Digital euro: Debunking banks’ fears about losing deposits

19 February 2024

By Ulrich Bindseil, Piero Cipollone and Jürgen Schaaf

On 18 October 2023 the ECB’s Governing Council outlined the scope and key features of a digital euro. The ECB also decided to proceed with the “preparation phase” of the digital euro project. The actual decision on whether to issue a digital euro will be taken at a later stage, but not before the legal framework is in place and all functional features have been specified.

Based on the specifications for a digital euro put forward by the ECB and the European Commission, we can expect the digital euro’s features to include pan-European reach, legal tender status and a high level of privacy. A digital euro would combine all the features of a modern digital payment solution. It would fill the gap left by the absence of a European electronic payment solution that is available and accepted free of charge throughout Europe, thereby strengthening the monetary sovereignty and resilience of the currency union.

To preserve the economic function of commercial banks, individual digital euro holdings would be limited. Merchants would be able to receive and process digital euro, but would not be able to hold them at all ‒ protecting the corporate deposit base of the banking system. Moreover, digital euro holdings would not accrue interest. Users would be able to seamlessly link their digital euro account to a payment account with their bank, enabling a “reverse waterfall” mechanism. This eliminates the need to pre-fund the digital euro account for online payments, as any shortfall would be covered instantly from the linked commercial bank account, provided it has sufficient funds available.

Addressing concerns about bank disintermediation

From the outset, questions concerning the risk to bank funding were at the centre of discussions about central bank digital currencies (CBDCs). In theory, CBDCs could affect financial institutions, as depositors might choose to move money from bank deposits to the central bank. This could reduce the ability of the traditional banking system to provide credit. However, central banks have analysed this issue and devised ways of tackling such risks upfront. In the case of a digital euro, the combination of the reverse waterfall, a holding limit and no remuneration would strongly reduce incentives to keep large amounts of money in a digital euro wallet. Users would rely on digital euro as a means of payment rather than use it for investment, particularly in view of the tendency of money holders to consolidate their liquidity pool. Moreover, banks could always offer higher remuneration to retain deposits.

But despite the explicit inclusion of mitigation measures in CBDC design, banking associations, bank-sponsored think tanks and scholars have continued to publish studies emphasising the risks associated with eliminating financial intermediaries from transactions ‒ known as bank disintermediation ‒ through the potential issuance of CBDCs in general and of a digital euro in particular.

Given the persistence of such criticism, it is worth taking a closer look at the arguments.

Some critics say that in an acute economy-wide banking crisis, a digital euro could accelerate bank runs, which could exacerbate the crisis. However, this is not very plausible for the following reasons:

• Since a limit would be applied to digital euro holdings, the ability of customers to withdraw unlimited amounts of cash would pose much more of a threat to banks. Indeed, the disadvantage of holding cash as a short-term store of value because of safety concerns would become less important in a crisis of such magnitude.
• Even in severe banking crises, many banks are still considered safe (also because central banks act as a system-wide lender of last resort). For example, during the great financial crisis in 2008 as well as in the recent crisis that hit US regional banks, safe banks continued to benefit from inflows.
• In recent decades bank runs have not generally been triggered by large numbers of retail customers withdrawing small deposits, but by incidents in the wholesale market or the withdrawal of very large individual amounts above the thresholds covered by deposit guarantee schemes.

Other critics say that the attractiveness of safe central bank money could lead to banks losing deposits as a source of refinancing in the long term. This could put a strain on lending to companies and private households. According to the Association of German Banks, substantial quantities of central bank money could be withdrawn from the banking system, which would restrict the ability of commercial banks to refinance against customer deposits. However, the combination of a holding limit, no remuneration, the reverse waterfall and the absence of corporate holdings of digital euro would mean that overall levels of digital euro holdings would remain rather low.

Comprehensive analysis must include banknotes

What matters most for banks is the total amount of central bank money in circulation. Focusing on digital euro alone ignores banknotes in circulation. This is misleading, as the way they both affect the financial accounts of the economy is identical. Banks experienced elevated demand for euro banknotes during periods of financial stress and low interest rates, but didn’t raise this as an issue at the time. Between 2007 and 2021 euro banknotes in circulation increased from €628 billion to €1,572 billion, which far exceeds the amount expected to be issued in the form of digital euro.

The declining use of banknotes for daily transactions will also eventually reduce the structural demand for banknotes. The point of having a “store of value” is that it should be spent, only not immediately. In addition, the usefulness of a store of value relies on the ease with which money can ultimately be spent. Therefore, the decline in the use of banknotes also risks reducing their attractiveness as a store of value in the long term.

Indeed, in 2023 the value of euro banknotes in circulation declined for the first time in nominal terms since 2002, by around €5 billion. Even though only 20% of the demand for banknotes can be attributed to domestic payments - and this trend reversal is probably mainly a reflection of higher interest rates - the digitalisation of payments is also a factor.

Digitalisation in general is likely to lead to lower real growth in central bank money in circulation, or even to a decline. From this perspective, the persistent complaints regarding future volumes of digital euro in studies sponsored by the banking system are not looking at the right variable (which is central bank money in circulation) and are outdated (since they ignore the digital euro blueprint).

Conclusion

As the ECB advances its work on developing a digital euro, it will continue to refine design choices, address potential risks and optimise benefits. The ECB has presented innovative design features that would limit the circulation of digital euro while offering benefits to users. The concerns regarding bank funding have been taken seriously by proposing holding limits, access constraints, no remuneration and the reverse waterfall. The holding limits would be calibrated based on a comprehensive analysis considering all relevant factors.

In terms of the interaction between central bank money and commercial bank funding, what really matters is the total volume of central bank money in circulation. Amid the declining use of banknotes, it is likely that nominal growth in banknotes in circulation will diminish or even turn negative. This could lead to a scenario in which there is a decline of central bank money in circulation relative to GDP.

Moreover, new players might pose a greater risk to bank funding than CBDCs. Stablecoins, e-money institutions and other narrow bank constructs, some sponsored by big tech companies with huge customer bases, do not care about the role of banks in the economy. Non-banks have no obvious incentive to limit the use of their stablecoins or the services they offer, and the use of stablecoins could become significant.

Banks are barking up the wrong tree when they rely on studies that overlook the outlined design features of a digital euro. In doing so, they ignore the many other challenges they need to address to ensure stable funding through deposits. Banks need to offer attractive products and services that incentivise customers to hold their deposits with them instead of migrating to new and powerful private competitors.

A longer version of this ECB Blog post has been published on VoxEU.

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