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The Financial Stability Board (FSB) is stepping up its investigation into decentralized finance (Defi) on concerns over potential for spill-over risks to traditional finance (Tradfi). The FSB will also analyze the asset tokenization and how it could increase linkages between crypto-asset markets/DeFi, Tradfi and the real economy. In addition, the FSB will explore approaches to fill data gaps to measure and monitor interconnectedness of Defi.

The Banque de France (BdF) published a paper that examines the impact of stablecoin issuer investment practices on the financing of the real economy. The largest stablecoins manage their peg with the US dollar (USD) by holding short-term safe assets, including USD-denominated commercial paper (CP). The analysis shows that CP issuers catered to the additional demand from stablecoins by issuing more, illustrating the implications of stablecoins for financial stability and the financing of the real economy.

"Digital currencies provide a potential form of liquidity competing with bank deposits. We introduce digital currency into a macro model with a financial sector in which financial frictions generate endogenous systemic risk and instability. In the model, digital currency is fully integrated into the financial system and depresses bank deposit spreads, particularly during crises, which limits banks' ability to recapitalize following losses. The probability of the banking sector being in crisis states can grow significantly with the introduction of digital currency. While banking-sector stability suffers, household welfare can improve significantly. Financial frictions may limit the potential benefits of digital currencies."

"Motivated by the regional bank crisis of 2023, we model the impact of interest rates on the liquidity risk of banks. Prior work shows that banks hedge the interest rate risk of their assets with their deposit franchise: when interest rates rise, the value of the assets falls but the value of the deposit franchise rises. Yet the deposit franchise is only valuable if depositors remain in the bank. This creates run incentives for uninsured depositors. We show that a run equilibrium is absent at low interest rates but appears when rates rise because the deposit franchise comes to dominate the value of the bank. The liquidity risk of the bank thus increases with interest rates. We provide a formula for the bank's optimal risk management policy. The bank should act as if its deposit rate is more sensitive to market rates than it really is, i.e., as if its "deposit beta" is higher. This leads the bank to shrink the duration of its assets. Shortening duration has a downside, however: it exposes the bank to insolvency if interest rates fall. The bank thus faces a dilemma: it cannot simultaneously hedge its interest rate risk and liquidity risk exposures. The dilemma disappears only if uninsured deposits do not contribute to the deposit franchise (if they have a deposit beta of one). The recent growth of low-beta uninsured checking and savings accounts thus poses stability risks to banks. The risks increase with interest rates and are amplified by other exposures such as credit risk. We show how they can be addressed with an optimal capital requirement that rises with interest rates."

"We examine the impact of a Central Bank Digital Currency (CBDC) on bank lending, emphasizing the role of different financial frictions. Within a stylized general equilibrium model, we integrate a banking sector characterized by market power on deposits and leverage constraints, together with liquidity in households' utility. Calibrating the model to US data and simulating a CBDC introduction as a shift in households' preferences for public money, our results indicate that a CBDC increases bank lending when market power is the primary operating friction in the banking sector. However, this outcome reverses when leverage constraints are binding for banks."

The European Commission (EC) published a paper [in June 2023] that analyzes the potential effect of a digital euro on banks' profitability. It uses a large sample of European Union (EU) banks that span the period from 2007 to 2021 to assess the sensitivity of banks' profits to the loss of deposits. The results show that, for a large take-up of CBDC, there might be substantial challenges for banks' profitability, especially for small banks, that mostly rely on deposits as a source of funding. The paper recommends that digital euro holdings be capped (e.g., at EUR 3,000) to preserve the inherited profitability that comes from banks' cheap deposit funding.

The Bank of Spain published a paper that analyzes the impact of introducing a central bank-issued digital currency (CBDC) on the operational framework of monetary policy and the macroeconomy as a whole. It is based on a theoretical model that is calibrated to replicate the main monetary and financial aggregates in the euro area. It predicts that CBDC adoption implies a roughly equivalent reduction in banks' deposit funding, but this has a rather small effect on bank lending to the real economy. This result reflects the parallel impact of a CBDC on a central bank's operational framework. For relatively moderate CBDC adoption levels, the reduction in deposits is absorbed by an almost one-to-one fall in reserves at the central bank, implying a transition from a 'floor' system - with ample reserves - to a 'corridor' system. For larger CBDC adoption, the loss of bank deposits is compensated by increased recourse to central bank credit, as the corridor system gives way to a 'ceiling' system with scarce reserves.

The Journal of International Financial Markets, Institutions and Money published a paper that examines the interconnectedness CBDC development and adoption levels, digital asset returns and financial stability. (CBDC development and adoption was measured with a news media coverage based "CBDC Uncertainty Index" developed by Wang et al (2022).) The paper finds a significant level of connectedness between CBDCs, digital assets and financial stability, but only a weak positive connectedness between CBDCs and returns on digital assets. Furthermore, the study finds bidirectional connectedness between CBDCs and other financial stability measures, suggesting that changes in CBDC performance can influence the overall stability of the financial system, and vice versa.

The European Central Bank (ECB) published a paper that shows the existence of a central bank trilemma. When a central bank is involved in financial intermediation, either directly through a central bank digital currency (CBDC) or indirectly through other policy instruments, it can only achieve at most two of three objectives: a socially efficient allocation, financial stability (i.e., absence of runs), and price stability. In particular, a commitment to price stability can cause a run on the central bank. Implementation of the socially optimal allocation requires a commitment to inflation.

The European Banking Federation (EBF) published a paper that examines the impact of different digital euro holding limits on bank deposit outflows. It confirmed that the higher the limit, the greater the outflows, with smaller banks being the most vulnerable, and the effect greater when the banking system is under stress.

Banca D'Italia published a paper on the channels through which the introduction of a central bank digital currency (CBDC) may affect the banking system and the economy at large. The paper also provides a set of illustrative exercises about the potential impact of a CBDC on the funding structure and profitability of banks using data on the Italian banking system between June 2021 and March 2023. It finds that the impact depends on how credit institutions re-optimize their balance sheets in response to the outflow of deposits induced by the CBDC. It finds that the potential impact could be manageable if there were individual holding limits and the CBDC were introduced in an environment characterized by ample liquidity and stable funding for banks.

The European Central Bank (ECB) published a paper that discusses the potential impact of retail CBDC introduction on monetary policy implementation if it leads to a decrease in commercial bank deposits. Should this happen, bank holdings of central bank reserve holdings might shrink. However, the paper argues that uncertainty as to the timing and extent of any conversions of deposits into CBDC might prompt banks to scale up their demand for central bank reserves in order to hold larger precautionary buffers. Consequently, central banks might need to adjust their reserve supply and other features of their monetary policy implementation. In any case, the paper suggests CBDC design features could mitigate the risk of negative consequences for monetary policy implementation.

The IMF published a paper that combes administrative data on credit, internet penetration and a land reform in Rwanda, to showsthat the complementarity between technology and law can overcome financial frictions. Leveraging quasi-experimental variation in 3G availability from lightning strikes and incidental coverage, it shows that mobile connectivity steers borrowers from microfinance to commercial banks and improves loan terms. These effects are partly due to the role of 3G internet in facilitating the acquisition of land titles from the reform, used as a collateral for bank loans and mortgages. The paper quantifies that the collateral's availability mediates 35% of the overall effect of mobile internet on credit and 80% for collateralized loans.

The U.S. Federal Reserve published a paper that examines the financial stability risks in times of stress associated with central bank digital currency (CBDC) under different design options. The analysis is based on lessons derived from historical case studies of bank runs as well as on an analytical framework that allows for the characterization of the mechanisms through which a CBDC can affect financial stability. It then discusses an extensive array of policy tools that can be employed to mitigate these risks.

The Journal of Economic Dynamics and Control (JEDC) published a paper that studies the macroeconomic consequences of a foreign CBDC available to residents in a small open economy using a DSGE model. It finds that a gradual and permanent increase in the domestic households' preferences toward the foreign CBDC leads to a structural reduction in economic activity, especially if the CBDC is designed to be similar to domestic deposits. The paper suggests several policy responses that may smooth the transition, limit disruptive effects and avoid the long-run GDP loss. It also shows that an economy with a large stock of foreign CBDC is better shielded from exogenous increases in the interest rate on foreign debt, if the CBDC remuneration remains constant.

De Nederlandsche Bank (DNB) published a paper that studies the transition from a steady-state without central bank digital currency (CBDC) to one in which the home country issues a CBDC using a two-country dynamic stochastic general equilibrium (DSGE) model with financial frictions. In the new steady state, the availability of CBDC, which is liquid and storage-cost-free, improves welfare. During the transition, however, demand for CBDC and money overshoot, thus crowding out bank deposits and leading to initial declines in investment, consumption, and output. However, these negative effects can be reduced with binding caps, with an optimal level of around 40% of the CBDC demand in the steady state. A two-tiered remuneration scheme is also effective in smoothing the transition if the penalty interest rate is extremely high (e.g., a negative 300% interest rate on holdings above 50% steady-state demand).

A paper by Rhys Bidder, Timothy Jackson and the Deutsche Bundesbank's Matthias Rottner examined the impact of CBDC on banks and the broader economy drawing the Bundesbank's Survey on Consumer Expectations using a structural macroeconomic model with endogenous bank runs. Based on the survey, they show that a substantial share of German households would include CBDCs in their portfolio in normal times - replacing, in part, commercial bank deposits. That is, there is hypothetical evidence of "slow" disintermediation of the banking system. In addition, during periods of banking distress, their willingness to shift to CBDC is even larger, implying a risk of "fast" disintermediation. They map the model to Euro area data under the status quo and in a hypothetical situation where CBDC is introduced. The model implies that slow disintermediation shrinks a banking system that is prone to runs with positive welfare effects. However, CBDC promotes fast disintermediation, and for reasonable calibrations, the second effect dominates and the introduction of CBDC decreases financial stability and welfare. However, complementing CBDC with a holding limit or pegging remuneration to policy rates can reverse these results, implying that CBDC is welfare improving. Such policies retain the gains of increased stability arising from slow disintermediation, but limit the downside of fast disintermediation.

The IMF published a paper that investigates how fintech activities influence risk taking by traditional financial institutions (FIs) using a curated databased covering over 10,000 FIs and global fintech activities. It finds that greater fintech presence is associated with heightened FI risk taking, although higher capitalization and liquidity ratios as well as greater income diversification can reduce this effect. Importantly, there is suggestive evidence indicating that in certain cases, greater fintech presence may be associated with less FI risk taking amid stronger domestic institutions. Hence, the paper concludes that robust institutions combined with strong policy frameworks and rigorous supervision can help reap the benefits of growing fintech activities while safeguarding financial stability.

The Bank of Canada (BOC) published a paper that uses a structural model where each household chooses which financial institution to deposit their digital money with, to estimate the extent to which a central bank digital currency (CBDC) competes with bank deposits. It uses a unique Canadian dataset which contains information on households' bank choices for a rich set of financial products. The paper finds that non-interest-bearing CBDC that does not provide complementary financial products can substantially crowd out bank deposits only if it provides an extensive service network. Also, a Canadian CBDC that uses post offices as service locations would benefit rural households more than a CBDC that uses bank branches as service locations.

"Economists at the Bank of Canada ran a model to assess the impact of introducing a retail central bank digital currency (CBDC) on bank deposits. It's widely expected that a proportion of bank deposits will switch to a CBDC. The economists believe that most assessments neglect the fact that banks provide products that complement deposits, such as mortgages and credit cards. If you assume consumers don't care about the other products their bank offers, then 39% of deposits could be crowded out by CBDC. "