Transformation or cohabitation? Retail CBDC's relationship with commercial bank money

The next time you find yourself depositing a banknote or two into an ATM, take a moment to reflect on the implications of such a seemingly trivial act. Colourful, polymer bills, designed, printed, and distributed by our nation's central bank. The safest form of money in the world, and complete with wonderfully rendered images of political leaders, the Queen, and other culturally relevant figures and scenes. Stuffed into an envelope, shoved into an ATM, in return for an IOU from a commercial bank that even the federal government worries enough about to provide you with insurance.

The relationship between central bank and commercial bank money is a dichotomous one. Commercial banks more than happy to loan their own money, created out of thin air, in order to effectively receive central bank money in the future. But with the catch that in the meantime, the loan can be converted to central bank money at any time. The non-intuitive relationship made even more confusing by capital adequacy and liquidity coverage ratios that by their definition acknowledge the riskiness in such a proposition, but alas allow the party to continue. Just keep the noise down.

And we allow the party to continue because commercial banks' adjudication of risk and creation of credit lead to - in perhaps most cases - economic growth and prosperity. And occasionally asset bubbles and financial crises. Okay, more than occasionally.

But with retail CBDC, it doesn't have to be this way. You would still have to give up those wonderful central bank notes at the ATM, but you get to keep the digital version. If you want. Which touches on the likely scenario when retail CBDC enters the picture. It will not replace commercial bank money, it will sit beside it. And central banks, whose mandate includes promoting financial stability, will pay careful attention to the seating arrangement. For example - will transfers between commercial money and CBDC accounts be so seamless as to turn an old fashioned bank run into a virtual bank sprint? And for that matter - will commercial banks even feel the need to offer CBDC accounts at all? Would they prefer simply competing against these accounts?

Perhaps a solution is for banks to have tiered accounts. Earn a high rate of interest on a commercial bank account that is not convertible to CBDC; earn less interest on a convertible account, and no interest on a CBDC account.

It seems inevitable in any event that bank balance sheets will shrink and lending will transform in uncertain ways. And while commercial money accounts and CBDC accounts will likely sit side by side, they are in for a bumpy ride. And central banks will need to make sure that both are wearing their seat belts.