An interesting issue with central bank digital currencies (CBDCs) is their status as a direct liability of the central bank. This distinction rarely gets the attention of the broader public, but it’s an important distinction because it could lead to a complete destabilization of the financial system as we know it. For example, a CBDC would likely worsen bank runs, lead people to leave the banking system, and increase the cost of loans. Broadly speaking, this direct liability feature is one of the main reasons that a CBDC represents a radical departure from the existing financial system.

What Is a Liability?

For those that might not be familiar, the term “liability” is used in finance to describe something that person A owes to person B. In contrast, an “asset” is something that person A owns outright. From here, we can see that something—such as a loan or a deposit—can simultaneously be a liability for one person and an asset for another person. The difference between what is owned (assets) and what is owed (liabilities) is referred to as “equity.” Generally, equity is the residual value that belongs to the owners of the bank.

If we step back to accounting 101, we can model the relationship between assets, liabilities, and equities in a simplified balance sheet for a bank (see Figure 1). There might be different items in each category, but, ultimately, assets should equal liabilities plus equities. This relationship is often referred to as “the accounting equation.”

Whose Liability Is It?

When people spend money digitally today with a debit card, the money in the corresponding checking account is a liability of the bank (e.g., Bank of America or Capital One). Similarly, when people spend money digitally today with a prepaid card, the balance is a liability of the private company that issued the card (e.g., Visa or Mastercard). In either case, the financial institution owes the customer the funds that are deposited in the account. When a customer transfers that money to make a payment, the financial institution that has the liability is responsible for transferring the money.

In the case of a CBDC, however, the digital money would be a liability of the central bank itself. That is, it would be the government that has the direct responsibility to hold, transfer, or otherwise remit those funds to the ostensible owner. This feature creates a direct link between citizens and the central bank.

Why Does a CBDC’s Liability Status Matter?

As mentioned in the initial accounting primer, something can be a liability to one person and an asset to another. However, something cannot be a liability owned by two separate parties (Note: the word “separate” is used here to exclude agreements like joint partnerships). In the context of a CBDC, this distinction means that a CBDC cannot be a liability on both the Federal Reserve’s balance sheet and a bank’s balance sheet. That condition matters because the basic business model for banks has long involved a strategy of using deposits (i.e., their liabilities) to fund loans (i.e., their assets).

If the number of deposits is cut down as people put their money in CBDC wallets instead of bank accounts, then the number of loans will be cut down, too (see Figure 2). As the supply of private loans decreases (Q1 to Q2), the price of those loans will start to increase (P1 to P2). In other words, this issue is about more than just bank profits. Yes, some banks would likely go out of business or merge with larger banks as the price of loans increases and cuts into profit lines, but this disruption would also make loans more expensive for everyone.

Why Would People Choose a CBDC Over a Bank Account?

There are many civil liberty concerns that might make people hesitant to adopt a CBDC. However, setting those concerns aside, there are reasons people may still be swayed to use a CBDC. Consider two situations that people may face in financial markets: a time of panic during a bank run and a time of peaceful planning during a period of financial stability.

Bank runs are instances when customers lose faith in their bank for one reason or another (often due to bad news about the bank’s finances) and, as the name suggests, run to the bank to withdraw all their money. In the past, that primarily meant people ran to get their money out in cash. Yet, as far as a run for cash is considered, the time waiting in line, the amount of cash available in the vault, the difficulty in carrying cash, and the security risk of storing cash all act as frictions that slow down runs. In contrast, as explained by the Federal Reserve itself, “The ability to quickly convert other forms of money—including deposits at commercial banks—into CBDC could make runs on financial firms more likely or more severe.” In other words, rather than run to the bank to get physical cash, a person could instead choose to transfer their balances into a CBDC without leaving their home. Not only that, but the money might be kept as a CBDC for prolonged periods because it would essentially be digital money that is “100 percent insured” and, unlike cash, people would not need to worry about storing, securing, or carrying a large sack of money.

While running for cash was more common in the past, technological advances have since led to digital runs where people instead wired or otherwise transferred their money directly to another bank instead of withdrawing cash (see Panel A in Figure 3). To be clear, the speed of these digital runs does pose a challenge. Yet, there is a silver lining with this development: this type of run is largely limited to the initial institution in question and does not affect the larger supply of deposits. Rather than leave the system, the money transferred flows into other institutions and stays within the financial system. The problem posed by a CBDC in this scenario is that people would instead transfer their money out of the financial system and into their digital wallets and purses—the digital equivalent of placing one’s money under a mattress (see Panel B in Figure 3).

It is also likely that incentives could be used—even without a crisis or failure to spark a bank run—to encourage people to leave the existing financial system. For example, some CBDC proponents have called for CBDCs to offer things like “high interest compared with ordinary bank accounts and full government backing with no need for deposit insurance.” For many people, the allure of above-market interest rates would likely make transferring to a CBDC a quick decision. In fact, proponents have specifically recognized that these offerings would crowd out alternatives in the private sector. When weighing the costs and benefits, one proponent went so far as to say that disrupting the banking system is the number one advantage of creating a CBDC even though doing so would lead to “profound systemic changes that threaten entire lines of business within banks and credit card companies.”

Theory is not the only source for concern when considering how government incentives might lead people to leave the banking system. For those that might not recall, the U.S. Postal Savings System operated from 1911 to 1966 on the premise of offering “safe and convenient places for the deposit of savings at a comparatively low rate of interest.” That low rate of interest, however, was set in stone by bureaucrats and later became comparatively high when market rates fell during the Great Depression—a period that coincided with a significant number of bank failures. So in addition to people leaving banks in pursuit of a higher return, studies have shown that other people moved their money to the Postal Savings System directly in response to the announcement of local bank suspensions. From 1929 to 1933, the amount of money deposited in the Postal Savings System had increased nearly eightfold from $154 million to $1.2 billion.

So both in times of panic and times of peace, a CBDC could destabilize the financial system.

Can’t You Just Store CBDC at the Bank?

With a general understanding of both liabilities and bank runs in hand, let’s dive deeper and explore how a CBDC might be used by the public. A common question that comes up when discussing CBDC risks is: Why can’t people just keep their CBDC at the bank? There are really three options for a consumer looking to store their CBDC—partially depending on what CBDC model is ultimately used.

With a retail CBDC provided directly by the central bank, people would store their CBDC in accounts directly managed by the Federal Reserve. That means every dollar held as a CBDC is a dollar that has either been taken out of the banking system or converted from cash. Any dollar stored as a CBDC here would be off-limits to banks. This arrangement sort of turns the Federal Reserve into a payments processor like PayPal or Cash App. However, rather than solely handling money like those services do today, the Federal Reserve would also be providing money directly to the public—another deviation from the current system.

With an intermediated CBDC supported by private intermediaries, people would store their CBDC in a digital wallet that banks (or other private institutions) maintain on behalf of the Federal Reserve. Although the bank would incur costs for things like processing payments, cybersecurity, and regulatory compliance, putting a CBDC into this wallet does not mean that the CBDC becomes the bank’s liability. Rather, storing a CBDC in this wallet is more akin to storing valuables 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 being maintained on behalf of the Federal Reserve.

With either of those two CBDC designs, people could instead exchange their CBDC for bank deposits—though, it’s a bit of a roundabout process. Behind the scenes, the bank would send the customer’s CBDC to the Federal Reserve in exchange for a credit that would then be used to balance a newly created deposit of equal value. This method would allow banks to use deposit accounts to fund loans and consumers to continue using the financial system like they already do, but the owner of the account would no longer be using a CBDC. A payment from that account would be a regular debit transaction like what already happens—without a CBDC—over 240 million times a day in the United States.

This last option is akin to what happens with cash, or paper money, that is deposited at a bank. When someone deposits cash, they no longer get to use an anonymous, physical money. Instead, they spend money by initiating transfers to and from a deposit account. Exchanging a CBDC for a deposit account would resemble this process as people would no longer have access to the features of the CBDC.

Hold On, Isn’t Cash a Direct Liability of the Central Bank?

At this point, some people might still be wondering how a CBDC poses a unique threat when cash is also a direct liability of the central bank and involves a similar exchange process when deposited at banks. It’s a good question to consider.

First, the existence of cash does facilitate disruptions to the financial system considering it gives consumers a final means of payments that they can run to. In fact, similar arguments could be made about physical gold during the gold standard era. Yet, a CBDC poses a unique threat because consumers would likely be able to pull out their money faster than ever before and store the funds easily without significant storage or security costs. It’s for this reason that the Federal Reserve said a CBDC would make bank runs “more likely” and “more severe.” The digital nature of a CBDC would increase the impact of a run and delay the return to normal relative to cash (see Figure 4).

The CBDC Tradeoff

Many others have also recognized that the risk of destabilizing the financial system is a serious threat posed by CBDCs. George Selgin (Cato Institute), Andrea Maechler (Swiss National Bank), Greg Baer (Bank Policy Institute), Rob Morgan (American Bankers Association), and researchers at the European Central Bank, Massachusetts Institute of Technology, and University of Michigan have all described similar concerns about CBDCs destabilizing the financial system. In fact, the Federal Reserve has acknowledged that the introduction of a CBDC, “could reduce the aggregate amount of deposits in the banking system, which could in turn increase bank funding expenses, and reduce credit availability or raise credit costs for households and businesses.”

Not ready to throw in the towel, some CBDC proponents have proposed making CBDCs intentionally bad to discourage and limit their use. For instance, the Federal Reserve and the European Central Bank have proposed not paying interest on CBDCs, limiting the amount of CBDC a person can hold, or limiting the amount of CBDC a person can accumulate over time. In other words, there won’t be interest payments, total CBDC holdings will be limited, and the amount that can be transferred over time will be limited.

William Luther, director of AIER’s Sound Money Project, has described this issue as the “CBDC Tradeoff.” Consider two extremes. On the one hand, a CBDC could pay interest, offer subsidized payments, and even tax discounts. These offerings would lead people to leave the banking system, but it would mean that the CBDC gains enough users to maintain a stable network. On the other hand, a CBDC could pay no interest, have some low cap like $10,000, and restrict how many transactions people can make. In this case, people probably wouldn’t leave their bank any time soon, but then the CBDC probably would not have enough users to be considered a worthwhile effort. In short, the tradeoff becomes a question between making something people will want at the expense of the larger financial system or making something no one will want at the expense of taxpayer resources.

Faced with this tradeoff, the best choice is to not introduce a CBDC at all.

Conclusion

Let’s quickly recap the ground that has been covered here.

Introducing a CBDC risks destabilizing the banking system and worsening panics. The Federal Reserve tried to lessen that risk by “including” banks in the process by proposing an intermediated CBDC. Yet, with an intermediated CBDC, banks would have to cover regulatory and overhead costs to maintain CBDC accounts even though they would have no loan revenue from those funds since the CBDC is still a liability of the central bank. Moreover, shrinking the supply of deposits would likely lead to costlier credit. That means loans will be more expensive for everyone.

Today’s financial system is not perfect, but it usually works so well that people rarely stop to ask: “Whose liability is it anyway?” Yet, being a direct liability of the central bank is a defining feature of a CBDC. In practice, that trait means destabilizing the financial system is a defining feature of a CBDC. Consequently, the risk posed to financial markets is just another reason why Congress should prohibit the Federal Reserve and Treasury from issuing a CBDC.