A well-designed digital euro would avoid risks for financial stability and banks’ profitability

The European Commission adopted today a legislative proposal to introduce a new digital form of money in the EU. The creation of a digital euro —equivalent of the physical cash and also issued by the European Central Bank—could play an important role in supporting the EU’s economy in a world that is becoming more and more digital.

But if not properly designed, the digital euro might pose risks to financial stability.

To help prevent any negative impact, scientists of the Joint Research Centre (JRC) have recently publish two reports that anticipate and shed light on the potential consequences: Central bank digital currency and European banks’ balance sheets (published today) and Bank profitability and central bank digital currency. Below, a synopsis of the research outcome.

Effects on the financial system

The reports, authored by the JRC scientific team working on anticipation and analysis of financial risks, in collaboration with the Commission’s department for Economic and Financial Affairs (DG ECFIN), analyse the implication of a retail-only digital euro on banks’ balance sheets and profitability.

The results of the research and the different scenarios modelled acknowledge that a digital euro might divert funding flows from bank deposits. This could threaten one of the most important financial sources of banks and, especially, of smaller banks: households’ deposits.

Impact on banks’ balance sheet

Nevertheless, the study found that a digital euro take-up of less than 3 000 euros per household would not pose any significant risks to financial stability.

Higher demand due to a widespread adoption of the digital currency could lead to a shift in funding sources and structural changes in balance sheets (i.e. banks might have to rely on funding sources other than deposits, like increasing the usage of reserves with central bank and/or the wholesale market for funding).

Consequences on banks’ profitability

With regard to small banks —which normally rely mostly on deposits as a source of funding— the challenges could be more substantial.

Small banks could face a potential decrease in profitability if demand for the digital euro reaches high levels: in a large-demand scenario, banks’ return on equity (ROE) might go down from an average value of 3.7% to 2.4%, without considering any other adjustment.

Macroeconomic implications

The presence of a digital currency generally produces only small changes in the response of the economy to macroeconomic shocks, especially with a cap on digital cash.

In particular, with a cap on digital euro take-up, the macroeconomic impact of a bank run is similar to the case of a cash-only economy.

Why a Digital Euro?

The European Central Bank only issues cash money. Cash is, at the moment, the only current form of central bank money available to the public and it is different from “private money” (or the money people have in their bank accounts). But cash alone is not any more sufficient to support the EU’s economy in the digital age.

As matter of fact, use of cash has declined consistently, as it does not satisfy today and tomorrow’s payment habits and/or needs, i.e.: it does not have the features required for remote instant payments and does not cater for the same type of demand as digital money (e.g. e-commerce).

Nowadays, businesses and consumers are shifting their payment preferences towards digital means of payment: card payments, transfers and other types of digital transactions are made through the platforms offered by banks, or other platforms available in the market.

Therefore, the creation of a European public digital money could play an important role in supporting the EU’s economy in a world that is becoming more and more digital.

A digital euro — issued by the European Central Bank and totally equivalent of the cash euros— would preserve the role of public money and it would ensure that central bank money remains present, available and accepted by everyone without affecting the role of cash.

The Commission’s proposal of supplying public money in digital form would also contribute to strengthening the international role of the euro and Europe’s open strategic autonomy against other currencies, such as third country central bank digital currencies.  In addition, this proposal would enhance the digitalisation of the European economy and reduce costs related to cross-border payments, by ensuring that the euro remains present and influent on financial markets and supports the EU’s economy in the digital age. A possible digital Euro, therefore, needs to be carefully designed to avoid possible risks to financial stability.