Options to extend SME financing through central bank digital currency

XI. Options to extend SME financing through central bank digital currency

Laura Komlóssy – Blanka Kovács – Soma Sándor

While a strong sector of small and medium-sized enterprises (SMEs) is the foundation for sustainable economic growth, these companies often face obstacles in accessing credit. In recent years, the Magyar Nemzeti Bank (MNB) has deployed several targeted instruments to support domestic SMEs’ financing with favourable conditions, and thus economic growth. This paper presents the prospective design and operational aspects of a possible form of SME-focused central bank digital currency. A low-cost and secure alternative lending channel in the form of central bank digital currency can help the SME sector, which is important for economic growth, to realise its development potential across financial cycles.

1. Relationship between the SME sector and the financial intermediary system

1.1. Smooth financing for the SME sector is fundamental economic interest

As the SME sector is one of the fundamental pillars of an economy based on inclusive growth, SMEs’ access to an adequate form and volume of financing is important in all countries. The SME sector plays an important role in Hungary, both economically and socially. Currently, more than 750,000 SMEs operate in Hungary, which account for more than 99% of

all domestic enterprises. According to data from the Hungarian Central Statistical Office (HCSO), the gross value added by the sector increased steadily from HUF 6,800 billion in 2013 to HUF 11,100 billion in 2018. In 2018, the SME sector’s share of the gross value added by the entire business community was 45.7%. SMEs are the largest employers, employing nearly two-thirds of the workforce (HCSO, 2018).

The number of SMEs in Hungary is the highest in the services, agriculture and construction industries (HCSO, 2019), the last

two also being the most capital-intensive. Maintaining the supply of funds to these businesses is therefore a priority not only from the perspective of their own growth and operation, but also that of the whole economy. If these firms do not access an adequate amount of funds in the appropriate structure, this may entail a drop in investments, rising unemployment and less innovation.

SMEs have limited financing opportunities; typically they can only raise funds through banks, whereas equity-type financing, even though showing an increasing trend, is not significant.

Unlike large companies, which can borrow directly from abroad or issue bonds in addition to having access to domestic bank loans, the financing of domestic SMEs is bound to be linked to domestic credit institutions. In terms of their financing opportunities, SMEs are also generally more likely to experience difficulties in effectively obtaining funds.

1.2. Market frictions and dysfunctions in financial services to SMEs, particularly in SME lending

In many cases, credit markets create barriers for companies seeking access to funds. In classical economic models, pricing plays the most important role in the relationship between lenders and prospective borrowers. In the credit market, realtime and reliable information about the financial position of companies is difficult to obtain, which creates a high degree of

information asymmetry in this market. Lenders are prompted to be more cautious about financing, in particular smaller and undercapitalised companies that have possibly been established only recently and are exposed to specific sectoral impacts—that is, SMEs. Additionally, at the turn of each economic or credit cycle, lenders’ appetite to take risks will change due to their more pessimistic assessment of the economic outlook ahead. In response, not only do they raise their interest rates, but also reduce the amount of credit granted, demand additional collateral, or refuse to lend completely. As a result, the average risk rating of companies deteriorates, and banks only find it worthwhile to finance more risky investments. Above a certain interest rate, they would lose more on a loan than they would receive in surplus interest, which leads them to suspend or reduce their lending in what is referred to in literature as “credit rationing”.

Three types of credit rationing

The three distinct types of credit rationing are redlining, intensive margin and extensive margin. Redlining occurs when a particular group of companies, defined by certain characteristics, are denied access to credit. This phenomenon is typical to the SME sector, mainly because of the size of such enterprises. Some of the problems associated with SME growth stem from the fact that the relative transaction cost of financing is high because of economies of scale. Zott and Amit (2007) find that large companies have more resources to implement new products and projects, which, if successful, will become more profitable by accessing larger markets. Ceteris paribus SMEs are less likely to succeed on average than large companies, and even if they do, their average return is lower than that of their large and medium-sized counterparts. As a result, banks may expect higher profits on loans to large and medium-sized enterprises than on loans to SMEs. The second type of credit rationing is referred to as intensive margin, where credit institutions lend less than

the companies require. An important part of a commercial bank’s business policy is to carry out a preliminary risk assessment, determine the exposures that are acceptable on the basis of those risks, and to make a specific decision based on those risks. Accordingly, in a number of cases, available loan amounts are maximised in relation to a potential debtor in alignment with the given risk profile. The typically high risk ratings for SMEs, especially start-ups and scale-ups, are accompanied by high capital needs, which a bank’s business policy is not always ready to satisfy in full. The third and extreme type of credit rationing is extensive margin, where the loan requested is completely rejected.

Another financing barrier is that some SMEs find it difficult or are completely unable to provide the collateral or other guarantees required by banks to prove creditworthiness. Difficulties may also often arise where, as part of the credit approval process, banks require at least 2 to 3 closed business years in order to reduce the risks they undertake, while they also limit the amount of credit available depending on the revenue that applicants generated in previous years. In addition, banks have less room for flexibility in terms of deviating from the assessment of the indicators integrated into their usual approval and monitoring processes, and the means to evaluate alternative criteria are also yet to be provided. All these factors point to lower expected profits for banks, which, in turn, will be more likely to refuse to lend (Jin and Zhang, 2019).

Higher risks may affect the time required to approve a loan,

resulting in long approval times. As a result of the limited information base, the credit approval process is longer as banks need to assess the competitiveness of the industry in which the SME operates, the profitability of the SME’s operations, and the maturity stage of the SME.

Compared to other sectors, SMEs are more exposed to the

procyclical behaviour of the financial system. During a cyclical upturn, stronger lending activity supports growth, but carries significant risks to the stability of the financial system. The improved growth outlook will further strengthen lending activity, driving the banking system to relax its terms of borrowing and increasingly lend to the SME sector as well, which is expected to derive a greater benefit from the overall upturn despite the risks, thereby also improving the profitability of banks. However, beyond a certain point, amid the general euphoria banks will become unrealistically optimistic in their risk assessment and see an increase in the number of their new loans carrying excessive risk, which will indeed soon fail due to their unsustainability. In Hungary, one example of such an overshoot in lending was the general uptake of foreign currency lending, and a similarly unhealthy expansion had also occurred in project financing before the crisis of 2008. Conversely, in a recession the banking system will seek to lend as cautiously as possible and provide less credit than optimal, only to contribute to the prolongation of the recession. Indeed, in many cases even truly creditworthy companies will be denied access to funds, which will in turn deepen the problem of the real economy and drive banks into stronger risk aversion. In times of recession, banks themselves may also incur significant losses, and with information asymmetry becoming more prominent in their risk analysis processes, they will reduce their lending to segments they consider more risky, leaving the SME sector even harder hit by cuts in bank lending (Balog et al., 2014).

The 2008 financial crisis was an extreme form of credit rationing,

when credit supply dropped drastically. In the years of the financial crisis, Hungary saw a prolonged decline in both retail and corporate lending. In the corporate segment, however, in addition to demand factors, supply also became a bottleneck, due in part to the banking sector’s ability to adapt quicker in corporate loans, where average maturity is shorter. Although parent banks

carried out capital increases, they did so mainly to cover their losses. As Hungarian banks found it more difficult to increase their capital, they cut back on their lending. From 2009 to 2013, the Hungarian financial system experienced a sustained credit crunch (Balog et al., 2014).

2. International examples for addressing identified market frictions

2.1. Lending incentive programmes introduced after the 2008 crisis, and the lessons learned

Following the onset of the financial crisis, a number of central banks eased their monetary conditions. When the interest rates hit the zero-lower bound, several central banks announced asset purchase programmes (e.g. government securities purchases), and, in addition to these, some also introduced negative policy rates, which had previously been deemed impracticable. Moreover, a wide range of central banks used liquidity-providing instruments to stabilise financial markets and reduce uncertainty about liquidity processes. In addition to interest rate cuts and asset purchase programmes, several central banks sought to address the friction in lending in a targeted manner: as a result of the banking system’s balance sheet deleveraging process, bank lending had dropped significantly, prompting the ECB, the Bank of England, the Hungarian central bank and others to introduce various instruments to support lending in order to stimulate the lending activity, and in particular to ensure the supply of funds to the SME sector. Nevertheless, these instruments always sought to achieve their intended financing effect by involving the banking sector, providing specific, dedicated funds, and continuing to build on banks’ risk-taking. Therefore, in any case, the success of the programmes also required banks’ participation and activity.

In December 2011, the European Central Bank decided to introduce a refinancing facility with a maturity of more than one year (Longer-Term Refinancing Operation, LTRO) to support

bank lending and provide the necessary liquidity. The loans were granted by the ECB with a maturity of three years, with the interest rate set at the average of the key interest rate (MRO100) over the period concerned. In June 2014, the ECB announced the launch of a Targeted Longer-Term Refinancing Operation (TLTRO I), available in proportion to the volume of lending to non-financial corporates and households. Under the 4-year instrument, banks were eligible for a loan amount corresponding to 7% of their respective credit stock. Each bank was required to make a commitment with regard to the development of its total loan portfolio and repay the loans before maturity if it failed on its commitment. In June 2016, the central bank launched a new Targeted Longer-Term Operation (TLTRO II). Unlike the TLTRO I, at this stage the ECB tried to encourage credit institutions to lend to the real economy at a lower interest rate; depending on the volume of lending, the cost of funds could fall to the level of the central bank’s overnight deposit rate. Under the TLTRO II, each credit institution could draw funds up to 30% of its loans outstanding to the private sector. According to the ECB’s analyses, TLTRO tenders contributed to the easing of lending conditions, and significantly reduced the marginal cost of funding for banks participating in the operations.

In 2012, the Bank of England introduced a scheme which, in addition to base rate cuts and high volume of asset purchases, sought to increase corporate lending, with greater focus on SME

lending over time, in more a targeted way. Launched in July 2012, the Funding for Lending Scheme (FLS) was novel in the sense that it tied the quantity and price of available funds to lending performance. The scheme was extended in April 2013, once an increase had been achieved in the portfolio of loans to SMEs, with

100 Main Refinancing Operations (MRO) rate

central bank funds available at a higher (ten times) multiplier. The scheme, launched in mid-2012 contributed to a sharp drop in banks’ cost of funds, which in turn led to a reduction in lending costs and better access to credit for both corporations and households. To address the situation that emerged in the aftermath of the Brexit decision, in August 2016 the Bank of England introduced a new programme called Term Funding Scheme (TFS) in order to foster the interest rate cut of August 2016 to spill over to corporate and household loans. The scheme enabled credit institutions to draw funds from the central bank at rates close to the base rate, over a period of 4 years. In both schemes, the amount of available funds was effectively set at 5% of the amount of the initial loan portfolio plus the amount of portfolio increment achieved over the reference period. In the central bank’s assessment, the TFS successfully contributed to a decrease in corporate and household interest rates, without causing any major reduction either in creditors’ net interest rate margin or in the credit supply to the economy.

In addition to significant base rate cuts, in recent years the Magyar Nemzeti Bank (MNB) has also supported domestic SMEs’ favourable access to finance, and thus economic growth,

with a number of targeted instruments. Under the Funding for Growth Scheme (FGS) launched in 2013, the MNB provided refinancing loans to credit institutions at an interest rate of 0%, which they used for lending to domestic SMEs for specific purposes at a maximum interest rate of 2.5%. The phases of FGS had different characteristics, and in the later phases of the programme the focus increasingly shifted to investment loans due to the opportunities of gradual restrictions on loan purposes and longer availability periods. In the phases already completed in the seven years since the start of the scheme, approximately HUF 3,400 billion worth of funds have been allocated under favourable terms to nearly 50,000 enterprises. Given its important role in turning SME lending into a rising trend following the crisis, FGS had a major impact on both economic growth and employment.

The MNB estimates the impact of the scheme on economic growth to have been around 4.5% in 2013–2020. In another targeted MNB instrument, the Market-Based Lending Scheme (MLS), the central bank provided banks with favourably-priced assets to support risk and liquidity management in order to stimulate lending, available on the condition that recipient banks would increase the volume of their SME loan portfolios.

2.2. Central bank responses to the coronavirus crisis to stimulate lending

Several central banks have announced extraordinary measures in the recent year to counteract the adverse economic effects of the coronavirus outbreak. In addition to interest rate cuts, asset purchases and liquidity-providing measures, some central banks also introduced other comprehensive economic recovery

measures to complement monetary easing. While targeted instruments were not widely used after the previous crisis, this time a wide range of central banks have opted to introduce measures focused on addressing market friction in specific areas of the economy. To maintain the lending activity in the banking system, a number of central banks have recently introduced lending incentive schemes, in several cases including additional incentives by design to improve the supply of funds to the SME sector.

The Bank of England’s (BoE) Term Funding Scheme with additional incentives for Small and Medium-sized Enterprises (TFSME) provides four-year101 refinancing funds to credit institutions until the end of April 2021, at or very close to the central bank base rate. Initially, each credit institution has access to refinancing funds corresponding to at least 10% of its outstanding loan portfolio. Additional funds may also be drawn

101 To support the government’s Bounce Back Loan Scheme (BBLS) program, the maturity of the central bank funding can be up to six years, which can be extended for another 4 years to 10 years.

in amounts determined by the BoE as a weighted average of bank lending to various sectors, with factor of five applied to SME lending. The central bank estimates that based on experience from the previous TFS scheme, the amount drawn under TFSME may exceed GBP 100 billion. The drawdown period for central bank funds was extended by the BoE in December 2020 by 6 months until the end of October 2021.

In March, the ECB decided to modify the terms of TLTRO III

and to reopen LTRO tenders temporarily. The more favourable terms of TLTRO III apply from June 2020 until June 2021. Due to the adverse economic effects of the coronavirus pandemic, the ECB extended the favorable terms of TLTRO III by 12 months in December 2020, until June 2022, and also announced three additional tenders for 2021 (June, September and December 2021). As part of the scheme, banks are granted ECB loans over 3-year terms and are encouraged to ramp up their lending to euro area companies and households, excluding property purchases in the latter segment. Refinancing funds are provided by the ECB at 50 basis points below the MRO interest rate (currently 0%), with banks that maintain their lending activity at its current level possibly eligible for lower rates. The maximum available refinancing was set by the ECB at 55% of the credit institutions’ loan portfolios outstanding as of 28 February 2019. In addition to TLTRO III tenders, the ECB is also providing funds to support lending to the real economy under a new Pandemic Emergency Longer-term Refinancing Operations (PETLRO) programme, introduced temporarily in connection with the coronavirus. Under PELTRO, credit institutions can apply for central bank refinancing at 25 basis points below the MRO rate, with decreasing tenors (16 months in the first tender, down to 8 months by the last tender). In contrast with TLTRO, the funds may be drawn in unlimited amounts against sufficient collateral, and can be used for any purpose (ECB, 2020). In December 2020

the Governing Council of the ECB announced an additional 4 PELTRO tenders for 2021 to provide the necessary liquidity.

In March, policy makers at the Swedish central bank decided to introduce a new corporate lending instrument with an overall

amount of SEK 500 billion. As part of the programme, Riksbank provides variable interest-rate refinancing to commercial banks, against collateral, at the key rate (currently 0%), with a maturity of 2 years. Participating banks accept to use at least 20% of the amount borrowed from the central bank for lending to the corporate sector, otherwise they will have to pay a penalty interest of 0.2% on the funds drawn. In March 2021, the program was stopped, and the Riksbank launched a new lending incentive program (Funding to Banks to support corporate lending, UBF). The new program continues to aim to support corporate lending, but the conditions attached to it are simpler, more generic and less time-dependent. The central bank’s funds are still provided by the Riksbank at the prevailing interest rate; in the event of non-compliance with the lending conditions, credit institutions will continue to have to pay penalty interest on the funds drawn. Unlike the previous program, banks’ lending activity to nonfinancial corporations is assessed on a 12-month frequency. Credit institutions must meet a 1 percent increase in loan portfolios. In the new program, banks can choose from 3 different maturities (April 2022, April 2023 and April 2024) during the tenders, instead of the previous weekly frequency, the tenders will be held monthly. The Riksbank will provide funding in the new program until the drawn funds reach 500 billion crowns (including the drawdowns of the old program) or until the Riksbank no longer considers central bank refinancing necessary.

Under the Term Funding Facility (TFF), the Australian central bank provides loans to credit institutions with a maturity of 3

years, at a fixed interest rate of 0.25%. The initial facility provided by the central bank is capped at 3% of credit institutions’ loans to the private sector outstanding as of 31 January 2020, but at

least USD 90 billion. Additional allowance may also be drawn in amounts depending on the increase in lending to large companies and SMEs. The initial facility may be drawn until September 2020, with additional allowance available until March 2021 at the latest (RBA, 2020). The call period for initial and additional funding was extended by central bank decision-makers in September 2020 until the end of June 2021. From November 2020, the interest rate on the newly drawn refinancing funds fell to 0.1 percent.

As part of its lending incentive scheme with an allocated overall amount of RMB 400 billion, the Chinese central bank purchases

SME loans from banks on a quarterly basis. The maturity of the loans is at least 6 months, and the scheme covers loans granted between 1 March and 31 December 2020. However, the banks participating in the scheme are required to repurchase these loans after one year, and the central bank will not assume the credit risk either. The central bank expects that the scheme, which helps smaller banks, could increase lending to small companies by some RMB 1,000 billion (USD 140 billion) (Reuters, 2020).

On 20 April 2020, the MNB launched its new FGS phase called FSG Go!, with an allocated overall amount of HUF 1,500 billion. In terms of its key parameters and the method of implementation, the new phase is identical with earlier phases of the FGS. As earlier, the MNB’s refinancing loans are granted to credit institutions at an interest rate of 0%, with interest charged to SMEs remaining capped at 2.5%. The FGS Go! addresses companies’ changing financing needs and provides funding to SMEs on more favourable conditions than before. In addition to investment loans and leasing transactions, the new phase provides access to working capital loans to cover operating expenses, while it also allows the pre-financing of EU and domestic grants, and the redemption of existing loans accessed earlier at market rates. With a minimum loan amount reduced to HUF 1 million, the programme continues to play an important role in providing access to finance for micro-enterprises. Its increased maximum

loan amount of HUF 20 billion helps to preserve the stability of major participants in the SME sector, and to implement large investments. Due to the significant demand for financing from enterprises, the MNB increased the budget of the facility by HUF 1,000 billion to HUF 2,500 billion in November 2020, and by another HUF 500 billion to HUF 3,000 billion in April this year.

3. Technology and design aspects of central bank digital currency focused on SMEs

3.1. Central bank objectives and general considerations in CBDC design

The fundamental objective of central bank digital currency (CBDC) focused on SMEs may be to support economic growth.

The development of a new SME financing channel directly provided by the central bank can mitigate the market problems (pro-cyclical lending, limited commercial bank financing under strict terms, longer approval times) referred to earlier. With FGStype programmes currently running, risks continue to be taken by the banking system, whereby if the risk appetite in this area is reduced, the problem could be addressed at the next level by transferring risk-taking to the central bank. A low-cost and secure alternative lending channel in the form of central bank digital currency can help the SME sector, which is important for economic growth, to realise its development potential across financial cycles in two ways: (1) CBDC funds can support the sector’s investment activity, and (2) a CBDC framework enables targeted support to be provided to the SME sector also in crisis situations, and maintains the sector’s value creation potential by ensuring its operational conditions.

In addition to the central bank objectives, the proper design of a CBDC project focusing specifically on the SME sector requires that consideration should be given to basic aspects such as other economic policy objectives underlying the blueprint design, the scope of access, and the monetary policy nature of the project. In the next step, the operational framework and the design of the technology underlying the system must be defined, which are partly dependent on previous decisions focusing on business and economic aspects (Figure 1).

Figure 1: Decision steps in designing a CBDC

VII. TECHNOLOGY

VI. ANONYMITY

V. FRAMEWORK

Is it feasible on traditional infrastructure? Is the use of blockchain/DLT justified?

Are anonymous transactions enabled? Account-based or token-based operation?

What actors are involved in the operation? What functions does the central bank perform?

IV. FORM

III. MONETARY POLICY NATURE

What form of money does it replace? Cash or bank money?

Deliberately effective, neutral or flexible?

II. ACCESSIBILITY

Who is able to transact with it?

I. FUNDAMENTAL GOAL

What is the basic purpose?

Partially determined

Independent decision

Source: own edit

From an economic policy perspective, the most important requirement is to strike the right balance between supporting the SME sector and maintaining financial stability in the banking sector, with targeted temporary intervention by the central bank. The ability to strike that balance can largely depend on the depth of financing opportunities provided by the central bank (see Chapter 4), and on the extent and frequency with which such finance is made available to the SME sector. The objective is to ensure that without classic lending channels being damaged,

alternative, complementary financing opportunities can provide supply for the high demand, and the SME borrowing market is sufficiently deepened and widened.

For a CBDC-based SME financing project, it is also important to define the specifications and technological background required for the newly established channel to operate as efficiently and

securely as possible. The method of implementation largely depends on the intended accessibility of the service, and the functionality expected. To select the specific project and elaborate its details, the decision steps shown in Figure 1 should be considered and used to identify the relevant aspects.

3.2. Accessibility and form

While the primary target group is the SME sector at large, consideration should also be given to more restricted access

within that sector. In the present case, the CBDC project would be targeted at the SME sector, yet it is to be noted that although a universal CBDC project accessible to all SMEs can be considered ideal, for the short and medium term it may be useful to design a targeted pilot project providing restricted access to test it in an easily controlled environment. Targeting will also allow for a more precise identification of groups and industries that are of primary importance for the development of the economy and competitiveness, but for which market frictions are more pronounced.

In order to arrive at a design that can be considered optimal for the market, it is necessary to specify whether companies’ use of central bank digital currency can be applied across borders,

or only domestically. In a CBDC project whose sole purpose is to help finance the SME sector and support domestic economic recovery, it may be useful to provide the option to convert CBDC into commercial bank money, which can then be converted into foreign currency if necessary and to the extent required by the investment and procurement activities of the enterprises.

3.3. Operational framework

Market needs must be assessed first, and the central bank must determine the appropriate operational framework accordingly.

The establishment of a reliable channel for payments and alternative financing in all conditions remains a priority as far as the SME sector is concerned. To achieve this, the central bank must consider whether it should provide companies with access to central bank digital currency directly, or indirectly through financial market participants (Figure 2). The principal task for the central bank is then to determine the structure of liabilities, and the responsibilities of the central bank itself. On those grounds, two architectures may be conceived (more details on feasibility are provided below): – Within the CBDC structure established with financial service providers as intermediaries, companies would continue to hold their accounts with the financial intermediaries (predominantly commercial banks) already servicing those accounts, only the loan would be provided by the central bank, which would also assume the risk along with the responsibilities related to creditworthiness assessment. The setup of a new central bank payment system is not required in this case. – The second option is for the central bank to open its balance sheet directly to the companies, whereby the companies would owe their debts directly to the central bank, which in turn would significantly increase the responsibilities of the central bank, with the amount of allocated central bank money accounted for separately for each company. Within this option, certain services could be outsourced to financial intermediaries to reduce the burden on the central bank resulting from additional services.

Figure 2: Possible forms of implementation of SME financing in the form of CBDC

Account management

Credit register

Mobilebank, netbank and other services Mobilebank, netbank and other services

Loan disbursement

A) Central bank manages one single credit account B) Direct access

Commercial banks keep in touch

Source: own edit

3.4. Anonymity and technology

Given that central bank money would be allocated as a loan,

account-based access needs to be ensured, and anonymous access should not be made an option.

Once the concept best adapted to market demand has been established, the technology underlying the entire system needs

to be specified. To determine this, it is necessary to define the most efficient system that best fits the operational framework previously established. In an SME financing model where a lending structure is to emerge, consideration may need to be given to relying on currently used infrastructure with appropriate improvements. On the one hand, this implementation would be less costly and resource-intensive, with market participants

allowed to continue using a system they already know. If the CBDC scheme involves a relatively small number of companies, or if funds are allocated indirectly through existing banking actors, enhancements to the old system could be less affected by capacity problems.

While it may also be worth exploring the possibility of developing a new, innovative technology, such as distributed ledger infrastructure, the deployment and maintenance of completely new infrastructure would entail significantly

increased costs and risks. From a security point of view, it is difficult to determine which one is more beneficial, since both systems are associated with different risks: attacks on the central system are a potential threat in the current structure, while in a distributed ledger system the consensus mechanism may be attacked (DDoS attacks102), but centralised variants (e.g. CLT103) can also be implemented in that regard. Overall, the use of new and innovative technology can only be justified if its efficiency, ease of use and reliability outweigh the operation of the system previously in place and, other than achieving the basic objective, additional aspects also arise in terms of upgrading other functions and registers related to SME finance (Auer and Böhme, 2020).

102 Distributed Denial of Service (DDoS) – Distributed denial of service attacks are electronic attacks originating from a group of systems that is capable of placing systems, services or networks under such a load that the system, service or network concerned may become unavailable. This can be achieved both by paralysing systems and by increasing network traffic, which will prevent legitimate data traffic from reaching the destination system. 103 Centralised Ledger Technology (CLT)

4. Possibilities for central bank SME account servicing and credit facilities in Hungary

Opening up the central bank’s balance sheet to the domestic SME sector may improve financing opportunities for companies,

while reducing the market frictions explained earlier. An examination of the options suggests that two levels of depth can be provided, which should be reviewed in terms of economic policy and feasibility: (1) by opening up the liabilities side of its balance sheet, the central bank keeps accounts for the SME sector, providing a platform for possible targeted fiscal interventions; and (2) by opening up the assets side as well, the central bank also provides credit facilities for companies.

4.1. Account keeping for SMEs

Opening up the liabilities side of the MNB’s balance sheet to the SME sector may contribute to companies’ more cost-effective

operations and easier access to State support. Accounts held with the central bank would enable the State to provide targeted economic stimulus directly from fiscal sources where necessary in an economic recession. However, while offering benefits to the SME sector, given the presence of more than 750,000 small and medium-sized enterprises in Hungary (KSH, 2018), this concept can place a huge burden on the central bank’s operations and systems, which may warrant considering the possibility of initially opening up to a restricted segment. As micro and small enterprises are the most affected by the financing disadvantages arising from size, they may be specifically assisted through a targeted pilot programme. Since financial education and the use of digital tools may also be more moderate among these smaller enterprises, a pilot CBDC can support both their digital maturity and closer integration into the financial intermediary system.

4.2. Providing credit facilities for the SME sector

Compared to account servicing, the central bank’s provision

of access to credit would be a project of greater volume. The fundamental objective being to support economic growth and to provide alternative financing to the SME sector, possible options include both investment loans granted and the maintenance of a liquidity facility, which can be drawn in specific cases determined in advance. Compared to account servicing, a central bank lending structure may be more instrumental in reducing market frictions across cycles, but it also significantly increases the central bank’s responsibilities, credit risk exposure and the burden of potential infrastructure development, depending on which of the two allocation options is taken.

4.2.1. Lending by intermediaries

Although on the recipient side the first type of architecture is largely identical in terms of structure to the operation of the SME lending incentive scheme established by the MNB and currently running as FGS Go!, its fundamental difference lies in the fact that the central bank assumes the full credit risk instead of merely offering lending incentives by providing liquidity.

Accordingly, companies will continue to hold their accounts with their financial service providers so that they can also access ancillary services from those providers, while the central bank will set up a technical credit account for SME lending and take over the full credit risk from the financial service providers, whereby the responsibilities it will be required to perform will increase significantly. To mitigate newly emerging risks, cooperation with financial service providers experienced in corporate lending may be warranted in order to enable the central bank to set up its own credit approval and collateral valuation processes and credit portfolio registration platform to the required minimum standard. At this point, the setup of appropriate incentive mechanisms (e.g.

“Skin-in-the-game”104) could enable the expertise and networks of the commercial banking sector to be channelled into the central bank programme.

SME lending by intermediaries requires the least amount of

changes compared to the system in place. Using the infrastructure and lending channel previously established, the cost implications and time requirements of a possible new form of lending may be kept within limits. However, the conceptual design of the operational framework of the specific programme supporting SME financing, ensuring compliance with legal requirements, and technological implementation remain rather a complex task.

4.2.2. Direct central bank lending

The second option of implementation is for the MNB to provide direct financing to the enterprises without the intermediation

of commercial banks. In contrast to lending by intermediaries, direct lending by the central bank would be required both to set up technical loan accounts, and to perform the complete range of lending functions. Taking that option would pose a greater challenge to the central bank, given the need for a complete takeover of the activities involved in commercial banking services, from credit approval to the setup of additional functions (netbank, mobile banking application), for which the provision of the appropriate duties is also key. Since the process would involve the setup of a completely new and independent functionality, it may be worth considering the development of a system based on a more innovative technology that would provide an alternative to the current systems and technologies in a new approach. That said, both the implementation of such a system and determining its efficiency pose a major challenge to the central bank.

The central bank has the possibility to outsource several services

to other market participants. The central bank can reduce the

104 I.e., to some extent, credit risk will be shared by the participant performing the credit approval and collateral valuation.

burden of new functions (such as, communication channels) by outsourcing them to other providers, such as FinTechs. However, regardless of the nature of services outsourced, the conceptual and technical aspects of the system ensuring consistent operations must be designed in compliance with the legal regulations. In that regard, ensuring interoperability between systems is a key enabler of technological innovations and continuous improvements.

Overall, the greatest challenge may lie in building a direct

lending structure with a focus on the SME sector, which could bring fundamental changes to the credit market structure and affect the income generation and profitability of the financial sector, which calls for a careful examination of this option to ensure that its potential benefits exceed the challenges and risks emerging at the level of both the central bank and the financial intermediary system.

5. Conclusion

Ensuring the smooth financing of the SME sector remains a top

priority for the national economy. Whenever a major economic shock occurs, including most recently during the pandemic, the vulnerability of financing the SME sector has been demonstrated. Therefore, central banks in several countries, including the MNB, have launched several programmes to support the provision of financing for small and medium-sized enterprises in a more difficult macroeconomic situation. Consequently, even theoretical considerations concerning the implementation of a CBDC framework raise the question whether it is worth exploring the feasibility of a financing channel deploying central bank digital currency.

A project based on central bank digital currency and designed to reduce market frictions involves several aspects that

the central bank must take into account. Finance provided

directly by the central bank may complement commercial bank financing by offering an alternative that is fast, cheap, secure, and ensures transparency regarding its operational criteria. In addition, a number of obstacles need to be overcome during implementation, ranging from the legal environment, through the acquisition of adequate knowledge and technical capacity, to the assessment of the effects of possibly irreversible interventions affecting the functionality of the financial intermediary system. The need for central bank intervention may also be influenced by the possibility of alternative forms of financing, such as crowdfunding.

Overall, in international professional work related to the introduction of central bank digital currency, the scope of using

CBDC for lending has so far been very limited due to its direct, presumably crowding-out effect on the financial intermediary system. Accordingly, for the foreseeable future, no such solution is expected even in countries leading practical implementation. Nevertheless, a volume of studies addressing the potential social benefits of CBDC should also include a more detailed theoretical overview of this option.

References

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Reuters (2020): China central bank to buy bank loans to spur lending to small firms worth 1 trillion yuan https://www.reuters.com/article/us-china-economy-pbocidUSKBN23828I

Riskbank (2020): Loans to the banks for onward lending to companies https://www. riksbank.se/en-gb/monetary-policy/monetary-policy-instruments/loans-to-the-banksfor-onward-lending-to-companies/ Zott, C.-Amit, R. (2007): Business Model Design and the Performance of Entrepreneurial Firms. Organization Science, 18 (2), 181-199. http://dx.doi.org/10.1287/ orsc.1060.0232