The Banking System Impact Question

Before analyzing CBDC's impact, we need to understand what banks actually do with deposits.

HOW BANKS CREATE MONEY

THE DEPOSIT-LENDING CYCLE:

Step 1: Customer deposits $1,000
┌─────────────────────────────────┐
│ Bank Balance Sheet │
│ Assets: Liabilities: │
│ Reserves: $1,000 Deposits: $1,000
└─────────────────────────────────┘

Step 2: Bank lends $900 (keeping 10% reserve)
┌─────────────────────────────────┐
│ Bank Balance Sheet │
│ Assets: Liabilities: │
│ Reserves: $100 Deposits: $1,000
│ Loans: $900 │
└─────────────────────────────────┘

Step 3: Borrower spends $900, recipient deposits at bank
┌─────────────────────────────────┐
│ Banking System Balance Sheet │
│ Assets: Liabilities: │
│ Reserves: $100 Deposits: $1,900
│ Loans: $900 │
└─────────────────────────────────┘

Step 4: Cycle continues...
Initial $1,000 deposit → Up to $10,000 in deposits
(with 10% reserve ratio)

THIS IS CALLED: Money multiplication / Credit creation
Banks don't just store money—they create it through lending
```

THE IMPORTANCE OF DEPOSITS

TYPICAL BANK FUNDING MIX:
Retail deposits: 40-60%
Corporate deposits: 15-25%
Wholesale funding: 15-25%
Equity capital: 8-12%

ECONOMIC IMPACT:
Less lending → Less business investment
→ Less home purchases
→ Less consumer credit
→ Slower economic growth
```

HOW BANK RUNS WORK

CBDC MAKES IT WORSE:
Before CBDC: Withdraw to cash (physical limits)
With CBDC: Transfer to central bank money instantly
No physical limits
Perfect safety at destination
"One-click bank run"
```

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BANK DISINTERMEDIATION DEFINED

CURRENT SYSTEM:
┌────────────┐ ┌──────────────┐
│ Depositor │─deposits─│ Bank │─reserves─→ Central Bank
│ │←loans────│ (lending) │←─────────
└────────────┘ └──────────────┘

Banks sit between depositors and the central bank.
Banks provide services (lending, payments).
Banks take risk (lending decisions, defaults).

DISINTERMEDIATION:
┌────────────┐────────────────────────→ Central Bank
│ Depositor │ Direct CBDC relationship
│ │←────────────────────────
└────────────┘
Bank bypassed or reduced role

RATIONAL REASONS TO PREFER CBDC

COUNTERARGUMENTS:

• Interest on deposits (CBDC may pay none)
• Services (lending relationship, advice)
• Inertia (already have account)
• Features (overdrafts, credit cards linked)

HOW MUCH DEPOSIT FLIGHT IS POSSIBLE?

SCENARIO ANALYSIS:

• CBDC used for payments only

• Holdings return to bank deposits

• Net effect: Small, transient

• Deposit loss: 1-5%

• Some savings shift to CBDC

• Holding limits constrain shift

• Banks adjust (higher rates)

• Deposit loss: 5-15%

• CBDC becomes preferred savings

• Crisis triggers flight

• Bank funding seriously disrupted

• Deposit loss: 15-30%+

• Bank solvency concerns

• Mass CBDC conversion

• Central bank intervention required

• Deposit loss: Could be massive

• ECB estimates: €1.5-2 trillion potential outflow

• Studies suggest manageable if limits enforced

• Crisis scenarios remain concerning

CRITICAL VARIABLE:
Depends entirely on CBDC design and economic conditions

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THE LENDING MECHANISM

HOW BANKS FUND LOANS:
Deposits → Loanable funds → Loans → Economic activity

IF DEPOSITS DECREASE:
Fewer deposits → Less loanable funds → Fewer loans

QUANTIFYING THE IMPACT:

• Bank has $100B deposits

• Lends 80% = $80B in loans

• 10% of deposits move to CBDC = $10B

• Deposits: $90B (down from $100B)

• Maximum loans: $72B (down from $80B)

• Lending reduction: $8B

SCALING TO ECONOMY:
US bank deposits: ~$17 trillion
10% to CBDC: $1.7 trillion
Lending impact: Potentially $1.4+ trillion reduction

• Banks could find alternative funding
• Central bank could provide liquidity
• Other factors might offset
• But the risk is real

ECONOMIC IMPACT CHAIN

Step 1: Deposits move to CBDC
↓
Step 2: Bank funding decreases
↓
Step 3: Lending capacity decreases
↓
Step 4: Credit availability tightens
↓
Step 5: Borrowing becomes harder/more expensive
↓
Step 6: Business investment decreases
Consumer spending decreases
Home purchases decrease
↓
Step 7: Economic growth slows
↓
Step 8: Employment may suffer
↓
Step 9: Political consequences

CENTRAL BANK DILEMMA:
CBDC might require looser monetary policy
to offset credit tightening—
but that could undermine CBDC goals

---

Central banks have developed strategies to limit banking system impact. Each involves trade-offs.

MITIGATION STRATEGY: HOLDING LIMITS

WHAT IT IS:
Cap on how much CBDC an individual can hold

TRADE-OFFS:

• Can't use CBDC for large purchases

• Savings must remain in bank

• Wealthy users especially limited

• Multiple wallets across providers?

• Family member wallets?

• Business accounts?

• Cash has no holding limits

• CBDC with limits ≠ digital cash

• Reduces "cash replacement" value

TYPICAL APPROACH:
€3,000-5,000 limit
Enough for payments, not for savings
Protects bulk of bank deposits
```

MITIGATION STRATEGY: INTEREST RATE DIFFERENTIALS

WHAT IT IS:
CBDC pays no interest (or negative interest)
Bank deposits pay positive interest

EXAMPLE:
Bank deposit: 2% interest
CBDC: 0% interest
Rational choice: Keep savings in bank

TRADE-OFFS:

• Why hold non-interest-bearing CBDC?

• Cash pays 0% but has anonymity

• CBDC may offer neither advantage

• 0% return + 2% inflation = -2% real return

• Holding CBDC loses purchasing power

• Poor store of value

• Could discourage CBDC hoarding

• But extremely unpopular

• Political backlash likely

• "Government taxing my money"

TYPICAL APPROACH:
0% interest rate on CBDC
Rely on convenience for transaction use
Banks offer interest advantage for savings
```

MITIGATION STRATEGY: TIERED REMUNERATION

WHAT IT IS:
Different interest rates for different holding levels

EXAMPLE STRUCTURE:
First €1,000: Normal rate (or 0%)
€1,000-3,000: Lower rate
Above €3,000: Negative rate (penalty)

TRADE-OFFS:

• Multiple rate tiers

• User confusion

• System complexity

• "Taxing larger balances"

• Progressive penalty unpopular

• Political challenges

• Multiple small wallets

• Family distribution

• Enforcement difficult

TYPICAL APPROACH:
Discussed but rarely implemented
Simpler holding limits preferred
Research continues on tiered models
```

MITIGATION STRATEGY: TWO-TIER DISTRIBUTION

WHAT IT IS:
Banks remain between central bank and public

STRUCTURE:
Central Bank ↔ Commercial Banks ↔ Public

TRADE-OFFS:

• Users can still prefer CBDC over deposits

• Two-tier is about distribution, not holdings

• Other limits still needed

• Users still need bank relationship

• Exclusion if unbanked

• Contradicts some inclusion goals

• Banks might charge for CBDC services

• Reduces CBDC cost advantage

TYPICAL APPROACH:
Two-tier is nearly universal
Combined with holding limits and no interest
Addresses distribution, not deposit risk
```

MITIGATION STRATEGY: CONVERSION LIMITS

WHAT IT IS:
Restrictions on how fast deposits can convert to CBDC

EXAMPLE:
Maximum €1,000/day conversion from bank to CBDC
Or: 24-hour delay for large conversions

TRADE-OFFS:

• Can withdraw unlimited cash from ATM

• CBDC with limits ≠ cash

• Reduces utility

• Implementing limits signals stress

• Could trigger panic instead of calm

• Self-fulfilling prophecy risk

• "I can't access my money"

• Trust erosion

• Adoption barrier

TYPICAL APPROACH:
Discussed as crisis tool
Not pre-implemented
"Break glass in emergency" option
```

MITIGATION TRADE-OFF MATRIX

STRATEGY EFFECTIVENESS CBDC UTILITY POLITICAL
FOR BANKS REDUCTION FEASIBILITY
─────────────────────────────────────────────────────────────
Holding Limits High High Medium
No Interest Medium Low High
Tiered Rates Medium-High Medium Low
Two-Tier Low (other) Low High
Conversion Limits Medium High Low

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ARGUMENTS: RISK IS OVERSTATED

IMPLICATION:
Cautious CBDC design is prudent
But catastrophic scenarios unlikely
```

ARGUMENTS: RISK IS REAL

IMPLICATION:
Mitigation measures are essential
Casual dismissal of risk is unwarranted
```

THE HONEST ASSESSMENT

WHAT WE KNOW:
✓ Disintermediation risk is real, not theoretical
✓ Magnitude is uncertain and model-dependent
✓ Crisis scenarios are most concerning
✓ Mitigation measures reduce but don't eliminate risk
✓ Design choices significantly affect risk level

WHAT WE DON'T KNOW:
? How people will actually behave
? How banks will adapt
? What crisis scenarios will emerge
? Whether mitigation will be sufficient
? Whether political will for limits will hold

POLICY IMPLICATION:
This is why CBDCs move slowly
This is why limits exist
This is why designs are conservative
```

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EVIDENCE FROM LAUNCHED CBDCs

OVERALL:
No CBDC has yet achieved scale
sufficient to meaningfully test
disintermediation hypotheses
```

ACADEMIC AND CENTRAL BANK RESEARCH

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✅ Disintermediation risk is real—if CBDC is safer and convenient, rational depositors have reason to switch.

✅ Bank funding depends significantly on deposits—loss of deposits affects lending capacity.

✅ Mitigation strategies have trade-offs—protecting banks reduces CBDC utility.

✅ Crisis dynamics are concerning—even if normal-time risk is modest, crisis acceleration is possible.

⚠️ Actual magnitude of deposit flight—models vary widely; real-world behavior is unpredictable.

⚠️ Whether mitigation will be sufficient—especially in crisis conditions.

⚠️ How banks will adapt—they may find new funding sources or new business models.

⚠️ Political sustainability of limits—if CBDC is popular, pressure to raise limits may be irresistible.

📌 Dismissing the risk as theoretical—central banks take it seriously for good reason.

📌 Assuming current models are accurate—this is a novel situation with limited empirical evidence.

📌 Ignoring crisis scenarios—normal-time stability doesn't guarantee crisis stability.

The banking system impact question is the primary constraint on CBDC design. Every major design feature—holding limits, no interest, two-tier distribution—exists largely to protect banks. Whether this protection is sufficient, and whether the trade-off is worth the reduced CBDC utility, remains genuinely uncertain. What's clear is that CBDC design cannot be evaluated without understanding this fundamental tension.

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Assignment: Analyze the banking system impact of a proposed or launched CBDC, evaluating the mitigation strategies and their likely effectiveness.

Requirements:

Part 1: Select a CBDC
Choose: Digital Euro, UK Digital Pound, India e-Rupee, or another CBDC with published design details.

• Total deposits (approximate)

• Deposit insurance limits

• Bank funding structure

• Historical bank stability

• What limits exist (holding, conversion, etc.)?

• What is the interest rate approach?

• What is the distribution model?

• Other relevant design features

Part 4: Impact Assessment (2 pages)

• How does it protect the banking system?

• What trade-off in CBDC utility does it create?

• How effective is it likely to be?

• What could undermine it (crisis, political pressure)?

• Is the design likely to adequately protect banks?

• What are the biggest remaining risks?

• What design changes would you recommend?

• Accuracy of banking context (20%)

• Thoroughness of design analysis (25%)

• Quality of impact assessment (35%)

• Reasonableness of conclusions (20%)

Time Investment: 3-4 hours
Value: Understanding banking system dynamics is essential for evaluating CBDC viability.

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1. Disintermediation Mechanism Question:

Why might a rational depositor move money from a bank account to a CBDC?

A) CBDC always pays higher interest than bank deposits
B) CBDC is a central bank liability with no counterparty risk, while bank deposits carry bank default risk
C) CBDC is required by law for all transactions
D) Banks charge monthly fees while CBDC is always free

Correct Answer: B
Explanation: The fundamental reason for deposit flight is safety. CBDC is a liability of the central bank (sovereign, essentially risk-free). Bank deposits are liabilities of commercial banks, which can default (as depositors above insurance limits at SVB learned). This safety differential, especially relevant during crises, is why rational depositors might prefer CBDC. A is incorrect (CBDC often pays 0%). C is not true. D may sometimes be true but isn't the fundamental driver.

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2. Credit Creation Question:

If 10% of bank deposits move to CBDC, what is the most direct economic impact?

A) Interest rates automatically increase
B) Banks have less funding for loans, potentially reducing credit availability
C) The central bank must print more money
D) Inflation immediately decreases

Correct Answer: B
Explanation: Banks fund loans primarily through deposits. If deposits decrease, banks have less money to lend. Less lending means tighter credit—harder for businesses and consumers to borrow. This can slow economic growth. A might happen as banks compete for remaining deposits, but isn't automatic. C isn't the mechanism. D isn't a direct effect.

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3. Mitigation Trade-off Question:

A €3,000 holding limit on a CBDC primarily:

A) Prevents anyone from using CBDC for daily transactions
B) Protects bank deposits by preventing CBDC from becoming a savings vehicle
C) Ensures CBDC is more convenient than cash
D) Satisfies privacy advocates by limiting tracking capability

Correct Answer: B
Explanation: Holding limits exist primarily to protect bank deposits. By capping how much CBDC someone can hold (€3,000 is common), the design ensures CBDC is used for transactions, not savings. Larger savings must remain in bank deposits, preserving bank funding. A is incorrect (€3,000 is enough for most transactions). C isn't the purpose of limits. D is unrelated to the purpose.

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4. Crisis Dynamics Question:

Why are crisis scenarios particularly concerning for CBDC-related bank runs?

A) CBDC systems always fail during crises
B) Conversion from bank deposits to CBDC can happen instantly, much faster than traditional cash withdrawals
C) Central banks cannot intervene during crises
D) CBDC becomes more expensive to hold during crises

Correct Answer: B
Explanation: Traditional bank runs require physical cash withdrawal—there's friction from queues, branch hours, and cash availability. CBDC conversion could be instant: tap, transfer, done. Everyone can do it simultaneously. This speed means a crisis of confidence becomes a liquidity crisis in minutes or hours rather than days, giving less time for intervention. A is speculation. C is incorrect (they can and do intervene). D isn't typically the case.

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5. Design Implication Question:

The fact that virtually all CBDC designs include holding limits, no interest, and two-tier distribution reveals:

A) Central banks lack imagination in CBDC design
B) These features are technically required for digital currencies
C) Banking system protection is a primary design constraint shaping CBDC architecture
D) Citizens have demanded these specific features

Correct Answer: C
Explanation: The convergence on bank-protective features (limits, no interest, two-tier) isn't coincidence or technical necessity—it reflects the power of banking interests and central banks' genuine concern about financial stability. These features reduce CBDC utility but protect incumbent banking systems. A is unfair. B is incorrect (other designs are possible). D is wrong (citizens generally want more utility, not less).

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For Next Lesson:
In Lesson 7, we examine the legal and regulatory foundations that CBDCs require—from legal tender status to consumer protection frameworks to AML/CFT compliance requirements.

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End of Lesson 6

Total words: ~5,800
Estimated completion time: 55 minutes reading + 3-4 hours for deliverable

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Course 58: CBDC Architecture & Design
Lesson 6 of 20
XRP Academy - The Khan Academy of Digital Finance