Comments on Fed CBDC Paper

Last month, the Federal Reserve issued a long-awaited discussion paper on the possibility of introducing a central bank digital currency (CBDC) for retail use. The Fed paper calls for comments on the benefits and risk of introducing a U.S. CBDC, as well as on its optimal design. In this post, we respond to each of the 22 questions posed in the discussion paper. For the most part, these responses are based on our previous analyses of CBDC (here and here).

At the outset, we highlight our doubt that the benefits of a U.S. CBDC will exceed the risks. In our view, other, less risky, means are available to achieve all the key benefits that CBDC advocates anticipate. Moreover, we are not aware of sustainable design features that would reduce the risks of financial instability that many analysts agree will accompany the introduction of a digital U.S. dollar.

However, this overall judgment regarding a CBDC’s benefits and risks is sensitive to two considerations that appear in the Fed’s analysis either explicitly or implicitly. First, CBDC may be a less risky alternative to stablecoins, should regulation of the latter prove politically infeasible (see our earlier post). Second, if other highly trustworthy financial jurisdictions (with convertible currencies, credible property rights protections, and free cross-border flow of capital) offer their own CBDC, the case for a U.S. CBDC—as a device to sustain widespread use of the dollar—would become stronger.

Against this background, we applaud the Fed’s conservative approach. Most important, the U.S. authorities are not rushing to act. Instead, they are thinking carefully about the design elements, are actively engaged in public outreach, and have committed not to proceed without first securing broad public support….

Central Bank Digital Currency: The Battle for the Soul of the Financial System

While the conflict is largely quiet and out of public view, we are in the midst of an epic battle for the soul of the financial system. Central banks are thinking about whether they should substitute publicly issued digital currency for the bank-issued digital money that people use every day. How this plays out can profoundly reshape the financial system and make it less stable.

The forces driving government decisions are unusual because there is a widespread fear of losing an emerging arms race. No one wants to face plunging demand for their currency or surging outflows from their financial institutions should another central bank introduce an attractive new means of exchange. But that pressure to prepare for the financial version of military mobilization can lead to a very unstable global system that thwarts monetary control.

Central bank digital currency (CBDC) can take many forms. While some may be benign, the most radical version—one that is universally available, elastically supplied, and interest bearing—has the potential to trigger destabilizing financial shifts, weaken the supply of credit, and undermine privacy….

Big Tech, Fintech, and the Future of Credit

Lenders want to know that borrowers will pay them back. That means assessing creditworthiness before making a loan and then monitoring borrowers to ensure timely payment in full. Lenders have three principal tools for raising the likelihood of that firms will repay. First, they look for borrowers with a sufficiently large personal stake in their enterprise. Second, they look for firms with collateral that lenders can seize in the event of a default. Third, they obtain information on the firm’s current balance sheet, its historical revenue and profits, experience with past loans, and the like.

Unfortunately, this conventional approach to overcoming the challenges of asymmetric information is less effective for new firms that have both very short credit histories and very little in the way of physical collateral. As a result, these potential borrowers have trouble obtaining funds through standard channels. This is one reason that governments subsidize small business lending, and why entrepreneurs are forced to pledge their homes as collateral.

Well, new solutions have emerged to overcome this old problem. In this post we discuss how technology is increasing small firms’ access to credit. By using massive amounts of data to improve credit assessments, as well as real-time information and platform advantages to enforce repayment terms, technology companies appear to be doing what traditional lenders have not: making loans to millions of small businesses at attractive rates and experiencing remarkably low default rates.

The biggest advances are in places where financial systems are not meeting social needs….

Libra's dramatic call to regulatory action

Facebook’s June 18 announcement that it has created a Geneva-based entity with plans to issue a currency called Libra is sending shock waves through the financial world. The stated objectives of creating Libra are to improve the efficiency of payments and to ease financial access. While these are laudable goals, it is essential that we achieve them without facilitating criminal exploitation of the payments system or reducing the ability of authorities to monitor and mitigate systemic risk. In addition, any broad-based financial innovation should ease the stabilization of consumption.

On all of these criteria, we see Libra as doing more harm than good. And, for the countries whose currencies are excluded from the Libra portfolio, it will diminish seignorage, while enabling capital outflows and, in periods of stress, accelerating capital flight.

Like Bank of England Governor Carney, we have an open mind, and believe that increased competition, coupled with the introduction of new technologies, will eventually lower stubbornly high transactions costs, improving the quality of financial services globally. But in this case, we urge a closed door….

Banking the Masses: 2018 Edition

The two leading financial trends of our time are the integration of digital technology and the advance of financial inclusion. The latter involves both provision of access to those who have no account (the “unbanked”) and increased usage of financial services by those with a tenuous link to the formal system (the “underbanked”). A combination of swift technological change and government promotion is speeding the rise of inclusion.

Six years ago, the World Bank estimated that roughly 2.5 billion adults (15 or older) had no bank deposit, no formal credit, and no means of payment other than cash or barter. Stunningly, in its Global Findex Database 2017 published last month, the Bank now estimates that the number of unbanked adults has plummeted to 1.7 billion. Over the past six years, more than 1.2 billion adults have gained at least basic financial access through a financial institution or their mobile phone.

In addition to a range of technological progress, India’s government-led financial inclusion program has been the second key factor in the recent advance of inclusion. By our estimate, the gains in India account for more than one-half of the 515 million persons who acquired access globally between 2014 and 2017!

In the remainder of this post, we briefly describe the benefits of financial inclusion, and highlight key trends regarding access since 2011 as well as prospects for achieving the World Bank’s goal of universal financial access. We conclude with a short discussion of Africa, where the largest gains still lie ahead. Reflecting long-term demographic prospects, we emphasize that the advance of financial inclusion in Africa will matter for the global economy, not just for Africa.

Universal Central Bank Digital Currency?

Digital currency is all the rage. Bitcoin has more than one thousand crypto cousins. There is even a token called dentacoin, whose issuers claim it will transform dentistry! In the past, we have been clear in our views. We agree with BIS General Manager Agustín Carstens: these are exactly like past attempts of people to issue their own private money. As Carstens said on another occasion, these tokens are “a combination of a bubble, a Ponzi scheme and an environmental disaster.”

Regardless of whether the blockchain will revolutionize dental health, the appearance of cryptocurrencies has driven central banks to think about one particular aspect of their business: paper currency issuance.

In this post, we expand on some aspects of our earlier discussion of central bank digital currency (CBDC). What is it and what would its wider introduction mean for the financial system? Our conclusion is unambiguous: Watch out what you wish for! ….

Banking the Unbanked: The Indian Revolution

Financial inclusion—providing universal access to financial services and encouraging their use—is an important means for promoting economic development. As of 2014, the World Bank estimated that there were still 2 billion adults without a bank account, and many others with only a tenuous connection to the financial system (see Global Findex). Better access will boost the efficiency of the payments system, promote household savings and access to credit, and improve people’s ability to manage risk. And, as it does all of these things, financial inclusion has the potential to reduce inequality and increase economic growth. In other words, reducing the multitudes of those that are unbanked will improve the fate of the poorest of the poor. (For more detail, see our earlier post.)

India’s unprecedented effort to “bank the unbanked” through the Pradhan Mantri Jan Dhan Yojana (PMJDY), or “Prime Minister’s People’s Wealth Scheme,” is by far the largest such undertaking. Launched merely three years ago, on August 28, 2014, the mission to provide no-frills, no-minimum-balance (hereafter, JDY) bank accounts to every adult (including the one-fifth of the population living below the poverty line and the large rural population with limited access to physical bank branches) has been remarkably successful. As of this writing, more than 300 million people have opened JDY accounts. And, while initial readings suggested limited use, over time, JDY account holders look to be learning about the benefits, so that use is rising toward levels observed for bank accounts of comparable individuals. Put differently, by lowering bank transactions costs, hundreds of millions of people who lacked access to financial services are revealing a latent demand....

Walmart and Banking: It's Time to Reconsider

Guest post by Professor Lawrence J. White, NYU Stern School of Business

Overshadowed by the media attention to the proposed repeal of Obamacare, the House Financial Services Committee recently approved substantial changes in financial regulation. The House of Representatives may soon consider the proposed bill—the Financial CHOICE Act—which would make major changes in the Dodd-Frank Act.

However, when financial regulation is being discussed, there is a large elephant that isn’t in the room, but really should be: Walmart. Starting in the mid-1990s, Walmart made two separate efforts to enter banking in the United States, but was repelled both times. After its second effort was rebuffed in 2007, Walmart gave up this effort in the United States (but has since entered banking in Canada and in Mexico).

One question to ask might be, “Why should Walmart be allowed to enter banking?” But a more relevant question would be, “Why shouldn’t Walmart be allowed to enter banking?” ….

Opportunities in Finance

“We’re really only at 1% of what is possible, and probably even less than that. […] We should be building great things that don’t exist.” Larry Page, Google I/O 2013 Keynote

With the summer coming to an end, professors everywhere are greeting a new group of students. So, our thoughts turn to the opportunities and challenges that those interested in finance will face over the course of their careers.

Like many important activities, finance is constantly evolving, so the “facts” that students learn in classes today will almost certainly change rapidly. With that in mind, we always strive to find a set of core principles that will endure, so that students can build a career based both on a set of specialized skills and on a broad capacity to imagine where finance and the financial system are heading...

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Money, Banking, and Financial Markets