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Morgan Stanley has a note out today on the digital euro, the European Central Bank’s grasp to retain monetary sovereignty in an increasingly paperless union.
Work on a eurozone Central Bank Digital Currency began in earnest in November, with two years allocated for the preparation phase. There’s a lengthy Q&A on the ECB website explaining what ECBitcoin will and won’t be, which includes lots of reassurances about inclusivity and privacy protection and not much on its potential to accelerate bank runs:
The ECB will minimise any potential threat a digital euro may pose to the financial system. Thus, the amount of digital euro that users can hold in their accounts will be limited to prevent outflows of bank deposits, even in times of crisis.
Allowing depositors to switch to a CBDC wallet on the first whiff of panic creates a risk-free, frictionless way to drain a banking system of stable funding. Harsh capital controls would nullify the whole project. Finding the middle ground is tricky.
This problem is particularly relevant because, absent a bank run, it’s not obvious yet why households would bother with ECBitcoin at all. It won’t pay interest (so is also useless for setting monetary policy) and won’t be programmable like private cryptocurrencies. As proposed, it’s just a banknote that’s on your phone rather than under your mattress.
Morgan Stanley analysts Giulia Aurora Miotto and Kerry Shaw assume digital euro deposits are capped at €3,000, which matches the recent guidance from ECB officials (such as here, here and here). They reckon the potential outflows would be manageable overall, though if everyone maxxed out their allocations panic would be ugly at the periphery:
Given that payments currently work already fairly well in the Eurozone, it is unclear what the incentive would be for households to start using the digital euro, and hence think more likely that households would end up using only a part of the €3,000 limit, and replacing part deposits and part banknotes with digital euro. However, in order to size the potential maximum impact to banks’ P&L, a scenario we think would be unlikely but possible, for example in times of financial distress, we have assumed that everyone older than 15 years in the Eurozone decides to convert €3,000 from deposits to digital euro. This could theoretically reduce euro area total deposits (defined as households’ and non financial corporations’ deposits) by €873bn, or 7%, and increase the loan-to-deposit ratio (LDR) from 98% to 106%. Banks in aggregate would hardly notice this change: LDR was last at 106% in 2019, and the significant surge in deposits brought about by the pandemic led it to fall below 100%.
Yet, looking at the detail by country shows that banks in smaller countries (in particular Latvia, Lithuania, Estonia, Slovakia, Slovenia and Greece), could theoretically be impacted harder than the average.
We think, however, that our bear case scenario is unlikely for these smaller countries because converting €3,000 of deposits into digital euro would be equivalent to converting 30% to 45% of total household deposits (hence including term deposits) into CBDC.
Although we don’t have data available, we suspect the median deposit is actually lower than €3,000 in some of these countries. If instead we assume that the maximum amount any citizen above 15 yrs would want to convert from deposits into CBDC would not be higher than 12% of their deposits (which is what €3,000 represents for the euro area in aggregate), then the impact on total bank deposits wouldn’t be higher than 9% (in the case of Greece), and the change in LDR would not be as large for lower GDP per capita countries.
Commercial banks that don’t want to shrink will need to substitute their lost deposit funding. Increased reliance on wholesale markets chokes off “a key differentiator amongst banks, the ability not to pass through a high rate on deposits”, Morgan Stanley says.
Cheap central bank lending could help close the gap, though this would increase demand for qualifying collateral and drive up the cost of safe assets. The overall effect is to make commercial banks even more sensitive to interest rates:
[I]f banks were to replace these deposits with wholesale funding, at [euro short-term rate], which is currently around 4%, then the impact on aggregate profits for Eurozone banks would be ~17%, or a 1pp impact on ROE: manageable but material. The impact however would reduce to 50bps of ROE, or 8% of earnings, if wholesale funding were available at 2%, which is the neutral rate expected by 2026 by our economists.
Anything else to worry about? Yep. Basel III ❤️ deposits. Bleed to the digital euro would erode banks’ Net Stable Funding Ratios as well as Liquidity Coverage Ratios. The ECB’s own simulation show that if the CBDC proves too popular, liquidity weakens significantly:
Building out the distribution infrastructure for the digital euro isn’t a costless exercise either — though assuming a launch in 2027 at the earliest that’s likely to be the next CFO’s problem.
Morgan Stanley had a handy crib sheet on what the banks have said about the digital euro. The common responses so far are “wait and see” and “why bother?”, with only CaixaBank (developer of the ECB’s prototype coin) vocally excited by the prospect. With Banco de España pushing forward with its own apparently blockchain-based CBDC that’s independent of the ECB project, there may be some politics involved in that position.
