CBDC and banking stability: Modeling cascading effects on reserves, lending, and liquidity

Abstract

This research uses a dynamic modelling approach to design and simulate an equilibrium model of the interaction between CBDC issuance, deposits and bank reserves. With many central banks announcing their intention to issue central bank digital currencies (CBDCs), it has become imperative to rigorously analyse the potential impact of these issues on the banking system. This study aims to examine the implications of the introduction of CBDCs within a robust analytical framework, in order to inform policymakers and financial sector players about the possible consequences of this major monetary innovation. The study results show that overconfidence of economic agents towards CBDCs can drastically reduce bank reserves, thereby limiting the lending capacity of banks and creating liquidity problems. Similarly, increasing reserve requirements in fiat currency for each unit of CBDC issued can constrain bank reserves and restrict loans and deposits. Additionally, a rise in interest rates on CBDC-related loans can discourage borrowers, thereby reducing loan demand and affecting banking activity. An increase in interest rates leads to a decrease in the quantity of CBDC in circulation, an increase in bank reserves and deposits in CBDC, and a decrease in bank loans. Monitoring the level of confidence of economic agents towards CBDCs is crucial to avoid excessive speculation.