Introducing a CBDC would be a catastrophe for the banking system

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Since the fall of Silicon Valley Bank,  many have expressed concern over the risk of deposits leaving community banks for larger institutions. But the risk would be present for all banks, regardless of size, if the Federal Reserve introduced a central bank digital currency, or CBDC.

Bankers should make no mistake: If a CBDC is introduced in the United States, operations are likely to be anything but business as usual.

The "issuance of a CBDC," said Rob Morgan, former vice president of emerging technologies at the American Bankers Association, "would fundamentally rewire our banking and financial system by changing the relationship between citizens and the Federal Reserve." At its core, a CBDC would create a direct connection between citizens and the Federal Reserve — as well as the federal government at large. This rewiring of the system opens up risks to financial privacy, freedom, markets and even cybersecurity.

Perhaps in an attempt to appease financial institutions and lessen the impact of such a radical proposal, the Federal Reserve has signaled its preference for an "intermediated CBDC," or a scheme where the central bank enlists the private sector to maintain CBDC accounts and digital wallets. At first glance, this idea might sound like the private sector is being cut in on the action, but those working in financial services should not be fooled by the bone being thrown here.

As Greg Baer, president and CEO of the Bank Policy Institute, cautioned at an event held at the Cato Institute, an intermediated CBDC would mean anything but business as usual for financial institutions. While CBDCs come in a few different forms, it is important to recognize that they are direct liabilities of the central bank.

For financial institutions, this distinction means that "if a consumer or business chose to hold a dollar of CBDC, that dollar is no longer available for bank funding." In other words, financial institutions will still incur costs due to expenses like anti-money laundering (AML) and "know your customer" (KYC) compliance, as well as cybersecurity maintenance, but there will be no source of loan revenue to balance those costs.

One might reasonably argue that customers already deposit liabilities of the Federal Reserve in the form of cash into financial institutions with no issue. The trouble with this reasoning is in how money takes different forms.

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When cash is deposited, it is technically transformed into another form of money known as "bank money." However, if a CBDC is to exist in a separate digital wallet in an intermediated system, that transformation would not be taking place. In a sense, an intermediated CBDC is somewhat akin to cash being held in a safety deposit box. Banks will maintain the account, but they can't touch what is inside or have ownership of it — as ultimately, those accounts are maintained on behalf of the Federal Reserve. And in practice, that means financial institutions would not be able to use CBDCs in the way they use cash deposited into savings or checking accounts.

From this perspective, the worst-case scenario is one in which banks experience runs as people take their money out of deposit accounts to exchange for a CBDC. Alternatively, in the best-case scenario, people simply don't use the CBDC. Is either scenario one that justifies "fundamentally rewir[ing] our banking and financial system" as Morgan described?

To be clear, this issue is not just a risk for those working in the financial system. Faced with the prospect of losing deposit funding, financial institutions will either turn to raising funds in capital markets (at greater risk and expense) or raising rates on deposit accounts in a bid to win back lost funds (at greater expense). Either way would likely translate into higher costs of loans for people looking to get a home, a car or even just emergency funds to get through a rough patch.

Considering these factors, Federal Reserve governor Michelle Bowman recently warned there are "significant risks in adopting a CBDC that cannibalizes rather than complements the U.S. banking system." Elsewhere, officials have scrambled to reduce the risk of a cannibalistic CBDC by proposing restrictions on how much money people are allowed to hold or spend. Others have suggested limiting the amount of interest paid.

But again, if such severe restrictions need to be put in place just to avoid destabilizing the financial system, is a CBDC something that should be adopted at all?

The good news is that Bowman is not alone in having concerns: Officials across the Federal Reserve, Congress and the broader public have all come to recognize the risks that CBDCs pose. As explained by American Banker's Kyle Campbell, there is still some debate over whether the Federal Reserve has the authority to issue a CBDC on its own. However, more and more members of Congress have taken the stance that the Federal Reserve cannot proceed without a legislative directive.

Given just how impactful a CBDC could be, it's a decision that should not be left to unelected officials. Regulators may have thrown smaller banks under the bus after suggesting that the biggest banks were unofficially given full insurance on all deposits. However, all banks — large and small — stand to lose if a CBDC were to be created.