Last week, the Bank of Israel published a paper assessing the potential impact of issuing a central bank digital currency (CBDC) – the digital shekel (SHAKED) – on the banking system’s stability. While the central bank has been building an action plan for the potential issuance of the SHAKED, it reiterated that it “has not yet decided whether it intends to issue a digital currency”.
As part of the action plan, the Bank of Israel analyzed the potential impact of issuing a CBDC on the stability of the banking system and its ability to fulfill its financial intermediation function. The issuance of a digital shekel would also lead to a change in the Bank of Israel’s balance sheet composition. The SHAKED would be added to the central bank’s liabilities (as an addition to the total cash in circulation), while the deposits at commercial banks would shrink.
The Bank of Israel’s analysis forecasted a negative impact on the commercial banking system’s profitability, but it is not expected to be significant to the sector’s business, stability or ability to provide credit.
However, it is forecast that the transfer of money from commercial bank deposits to the digital shekel would erode commercial bank liquidity ratios and lead to a limited increase in bank interest expenses and the subsequent attrition of net profits. The transition of consumer bank deposits to SHAKED may weaken commercial bank balance sheets, possibly eroding the liquidity safeguards implemented for banks since the 2008 financial crisis through to the Basel III regulatory framework.
If the transfer of the public’s deposits to the digital shekel reaches large volumes, the banking system would have to attract funds elsewhere. For example, the paper presents a scenario where the Bank of Israel issues loans to the banking system.
CBDC assumptions
Nonetheless, these findings are also based on a series of assumptions. The main assumption is that the banking system would be interested in maintaining the same level of credit to the public. Additionally, the paper assumes that the banking system will absorb the erosion of credit margins instead of passing it on in higher interest rates.
It also predicts the SHAKED will not bear interest and does not take into account possible adaptations of commercial bank business models as a result. Ultimately, “it is difficult to impossible to reliably assess what will be the scope of the substitution between deposits and SHAKED, since it depends greatly on the technological and business characteristics of the SHAKED”.
Meanwhile, last year, the outgoing head of Germany’s Bundesbank said that commercial banks should not be protected like an endangered species. This February, the non-partisan U.S. Congressional Research Service published a paper on CBDC in which it explored various systems that a CBDC might crowd out. It included crowding out bank deposits but also private payment systems, private digital currencies, cash, and cross border payment platforms.