OFR, Report: Digital Currency and Banking-Sector Stability

“Digital currencies have the potential to greatly reshape the financial sector. We provide a macroe­conomic model with a financial sector in which digital currencies coexist with bank deposits and households hold both forms of liquidity. Our main theoretical result is that when banks face financial frictions (costly equity issuance), digital currency harms financial stability, increasing the like­lihood of crises and financial distress. Digital currencies depress deposit spreads, which hinders banks’ abilities to recapitalize following losses. Digital currency, whether privately or publicly issued, is likely to be detrimental to financial stability, and bank valuations can be significantly harmed. Despite the costs to financial stability, we find that digital currency can be welfare improving for households. In our benchmark calibration, the welfare-maximizing level of digital currency increases household welfare by 2.8% of consumption-equivalent, even as the probability of crises doubles from 3 to 6%. Our results suggest that financial frictions may limit the potential benefits of digital currencies, and the optimal level of digital currency may be below what would be issued in a competitive environment.”