Digitization has made possible to conduct many banking operations without visiting a branch, which has been vital to the industry growth. However, the core idea behind the banking system has remained largely the same for the past few centuries.
The introduction of digital currencies has made banking much more convenient, but its potential to revolutionize the banking model has yet been fully unveiled.
Many experts argue that the introduction of the Central Bank Digital Currency (CBDC) can have an immense impact on the banking system. Potentially, it can enable much more efficient transaction monitoring, reduce fraud, make banking more inclusive, and decrease operational costs by eliminating the need for physical branches.
This will impact the nature of banking software, too, as the technological foundation of CBDC will most certainly be blockchain, the technology that underpins Bitcoin. This isn’t surprising as blockchain ensures transaction security, provides transparency and decentralizes money storage.
The current banking system
To understand how exactly CBDC can make banking better, we need to recall the basics of the current banking model.
Businesses or individuals make deposits with banks. Banks use the depositors’ money to make loans while reserving around 10% of the total amount for depositors to withdraw. Essentially, banks profit from the difference between the interest they pay to depositors and the interest they receive from loans.
The catch here is that when someone borrows money from a bank, this loan is considered another deposit, which can be lent to someone else. So this process becomes an ever-repeating cycle, enabling banks to lend significantly more money than they have in reserve.
While this is an inherently good concept that has a largely positive impact on the economy, it has also proven quite risky. There is a myriad of reasons for borrowers to become unable to pay the debt, the deposit interests may become higher than the loan ones, and depositors may want to withdraw more cash than a bank has. When any of these scenarios happen, the implications are somewhat alleviated by the financial support from a central bank, which has paper cash as its liability.
Currently, digital cash is a liability of an issuing bank. This digital form of money is valuable and safe because it’s backed by paper cash. However, as we’ve figured out, issuing banks may have insufficient amounts of paper money for depositors to withdraw. CDBC can enhance the current banking system by transferring the liability for digital currencies from commercial banks to a central bank. In other words, a central bank becomes responsible for digital currencies, just as it’s responsible for paper cash. This makes digital currencies a much safer form of money to deposit.
With CBDC in play, depositors are faced with little to no risks, as their money is essentially backed by the government and not by a commercial bank that may or may not have enough capital. As a result, liquidity risks are getting carried by all the banking system depositors, and not by depositors of a particular commercial bank. CBDC also lowers the entry barrier for new competitors, as no bank will be able to claim that it’s more secure than any other bank.
Significantly, CBDC will also dramatically lower the costs of running the banking system. In an all-in CBDC scenario, customers will no longer require cash deposits, resulting in physical branches becoming completely irrelevant. It will also significantly increase payment processing speeds and decrease the associated costs, especially relevant for cross-border payments.
Today’s regulators are forced to rely on financial reports provided by banks to detect suspicious transactions, address fraud, and identify any other issues that banks can face. This causes regulatory bodies to solve problems with significant delay. Given that blockchain underpins CBDC, regulators will have a more transparent view of the whole banking system and can react to issues much faster.
With the overall digitization of our world, the shift to a no-cash economy seems inevitable. With a well-thought-out CBDC implementation strategy, the banking industry is destined to change for good. It will end the disproportionate advantage that established banks have, lower the entry barrier for new industry players, and decrease the majority of risks that the current banking system faces. In addition, CBDC will facilitate banks to compete based on their ability to provide value through better customer experiences and faster services rather than brand reputation and several physical branches.