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The simplest fix for banking

Mar 27,2023 - Last updated at Mar 27,2023

 

BARCELONA — Last year, the Nobel Prize in Economics went to two economists who study the dynamics of bank runs, as well as to former US Federal Reserve Chair Ben Bernanke for his work analysing how central banks have dealt with some of history’s worst banking crises, such as those in the Great Depression of the 1930s. Half a year later, we are witnessing another bank run whose contagious effects could de-stabilise economies, trigger recessions, and impose high costs on taxpayers.

Banks play a double role in the economy, taking short-term deposits and savings and then using those savings to lend money over the long term in the form of mortgages, business loans, and other investments. A run occurs when enough depositors come to fear that a bank may go bust, taking their savings with it. They all run to the bank to withdraw their funds, but because the bank has deployed those funds toward the other services it provides, it becomes insolvent. Having witnessed such runs, US President Franklin Roosevelt’s administration (followed by others around the world) created insurance schemes to alleviate depositors’ fears that they would not get at least some of their money back following a run.

But we now have a technological solution that could end bank runs forever. A country’s monetary authority could introduce a central bank digital currency (CBDC) and provide all depositors (taxpayers) with interest-bearing accounts at the central bank. Such a system would eliminate many barriers to financial transactions by making the broader payments system more fluid.

This system would not be anything like the Wild West of cryptocurrencies and speculative pyramid schemes that have cropped up in recent years, nor would it be socialised banking. There are already plenty of fintech companies (Revolut, Wise, N26) offering sleek apps and innovative services that enable instantaneous smartphone payments to other users who bank with competing operators. These same financial operators could access CBDC balances held by the central bank and compete for customers by minimising transaction costs.

Of course, traditional banks also compete; but they do it worse and at a scandalous cost to customers. If the interbank rate charged by the central bank is 3 per cent, your traditional bank offers you at best 1 per cent on a deposit, taking the other 2 percentage points as profit. Traditional banks can exert monopoly power because there is no instantaneous clearance for payments. In the United States, it generally takes at least two working days for a money transfer to enter your bank account. And making matters worse, traditional banks’ excessive risk-taking transforms your risk-free deposit into a risky investment when the bank cannot meet your withdrawal request.

With an interest-bearing CBDC, a bank run is impossible. As the lender of last resort, the central bank could issue as much money as needed if depositors wanted to withdraw their money simultaneously. And, owing to fluid, instantaneous transfers between users, competition would deliver a 3 per cent return on those deposits. Other than traditional banks, who could possibly oppose this solution?

To be sure, traditional banks are crucial for the financial system because they create value by making loans. They monitor whether households that apply for mortgages are solvent, and whether business loans will be used for profitable investments. Because lending is always risky, even the most competitive bank will charge a spread on a loan. The same 3 per cent interbank rate at which the bank can obtain funds today may result in a 5 per cent interest rate for a mortgage, or a 9 per cent rate for a risky investment by a tech startup. Some institution, such as a bank, is needed to evaluate and price these risks.

But, because banks can profit by playing with depositors’ money and relying on the government to bail them out, they tend to assume too much risk. That is why academics and regulators have long argued that banks should be subject to higher capital requirements. When they cannot use households’ savings to finance risky investments or rely on government bailouts, their risk-taking will be sharply reduced.

A CBDC would bring market discipline to the banking sector. Traditional banks would be forced to focus on picking profitable loans, and they would close most of their network of retail branches. Likewise, the credit-card oligopoly that hijacks our credit-less payment system would melt like snow in the sun. In its place, we would get a fluid payment system operated by a network of competitors offering access to your CBDC account. In today’s economy, households would receive 3 per cent on deposits that are safely shielded from bank runs.

A CBDC is not imminent, though. Central bankers are scared to slaughter the cash cow of the traditional banks, under the pretext that doing so will lead to the collapse of the banking sector. The private bank lobby will strongly oppose digital innovation and seek to maintain its dominant position at the cost of the stability of the financial system.

Still, we may see CBDCs introduced sooner than anticipated. If one major economy takes the plunge, others will be forced to follow suit or risk seeing their currencies be eclipsed. That is why the Canadian central bank has already signalled its readiness to introduce a CBDC if the US decides to launch its own. If China tries to dominate international transactions with its digital renminbi, other central banks certainly will be prompted to follow suit.

Whoever takes the first major step in disrupting the banking sector, it cannot come soon enough. We already have the tools to end bank runs and ensure financial stability. All we need is the will to use them.

 

Jan Eeckhout is professor of Economics at Universitat Pompeu Fabra and author of ‘The Profit Paradox: How Thriving Firms Threaten the Future of Work’ Princeton University Press, 2021. Copyright: Project Syndicate, 2023. 

www.project-syndicate.org

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