Theoretically, digital currencies that are fully integrated into the financial system may lead to improvement in household welfare and decrease financial system volatility but could weaken banking-sector stability, according to a working paper published Wednesday by the Treasury Office of Financial Research (OFR).
The paper’s authors, in a blog post, laid out the paper’s theoretical observations, noting that with the full integration of digital currency:
- The probability of a banking sector crisis increases – A decline in deposit spreads is the primary reason a crisis’s probability increases with digital currency issuance. A fully-integrated digital currency depresses bank deposit spreads, particularly during crises, which limits banks’ ability to recapitalize following losses. In addition, because banks are less able to rebuild equity after adverse shocks, banks, on average, have lower equity. Accordingly, bank valuations decrease significantly. As a result, the probability the banking sector is in crisis or a distressed state can grow significantly.
- Household welfare can improve – Fully integrating digital currency into the financial sector would increase household welfare, and these welfare consequences are potentially large. For example, household welfare could increase by 2% in terms of consumption, even though at this level of digital currency, the probability of crises doubles.
- System volatility decreases – Financial system volatility declines with the full integration of digital currency. This decline is primarily reflected in a decrease in the volatility of asset prices. While financial markets improve with lower volatility and higher prices, the financial sector suffers because the banking sector is at greater risk of insufficient capital levels.
The authors said their financial stability focus for this working paper is on the risk that banks have insufficient equity capital following losses from their investments. “Investment losses, not runs per se, create instability in this context,” they wrote. They also noted that other analyses suggest that the risk of bank runs “is not as big as initially feared.”
Blog post: Digital Currency May Increase Household Welfare, Lower Volatility but Pose Risks to Banks
Working paper: Digital Currency and Banking-Sector Stability