector. This is not a clearly unfavourable development in terms of the stable functioning of the banking system, as it may also result in more cost-effective operations. On the other hand, banks can compensate for loss of income by lending to more risky customers, which can certainly be considered disadvantageous from a stability point of view. At the same time, it is also possible that the central bank may be able to satisfy the credit demand of economic agents, in a targeted manner and under conditions optimal for the fulfilment of the central bank’s objectives, which are not reached by the product supply of financial intermediaries in the market, at least temporarily, or because of a market failure affecting their operations. In this case, lending by the central bank would only

complement the activities of commercial banks and thus would not have a significant impact on their balance sheet either. Another important question is how efficiently the central bank can perform the lending tasks undertaken by it in the above cases, because the inefficient allocation of resources can lead to sacrifices in terms of economic growth. A wider direct lending activity by the central bank would entail significant organisational and operational needs (IT systems, front and back office administrators, credit approval processes, decision-making, risk management, monitoring, work-out, etc.). Currently, for example, the Hungarian banking system employs a workforce of almost 36,000 employees, with a major proportion carrying out lending and related work processes. Accordingly, introducing CBDC for lending purposes could be a reasonable and feasible alternative for a narrower credit segment, with the aim of addressing some well-defined market failure.

3.2. Other potential transformations in banks’ systemic risks

Transformation of deposit flight and bank runs An extreme materialisation of the liquidity risks outlined above is the occurrence of a deposit flight or a bank run. The risk of this is as old as the banking system, but the availability of CBDC, depending on its design, can bring about a significant change in the withdrawal possibilities available for bank depositors. The clear reconstruction of the root causes of bank runs is a complex task, in which the weak financial position of banks, the selffulfilling expectations of depositors and panic all play a role.60 However, it can be assumed that depositors are more prone to opt for the withdrawal of their deposits if they can do so at a lower switching cost and more conveniently (Brown et al. [2013, 2020]), in which, among other factors, easy access to digital channels can

60 For example, see Calomiris & Gorton (1991) for an overview of the suspected causes of bank runs, among many other studies on the subject.

now play an important role. The risk of digital or ‘one-click’ bank runs should be taken into account by the regulatory authorities, see, for example.61 An efficient, customer-friendly and risk-free CBDC, which is beneficial in many respects, can be a new, easily accessible alternative for bank depositors who wish to withdraw their savings from the banking system in a crisis of confidence affecting banks. In addition, CBDC may offer certain advantages over many other forms of savings, such as the possibility to purchase electronically, thus potentially offering an increasingly attractive medium of exchange or store of value alternative compared to traditional (more appropriately termed historical today) outflows of cash deposits (see also Juks [2018], Chapter 5). Ideally, the central bank maintains the confidence of savers even during periods of financial stress, and the more successful and widespread the CBDC, the more obvious the choice for customers to convert bank deposits into central bank money.62 Furthermore, a characteristic of the operation of CBDC, as far as those implementations are concerned which offer unrestricted depositor access and are not priced in ways that would provide disincentives for mass conversion, is that the central bank money flowing from more vulnerable banks does not end up at other banks or other financial corporations, thus reducing the reserves of central bank money in the banking system.63 The increased risks of deposit flight and the liquidity in central bank money available in the system may also increase the significance of the central

61 A reminder by Cœuré (2018) of European banking disintermediation trends in favour of digital currencies and non-bank financial service providers, but also Panetta (2018) arrived at a similar assessment. 62 See the investigation and hypotheses by Schoors et al. (2019) about the role that a familiar, local alternative bank can play in depositors’ withdrawal decisions in a crisis of confidence.

63 Juks (2018) presents one of the rare experiences of similar, so-called aggregate bank runs through the example of the Swedish banking system during the 2008–2009 crisis.

bank’s function as lender of last resort in respect of individual institutions or even the banking system as a whole. With the introduction of CBDC, the increased risk of bank runs can be mitigated through the application of appropriate planning solutions. First, in the context of practical implementation, consideration may be given to quantitative or other restrictions on the aforementioned CBDC conversion, or to the use of pricing to discourage customers from hoarding CBDC assets (see, for example, Bindseil’s (2020) proposals on, inter alia, twotier interest payments). At the same time, Mancini−Griffoli et al (2018) also point out that designs that limit the total amount of CBDC available at system level rather than individually based on the demand of individual customers, or determine the price of CBDC based on the growing aggregate demand, may have an adverse effect by intensifying the occurrence of bank runs. Indeed, these may encourage depositors to convert their bank deposits into central bank money in advance of others (based on the first mover advantage mechanism also known from the description of bank runs). The possibilities for central bank intervention are nevertheless broadened by the fact that, according to the findings of Brunnermeier and Niepelt (2019), the central bank can obtain information about deposit flights reflected in CBDC conversion relatively early compared to obtaining information about any large deposit outflows affecting other financial instruments. It should be noted that potential risks deserve particular attention during the possible introductory period of a CBDC, as the emergence of the new alternative may lead to concentrated withdrawal of deposits in the banking system within a short period of time. Conversely, Brunnermeier and Niepelt (2019) discuss the application of a design, whereby the central bank plays a significant role in the financing of commercial banks by replacing deposits flowing towards CBDC. As central bank financing increases, the losses associated with a potential bank run are increasingly borne by the central bank alongside the depositors remaining

with the given commercial bank (in other words, the costs of a bank run are increasingly internalised by the central bank). Undertaking the highly concentrated central bank financing, the central bank may be more credibly committed to maintaining central bank financing, reducing the risk of bank runs as it reduces the incentive for other depositors to withdraw deposits. Withdrawal would be reinforced by expectations of the opposite behaviour, i.e. the intention of other depositors to withdraw their deposits.64 Abstracting from the specific alternatives of design, consideration may also be given to the additional market or regulatory mechanisms through which CBDC may influence the risk of bank runs, or on the contrary, the cases in which its operation does not have a special impact on the risk at issue. Mancini−Griffoli et al (2018) note, for example, that traditional withdrawal signals such as lines snaking in front of branches or ATMs, which can contribute to the spread of panic, do not occur in the case of CBDC (however, this is also the general characteristic of digital bank runs, where signal information is spread in digital media spaces). On a theoretical level, however, the presence of CBDC in the financial system is considered neutral in macroeconomic situations where depositors in vulnerable small open economies would be fleeing the domestic currency and quasi-risk-free assets denominated therein (e.g. currency and debt twin crises). In such cases, CBDC may also fall victim to the crisis of confidence. Finally, it can be assumed that the incentive to withdraw deposits

64 This statement is also linked to the problem of whether the losses incurred by the central bank can induce a run on the central bank for central bank money if neither the fiscal policy is ready, nor the monetary instruments can be used to cover the losses of the central bank. Fernández–Villaverde et al. (2020) provide a formalised discussion of the problem through a model assuming such a world state, and conclude that subject to certain rules on the composition of central bank assets, the central bank can reduce the risk of bank runs against it, while possibly approximating the supply of liquid deposit-type CBDC assets, generated through maturity transformation, to the market.

can be reduced by strengthening the Deposit Guarantee Scheme, but this may also have an undesirable effect. If uninsured, typically larger institutional depositors abandon bank deposits in favour of CBDC, depositors’ monitoring of banks may weaken further as a result. The ability and incentive of the insured group of depositors remaining with the bank, with typically smaller deposits, may be more moderate in controlling the risk taking of the bank.65

System-critical activities and the transformation of systemically important institutions Another important condition for safeguarding financial stability is that systemically critical financial services, such as the operation of payments, remain uninterrupted and continuously accessible to real economy customers. The various designs of CBDC can transform financial connectivity and also extensively rearrange the operational tasks and the related roles of service provider and developer between the central bank and market participants according to new structures. As a consequence, credit institutions, institutions specialising in the operation of financial infrastructure, companies offering payment services, or the innovators developing them, may also see changes in their systemic importance. The central bank may decide to entrust the development and realisation of operational, business and other tasks related to the functioning of the CBDC to efficient, competitive market participants with experience in terms of related risk taking (operational, reputational, financial, etc.). Auer and Böhme (2020) outline three operational models through which the allocation of different operational tasks between the central bank, financial corporations participating in the provision of CBDC services and end-user customers can be discussed.

65 In their assessment, Wierts and Boven (2020: 24) also discuss the interaction with deposit insurance, assuming a similar substitution between CBDC and uninsured deposits.

i. Indirect model: in this design, commercial banks would continue to play an important role in retail payments as service providers. Customers CBDC assets would constitute a claim on banks maintaining an extensive financial relationship which, for example, might include the initiation and receipt of customer orders, the resolution of legally disputed issues, customer due diligence and identification (KYC) obligations, customer communications and service development would remain the responsibilities of commercial banks. ii. Hybrid model: in this case, customers’ CBDC assets are direct claims on the central bank in terms of the legal-financial relationship, but the so-called payment service providers (PSP, or payment interface providers, PIP) provide the information technology services through which they communicate with the customer and execute customer orders. In the event of an operational disruption to a PSP, portability should be legally and technologically feasible so that the customer relations of the dysfunctional service provider can be taken over by an operating service provider as soon as possible. iii. Direct model: such CBDC design does not only entail customers’ claim on the central bank, but the central bank also builds and operates a payment infrastructure and assumes the associated risks.

Cases (i) and (ii) above involve outsourcing the provision of services related to CBDC flows to third parties, and moreover the engagement of market suppliers (such as cloud providers) may also complement case (iii). Among third parties, the central bank needs to identify “critical service providers” (CPS, as referred to in Kiff et al. [2020]) whose disruption, discontinuation or bankruptcy could result in a serious deterioration in the continuous availability or, in a broader sense, even in the competitiveness of the CBDC service. This may be wider group than the PSPs referred to previously. For example, a critical role may be occupied by IT specialists (such as software developers

and maintainers or network service providers) related to the system. Overall, depending on the CBDC model applied and its precise implementation, the number of market participants with a prominent role in financial stability may increase significantly, the regulation and supervision of which is traditionally not one of the foremost competencies of a central bank.

Novel systemic risks: threats to cybersecurity The scope of systemic risks changes along with the continuous transformations of the financial system and innovations, so that existing types of risk need to be given new interpretations, or emerging or intensifying types recognised in a novel context. Depending on its design, the introduction of CBDC can not only lead to a change in the business models of financial intermediation, but it also represents a large-scale IT undertaking whose innovative technologies deployed for the implementation of payments may be associated with specific risks. CBDC designs could possibly include cases where, due to the increase in the tasks of the central bank, implementation would require a drastic increase in the IT resources and infrastructure available to the central bank, and the expert workforce, with arrangements for the newly emerging extensive business and related risk management tasks. This creates a number of new risks associated with operation. Operational risks to the CBDC payment infrastructure that may disrupt business continuity are also systemically relevant, as safeguarding the security of payment infrastructures is a financial stability objective even today. The central bank should also verify compliance with the anti-money laundering and customer identification requirements and, where appropriate, comply with them itself. Accordingly, designs of the CBDC that may render the verifiability of AML/ CFT66 requirements uncertain and thus threaten the sustainability of the operation of the system also pose a systemic risk.

66 Anti-Money Laundering and Combating the Financing of Terrorism

With the rapid digitalization of the financial system, micro and macroprudential supervision is also paying increasing attention to mapping cyber risks. Paraphrasing the Cyber Lexicon compiled by the Financial Stability Board (FSB, 2020), which is often cited in the context of financial stability, cyberspace refers to information systems, procedures and networks and interactions of participants and operators that often handle sensitive data. Cyber incidents, whether due to deliberate attacks or to unintended errors, are incidents that jeopardise the data of the information system, as well as its information management and security procedures. Unintended errors may pave the way for attacks or, in the absence of transparent and understandable communication, may be construed as attacks leading to a loss of confidence in the information system. The CBDC system and the related infrastructures, whether operated by banks or other service providers, may also be subject to various cyberattacks, which may significantly damage masses of customers and operators, disrupt operations and force them to shut down, and cause a permanent loss of confidence among users. For a hypothetical evaluation of cyber incidents to assist preparations, the European Systemic Risk Board (ESRB) has developed an analytical framework67 that provides an overview of the diverse causes and systemic risk consequences of cyber incidents, despite the fact that incidents observed in the past are still rare or that there are no observations at all for certain types. The limited availability of experience also suggests that incidents are likely to materialise only rarely as systemic disruptions to the financial system. In order to assess whether a systemic impact is expected with the occurrence of a cyber incident, the ESRB recommends examining the following stages of the process leading up to it:

67 See, for example, the summary by the ESRB (2020a, 2020b) on systemic aspects of cyber risks.

i. Environment, context: among the preconditions for the systemic spread of the incident, the following aspects must be examined: – whether operations are disrupted due to a planned cyberattack or unintended error, how and what damage the technical and IT characteristics of the incident may cause; – whether one or more financial institutions or institutions operating the IT infrastructure have been affected, and whether the functioning of those institutions is affected similarly or to a different extent and in a different manner; – the extent to which the institutions concerned are prepared to eliminate the disruption or prevent the attack, the incident management tools at their disposal; – what financial or IT assets (including software, hardware and intellectual property) are at risk. ii. Cybershock: various incidents that can be interpreted as shocks can affect the financial institutions and related IT infrastructures in different scopes and to different degrees, causing technical disruptions and business damage. Shocks can compromise basic information security criteria such as the confidentiality, integrity, accessibility (the characteristics defining the “CIA triad”), authenticity, accountability of those accessing the data and non-repudiation of access, and the reliability of data processing and security techniques.

Furthermore, shocks may affect the business results of financial corporations, their compliance with regulatory requirements, the confidence of customers and investors, the perception of the financial markets about them and their ability to raise funds, their corporate reputation, press coverage and brand, but may also directly cause disruptions to the performance of critical financial functions. iii. Systemic amplification: the shock caused by a cyber incident may occur directly to a systemically significant financial

institution or to a system-critical entity or service company of the IT infrastructure, so that the incident itself may be considered systemically relevant. However, with second-round effects of the incident potentially emerging, other participants, nodes or functions of the financial or IT system may also be affected by the shock. Cyber incident contagions can spread through operational, reputational and financial connections.

The likelihood and extent of contagion can be influenced by a number of characteristics of the financial network: the density of relations between financial institutions, the degree of timecriticality of the problematic activity, the time of detection at different network nodes, the preparedness of the institutions for intervention, the homogeneity of the IT tools they use, the possibility of coordinated crisis management in the system, the possibility to reconstruct the situation before the occurrence of an attack or error, and the degree of complexity of the system, which may also make problem detection difficult. iv. Systemic impact and its management: Where the impact of the incident reaches the system-critical level, in order to determine the actual consequences, it should be taken into account whether the resilience of the system is strengthened by tools of preventive surveillance and crisis management mechanisms.

Possible tools to support the mitigation of this risk include:68 – modelling the systemic effects of the cyber incident – cyber stress testing, ethical hacking exercises – monitoring system to facilitate risk monitoring – sharing information among the members of the system about the identified possible points of attack and vulnerabilities, coordinated development of industry-wide crisis management practices and scenarios

68 DTCC and Oliver Wyman (2018), BCBS (2018).

– involvement of an expert third party in the risk assessment – agreements on taking over critical activities between market participants – use of secure data repository services – control of the introduction of circuit breakers69 to limit contagion – support for the introduction of techniques to strengthen the cyber resilience of financial institutions, such as zero trust architectures70

– the introduction of macro-prudential instruments to strengthen financial resilience, which would mitigate the adverse effects of ancillary financial losses; – development of an effective market and supervisory crisis management communication strategy.

69 Financial circuit breakers (named by analogy of the security arrangements in electricity networks) allow time, by halting the trading of a company, a type of financial instrument or overall trading systems, to ensure that market imperfections (e.g. traders overloaded with operational tasks due to active trading) cause less distortions in efficient market pricing. Similarly, certain cyberattacks can compromise the efficient functioning of financial markets, such as the dissemination of false information, unauthorised access or cyber insider trading committed through data theft. It should be examined whether halting trade in the compromised asset or in the market segment can contribute to avoiding negative consequences. 70 In the zero trust cybersecurity paradigm (i.e. a system of principles governing the organisation of IT workflows, system designs and procedures), users belonging to an IT network and their devices are not exempted from security procedures, either on the basis of the users’ network positions, or on the physical position of IT assets, or on the owner of a device, such as verifying their identity when accessing the IT system’s processes and other tools. The zero trust architecture may cover certain critical network segments, such as the data centre, but also the connection with external service providers (such as cloud, web and other IT service providers). See NIST (2020) for more details.

Central banks must also defend themselves against cyber incidents, as highlighted by cyberattacks on the financial systems of Bangladesh, Mexico or those launched by Anonymous against targets including the US Fed, and the central banks of Greece and Cyprus. With the introduction of CBDC, for certain designs the centralised information generated on customer transactions may be the target of attacks. By hacking the databases, and in the event of unauthorised access, customer data can be accessed on a massive scale. In order to maintain trust, the design should also enable customers to easily and effectively preserve the security of customer identification, and ensure they feel their CBDC assets are protected. Finally, the system should be designed in such a way that, despite a possible successful attack, it is possible to restore it within a short period of time in the largest possible number of cases. This requires not only IT preparation, but also the renewal of regulatory and supervisory expectations that strengthen cybersecurity on an increasing scale.

4. Rethinking the regulatory framework in the event of introducing CBDC

The introduction of CBDC also requires a rethink of the current institutional and prudential legal framework. On the one hand, the widespread uptake and use of central bank digital currency also necessitates the renewal of the current legal framework based on traditional financial services provided by banks (deposit taking, account servicing, lending, etc.), taking into account the need to maintain their international harmonisation. According to ITC (2019), these include, inter alia, central bank’s mandate to create money, the legal and financial definition and management of digital assets, and data protection and banking secrecy requirements. On the other hand, it is necessary to rethink

the specific regulatory and supervisory frameworks that set expectations for the safe functioning of the banking system and significantly affect the possibilities for introducing CBDC. Further complexity and challenges result from the fact that the design of CBDC can vary considerably across countries. This may justify the expansion or even the transformation of the rules on the basic functioning and tasks of the banking system and central banks, and in the absence of cooperation between countries, the very implementation of an effective CBDC may become questionable. Of the above, we will focus on the prudential requirements that were strengthened after the 2008 economic crisis in order to mitigate the risks in the banking sector. These may require a rethink in order to take full advantage of CBDC due to the transformation of banking system operations alongside the introduction of CBDC.

4.1. Principles for transforming prudential regulation

Based on the collection of Kiff et al. (2020), the regulatory framework should be established along the following lines: – What central bank objectives will CBDC serve? – In what technical and infrastructural framework will the central bank digital currency operate? – What is the current legal and regulatory environment and what obstacles can be identified within it? – What internal organisational structure will be in place for the introduction of CBDC and the subsequent operation of the system? In order to properly assess risks, central banks can test the effects of introducing central bank digital currency through pilot projects, thus identifying potential operational and systemic risks. This can be supported by “sandboxes”, which are being adopted by central banks on an increasing scale, and where central banks and

market participants can test new technologies and the regulatory environment in a secure manner, under specific conditions, with real customers. Accordingly, national digital central bank currencies have to date been introduced on a pilot basis and subject to restrictions in several countries (such as China and Sweden).

4.2. Challenges for prudential regulation

In order to ensure financial stability, the MNB, following its macro- and micro-prudential mandate, mitigates the risks arising from the operation of the banking system, systemically important institutions and financial infrastructures through regulation and supervisory tools, and ensures the stable functioning of the financial system.71 Depending on its design and technological specificities, the possible introduction of CBDC may affect most elements of the prudential instruments. Whether regulations are affected and need to be rethought largely depends on the fundamental issues outlined previously in connection with the introduction of CBDC. In particular, the objective of introducing central bank digital currency determines the impact on the banking sector and thus on the prudential and supervisory regulations and instruments.

4.2.1. Cash-substitute CBDC designs Due to its relatively moderate impact on systemic risk, CBDC introduced as a cash substitute would presumably lead to less drastic changes in the functioning of the banking sector. Cash and cash transactions account for only a small part of the balance sheet and services of the banking sector (in many cases this is only a necessary complementary service, which may not even be profitable due to the costs of cash transit and ATM network maintenance). There are nevertheless new aspects that need to

71 The theoretical basis of the macroprudential regulatory framework and the domestic practice are summarised in the MNB’s Macroprudential Strategy: https://www.mnb.hu/letoltes/stabilita-s-ma-stabilita-s-holnap-hun.pdf.

be taken into account from a regulatory and supervisory point of view:

– Possible emergence of new system-critical activities and institutions: With the entry of CBDC in the market, the structure of payment systems may change as outlined earlier, new players and payment solutions may emerge, potentially playing an important role at the system level. While systemically important institutions are given special attention in the banking sector, it may be justified to revise and extend the previous set of rules for new non-bank players. – Possible increase in the risk of cyberattacks: In connection with the greater uptake of digital solutions, the expected emergence of new providers specialising in digital services, and central bank functions related to CBDC, cyber risks and the resulting abuse and fraud attempts are also expected to increase. Preparing for cyberattacks is a challenge not only for the central bank, but also for service providers in the financial system.

Accordingly, consideration should be given to the renewal of the cyber-protection standards and supervisory solutions currently in place, which are internationally fragmented, and lack harmonisation. Based on the recommendations of

Crisanto–Prenio (2017), this should include the development of banks’ internal rules and cyber risk management systems, the improvement of the qualifications of bank employees and the strengthening of international cooperation. – Possible contribution to the risk of deposit flights: As described above, central bank digital currency, which is an easier and more convenient alternative to cash, can, on the one hand, also increase risks of a bank run at the sectoral level. On the other hand, when introducing CBDC, measures are needed to ensure that retail customers only replace their cash holdings and that savings in deposits do not flow into CBDC on a massive scale.

The increase in withdrawals in this case is not caused by a bank run due to external shock, but in general the withdrawal of

deposits can be accelerated by the simplification and efficiency gains in the process. In the case of cash-substitute CBDC, the risk to the financial system is moderate. However, it can also be discouraged by design solutions such as limited convertibility, limited volume or differentiated pricing, primarily in normal times and not under stress.

– Possible changes in risks related to money laundering and terrorist financing: The emergence and subsequent uptake of

CBDC could reduce the volume of cash transactions and, with the implementation of specific CBDC designs, contribute to ensuring that the system of anti-money laundering and counterterrorist financing (AML/CFT) institutions can effectively prevent the offences targeted by it. For example, it could also be easier to detect indications in due course and to monitor suspicious monetary movements. At the same time, CBDC can also be implemented with designs that present novel challenges for anti-money laundering and counter-terrorist financing activities (CPMI, 2018); for example, a high degree of anonymity in the choice of implementation may need to be balanced with a design that also enables the effective control of money laundering. Such a trade-off may include, for example, the design outlined by the ECB (2019, 2020), under which the identity of users and the history of transactions in small transactions are not accessible to either central banks or credit institutions, although both types of institution are involved in the operation of the system, but large transactions may be audited by the authority performing the AML functions.

4.2.2. CBDC designs implementing the concepts of the deposittaking and creditor central bank Profitability and capital

The possible consequences of the potential deterioration in the profitability and capital position of credit institutions

are an incentive to take risks and a change in regulation. The introduction of CBDC may reduce banks’ profitability due to more

expensive means of raising funds and a possible decline in banks’ role in the credit market. As income generation is an important way of generating capital, compliance with capital requirements may be jeopardised. Moreover, the profitability of the banking sector is not only challenged by central bank digital currency, but is also subject to constant pressure from other factors. Some of these include direct competition within the banking sector, external competitive pressure, and the popularity of shadow banks, FinTech financial intermediaries, digital currencies, payment service providers and other alternative forms of savings and investment in a persistently low interest environment. As a result, the already observed bank response strategies and trends may further strengthen after the introduction of CBDC. This and the changing landscape of risks may require a rethinking of the framework for capital requirements, and preparing supervisory work. The implications of decreasing profitability for risk taking by banks, market structure, and regulations are summarised as follows:

– Higher risk appetite in the banking sector: The banking sector may be unable or, due to profitability considerations, unwilling to adjust to the decline in deposits and capital accumulation.

Investor expectations, increasing leverage and decreasing profitability can all be incentives for increased risk-taking. As a result, it can maintain its previous (lending) activity within regulatory limits, or even increase its risk taking, while its capital and liquidity buffers decrease. The supervisory authority must be prepared to monitor banks more closely, and for dealing with both minor breaches and major stress events. – Regulatory arbitrage: The increase in risk appetite may reach a point where the bottleneck for the bank’s liquidity and capital buffers will be represented by regulatory requirements rather than internal risk assessment. Pressure will then increase for the development and sale of products that do not involve higher requirements in legal terms, but provide the expected

profitability through greater risk-taking. Since legislators focused on existing products when defining the rules, consideration must be given to the possibility that regulatory arbitrage develops through new products. This risk will require regular review of the regulation at macro level and verification of the banking classification of individual products at micro level.

– Less regulated institutions: The service provider may try to conduct its activities through less strictly regulated financial intermediaries (shadow banking phenomenon). An increasing proportion of the current commercial banking may shift to other financial institutions, where not only does the supervisory authority have more limited powers today, but because of the simpler reporting, it will not have the same insight into the processes. However, the emergence of a competitive CBDC may even reduce the market penetration of new players specialising in payment traffic, such as FinTech companies. – Possible divergence of commercial banking functions:

Maintaining payment accounts, deposit taking and lending may become services offered by separate institutions in the future, should CBDC become widespread. Current supervisory work in Hungary is helped by the fact that the vast majority of banks are commercial banks, i.e. all three activities are often provided by institutions which are subject to the same regulations (NDIF coverage, capital and liquidity requirements, etc.) If these functionalities become separated72 and each specialised institution is obliged to comply with the relevant legislation with distinct adjustment strategies, the individual financial products

72 Effective spin-offs or the returns of business licenses is unlikely, but it is possible that some banks will be crowded out of certain market segments and retain specific products only for the full service of their own premium customers. Rather, divergence at the sectoral level can be a result of new players achieving significant shares in specific market segments with their focused services.

and business models have to be assessed separately. This is also challenging from the supervisory side, but the investor or the customer may also face new risks, which also raises investor and consumer protection issues. – Increasingly limited scope for bank modelling: Based on the above, the range of available data may become narrower, which makes bank modelling difficult in the areas of risk management and capital adequacy, as well as other compliance areas. This may adversely affect credit approvals, but also the accuracy of impairment provisions and capital requirements.

The use of regulatory instruments preventing excessive risk taking related to credit growth could strengthen capital

positions. If the adverse income effects materialise and the banks concerned respond by increasing the risk of their lending activities, an adjustment may be made to the instruments aimed at mitigating credit risks, including capital buffers that strengthen the capital position and are likely to mitigate risk-taking incentives. In the case of direct lending models of CBDC, the central bank has more direct control over credit outflows. These designs may reduce the risks arising from excessive lending if appropriate risk assessment and management mechanisms are put in place. At the same time, the capital rules may need to be reconsidered because of central bank loans intermediated by commercial banks, while the borrower-based measures (requirements limiting the amount of loans available on the basis of income or collateral) may need to be reconsidered, for example, with regard to risk management systems applied by central banks, or to non-mortgage lending that is likely to be preferred in central bank lending.

Financing structure

Changes in the funding risks in the structure of bank liabilities can be significantly influenced by the funds replacing deposits.

With regard to the financing opportunities of commercial banks, it is primarily sight deposits that will receive a new competitor

with the introduction of CBDC, to complement cash, securities, investment units, digital currencies and other cash substitutes. If an attractive CBDC instrument is designed successfully, the banking sector will have to respond to the resulting restricted supply of stable, inexpensive, unsecured funds. The replacement of funding may result in new risks, and the new investors may require collateral or a premium. Depending on the technical solution chosen by the bank or emerging on the market, a funding risk may arise, which may increase the importance of the corresponding rules. In theory, the central bank could redistribute the savings flowing into CBDC to the commercial banks. However, the use of refinancing and the transformation of the financing structure largely depend on the maturity, pricing, collateral requirements and purpose limitation at which the central bank provides funds to the banks, and on the extent to which these conditions prove to be time invariant. In other words, banks may also run regulatory or business model risks with regard to central bank credit conditions.

In addition to balance sheet considerations, taking customer deposits brings other informational and business benefits to banks, the availability of which may also become restricted.

Customers also use a number of payment services, which involves significant revenues from fee and commissions. They also provide opportunities for targeted outreach to sell other products: savings, for example, first appear in current accounts. In addition, they provide an information base e.g. for assessing the periodicity of income for credit approval purposes, and for monitoring the customer’s income (real estate insurance premium) in the case of an existing credit relationship. Possible problematic consequences of the reduction in deposit taking, requiring regulatory and supervisory attention, may include: – Miss-selling: If the banking sector seeks to compete with the central bank’s deposit taking, then one approach to attempt this could be through the provision of complementary services. This

may be a preferred choice for banks also because if the central bank only provides limited services, the banks’ competitive advantage in other areas will remain. This may include credit cards, but it is also possible to offer foreign currency accounts and provide investment services even if the conceptual design of the creditor central bank is implemented. Product development and better serving customer needs can fundamentally be a positive contribution from the introduction of CBDC, but the pressure may increase on banks to force customers to use services that they do not need. – Agency sales: If banks lose their customers along with the relationship of maintaining their account, it will be more difficult to sell other products. For this reason, banks may be forced to look for new customers, with the potential result of more widespread agency engagements, which requires more attention from the supervisor. – Potential increase in bond issues and securitisations: In the

Hungarian market, the issuance of securities itself is currently a rather underutilised option to raise funds. Securitisation also realizes the transfer of credit risk, that is, it also reduces the capital requirement from a banking point of view, thus it also releases this constraint on lending. Currently, the issuance of securities is considered an expensive way to raise funds in terms of interest rates and fixed costs, but if banks are forced to offer higher deposit rates due to the shortage of funds resulting from central bank deposit accounts, the cost disadvantage may decrease. After the first issues, this form of funding can spread relatively rapidly, as it is easier to compile the issuance documentation for the second time, investors become familiar with and price in the securities, and a wider range of investors can also have a beneficial effect on the secondary circulation (liquidity) of the paper. Smaller series and issuers may also appear as the market develops. The process also requires greater supervisory control due to the additional risks of securitisation.

Regulations on the management of liquidity and financing risks may need to be adjusted to address potentially changing

financing structures. Current regulations (LCR, NSFR, etc.) require banks to maintain sufficient liquidity and stable financing even under market stress. Although these are effective and necessary risk mitigation steps in banks’ current operating model, which relies heavily on deposit financing and bank lending, they may significantly restrict the possibilities for introducing CBDC, as explained previously. Therefore, if central bank digital currency is implemented on a wide scale then these regulations also require rethinking these regulations. For example, consideration needs to be given to a reassessment of the stable classification of specific items and their weights, or even to the replacement of the indicators used so far with solutions tailored to the new banking model. Bank stress tests and related regulation (e.g. LCR) should also be considered from the point of view that whether the transactional motives of a cash substitute or the motives for deposit holding dominate, due to the small impact on the normal course of business, historical time series provide relatively limited information to model the behaviour in stress situations.

Other regulatory areas – Instruments to limit excessive exposure concentrations: The uptake of CBDC on a wide scale and the substantial replacement of customer bank deposits, as well as the takeover of lending functions by the central bank, may reduce diversification in financial services and may also cause risks currently distributed among institutions to be concentrated at the central bank. In the case of indirect central bank lending expanding through the banking system, a large exposure with a significant credit risk, depending on the level of concentration in the banking system, may appear among central bank assets. Simultaneous implementation of direct and indirect lending may reduce the former concentration, but commercial banks may get crowded out of certain market segments financed by the central bank or capital markets. In the case of direct central bank lending, while

maintaining the quality of the service, this may pose challenges to the central banks on the operational side, which requires considerable preparations and a major enhancement in central bank apparatus and technological background. With the entry of direct central bank lending, transparent regulation of the central bank’s own operations must be established and ensured as well. From the point of view of operations and regulation, it is necessary to develop a well-defined and distinct solution for the overseeing of the activity by the central bank. – Instruments to mitigate the risks of systemically important service providers: As explained earlier, CBDC can divide the operational tasks and the related roles of service provider and developer between the central bank and the market participants according to new structures, whereby new critical participants may also emerge. Regarding systemically important players and critical functions, the prudential system already applies a variety of instruments in the banking sector (e.g. through macroprudential capital buffers, tighter supervision and the resolution framework). Extension of this system may be necessary for new entrants, with the possibility of a shift in the focus of frameworks from institutions to activities.

– Consumer protection challenges: Consumer protection tasks are also heavily influenced by the central bank’s role in the introduction and operation of CBDC. For example, in the case of a CBDC model involving direct central bank account servicing, the central bank itself may be required to comply with the relevant financial consumer protection and complaint management provisions. In the case of an indirect CBDC design or a hybrid model, the issue of liability for individual consumer losses and the protection of consumer-owned CBDC assets could arise. From a consumer protection point of view, it is also necessary to consider the social policy aspect that certain categories of consumers who could find it challenging

or impossible to handle their transactions with CBDC should not be excluded from the use of the financial intermediary system and the services provided by other market participants. Thus, the possibility of using CBDC in offline mode may arise due to possible problems with internet coverage. Operational risks related to cybersecurity, fraud and abuse can also create consumer protection risks – such as loss of consumer confidence, material damage to consumers, theft of consumer personal data – and therefore, from a consumer protection perspective, safe and reliable operation of the CBDC system is of paramount importance. – Other considerations: The need to develop the legal framework may also arise in relation to other expectations that are not prudential but have an impact on banking operations. For example, one of the key issues in the introduction of CBDC is data protection, especially where related tasks are also performed by actors other than the central bank, and outside the banking sector. Maintaining confidence in the banking system is a key financial stability objective, which calls for the establishment of a strict set of requirements for data processing, to be defined according to the new digital solutions. Hayashi et al. (2019) and Nabilou (2019) also point out that due to the specificities listed previously and their implications, it is appropriate to examine in detail the need to amend the legislation and the supervisory activity in the event of the introduction of a wider CBDC framework. If the central bank wishes to operate the CBDC solely or mainly within its own institution, this may lead to conflicts of interest regarding regulatory compliance. A rethink of the prudential framework entails significant costs that should be taken into account in a possible introduction of the CBDC (Wierts and Boven, 2020). In addition, it is important to note that a significant part of the emerging issues and potential changes brought about by the CBDC also affect international regulatory

expectations, given that in recent years regulatory harmonisation has been key concern both globally (e.g. through BIS) and in the EU. For that reason, and in order to address potential cross-border impacts, it is important to review the regulatory approaches in international cooperation and to lay the foundations for a new harmonised regulatory framework jointly.

5. Conclusion

In our analysis, we reviewed the financial stability aspects of the possible introduction of CBDC through changes in the balance sheet of the central bank and the banking system in a general approach in which no significant restrictions were made on the technical operation and design of CBDC. In addition, we examined other operational and systemic risks that could pose a threat to financial stability, then examined the main principles and areas of revision of the regulatory framework in relation to CBDC. In the case of cash substitute CBDC, we found that its introduction would not give rise to classical financial stability risks in terms of either financing or profitability. The effect of the central bank crowding out cash in its function of deposit-taker and/or creditor can be considered neutral for financial stability purposes. A number of financial stability risks have already been identified for the deposit-taking central bank. Some of these include the risk associated with the financing of deposit outflows, such as the renewal risk of wholesale funds (from financial corporations), the wider maturity and currency mismatch associated with raising such funds, and the increase in short-term external debt. The other significant risk relates to a decrease in profitability, which may stem in part from an increase in funding costs and in part from the loss of fee income from payment services. As a result of all these factors, therefore, the profitability of the banking

system decreases, which may direct its lending activities towards more risky transactions with higher returns. At the same time, decreasing margins and the fight for deposits can also lead to increased competition between banks, which can be seen as a positive development in a less competitive banking system. However, as demand for CBDC grows, deposit withdrawals from the banking system already lead to a reduction in banking system liquidity, which reduces the shock resilience of the banking system. At this point, the transformation of central bank instruments becomes necessary, because the central bank must arrange for long-term financing of the banking system. However, if the popularity of CBDC continues to increase, the continued outflow of deposits will lead to a contraction of the balance sheet of the banking system, resulting in a fall in lending and ultimately a slowdown in economic growth. In the case of the creditor central bank, financial stability risks arise primarily in terms of decreasing profitability, which, as in the case of the deposit-taking central bank, may arise in a riskier lending activity of the banking system. In our view, introducing CBDC for lending purposes could be a reasonable and feasible alternative for a narrower credit segment, with the aim of addressing some well-defined market failure. However, the introduction of CBDC may also entail other risks arising from the emergence of new services, infrastructures and institutional systems associated with central bank digital currency. In addition to the increasing possibility of bank runs, the emergence of new systemically important institutions and infrastructures and the increase in cyber risks are challenging for central banks.

The new framework also calls for a renewal of regulations and the supervisory instruments. This also means reviewing the mandates of the central bank and the laws governing the functioning of the financial system (e.g. the management of digital money, remote administration, money laundering and data protection

regulations) and rethinking the prudential requirements and the supervisory monitoring and expectations system. In addition to adapting existing rules and expectations in the fields of lending, liquidity and capital adequacy to new conditions, it is also necessary to establish a framework to support the management of new risks, such as cyber risks. In order for the potential introduction of CBDC to be successful, efforts are needed to specify design aspects ensuring that the resulting stability risks remain manageable and do not outweigh the benefits of CBDC use. In the framework of the above analysis, we see headroom from both the deposit-taker and the creditor central bank roles.

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