Resilience of bank liquidity ratios in the presence of a central bank digital currency

Key messages

  • To estimate the potential impact a central bank digital currency (CBDC) could have on bank liquidity, we use pre-pandemic data (January 2020) to perform a hypothetical exercise under four increasingly severe scenarios. As part of this exercise, we raise the run-off rates on the volume of funding equal to transactional retail deposits (i.e., chequing and savings) in the:
    • liquidity coverage ratio (LCR) of the Big Six1 and seven medium-sized Canadian banks2
    • net stable funding ratio (NSFR) of the Big Six
  • Our results represent an upper bound estimate of how a CBDC could affect bank liquidity because the scenario assumptions overestimate the potential shock that could arise from issuing a CBDC. They do not reflect what could occur or represent any predictions.
  • We find that, due to their large liquidity holdings and diversified funding portfolios, Canadian banks should continue to meet their regulatory liquidity requirements after a cash-like retail CBDC is issued.
  • We expand on previous work by García et al. (2020), which also concludes that a CBDC does not pose a significant concern for financial stability. Recent work by the Bank of England (2021) also finds that, given their large liquidity holdings, banks could withstand the introduction of new forms of digital currency.3

CBDC could compete with retail transactional deposits

A cash-like retail CBDC is simply cash in digital form—an instrument meant for retail transactions that bears no interest. A Canadian CBDC with these features would compete with individual and small business (i.e., retail) chequing deposits as well as low-interest savings deposits, particularly those used for transactions, which we refer to as “transactional retail deposits” in this note. Issuing a CBDC would therefore increase competition for transactional retail deposits in Canada (see Usher et al. 2021), changing the profile of bank funding.4 The Bank of Canada (2020) does not see an immediate need to issue a CBDC but is continuing its work to develop the capability if it were to become desirable in the future.

Retail deposits are a stable funding source for banks because they are less likely to be withdrawn or run off the balance sheet, either in normal times or a stress event.5 On average, Canada’s Big Six banks attain about 30% of their funding from retail deposits, with one-third of that amount coming from transactional retail deposits (Chart 1). In contrast, the seven medium-sized banks rely on retail deposits for almost 50% of their funding, but, on average, only 6% of total funding comes from transactional retail deposits. Overall, the Big Six tend to rely less on retail deposits for funding than the medium-sized banks do because they have better access to capital markets and wholesale deposits (see Truno et al. [2017] for more on wholesale funding). Most of the funding for deposits for medium-sized banks comes from rate-sensitive deposits, such as brokered deposits and high-interest savings accounts (HISAs), which are not often used for transactions.6 As a result, these deposits are less likely to face competition from a cash-like non-interest bearing CBDC.

Chart 1: Medium-sized banks tend to have relatively fewer deposits that would compete directly with a CBDC

Note: The volume of retail deposits reported in the chart also includes notice deposits that are stable, short-term and not rate-sensitive. Rate-sensitive deposits include high-interest savings accounts, brokered deposits and uninsured deposits. Longer-term deposits are those that have a fixed term (such as a guaranteed investment certificates) with a maturity greater than 30 days. Rate-sensitive or term deposits would not compete as directly with a central bank digital currency (CBDC) as transactional retail deposits would.
Sources: Office of the Superintendent of Financial Institutions’ regulatory returns, liquidity coverage ratio (LCR) and balance sheet (M4) of the Big Six and seven medium-sized banksObservation date: January 31, 2020

A CBDC could reduce the funding stability of banks through two mechanisms:

  • Stability. Transactional retail deposits could become more susceptible to being withdrawn because CBDC creates a new risk-free digital product that depositors can substitute for cash and deposits. Hence, deposits that compete with CBDC could become less stable and run off the balance sheet at higher rates in both normal times and periods of stress.
  • Volume. If the Bank were to issue a CBDC, depositors may choose to move a share of their transactional retail deposit balances to CBDC permanently, reducing the volume of deposit funding available to banks. If banks want to maintain the size of their balance sheets, they will need to turn to substitute sources of funding. Depending on the substitute used, the effect on banks’ funding stability could be negative, neutral or positive.7

Introducing a CBDC could therefore result in bank funding becoming less stable through either mechanism or a combination of both.

The potential impact of a CBDC on banks’ regulatory liquidity ratios

Reduced stability and volume of retail deposit funding could make it harder to meet regulatory liquidity requirements. Under the Basel III framework, the Basel Committee on Banking Supervision (BCBS) proposes that banks meet two minimum liquidity standards: the LCR and the NSFR. In Canada, the Big Six banks must comply with both, while the seven medium-sized banks only need to comply with the LCR. We focus our analysis on these two ratios to understand how a CBDC would affect Canadian bank liquidity.8

The LCR ensures that banks have enough liquid assets to withstand a short-term liquidity stress scenario. To meet the LCR, banks must hold sufficient stock of unencumbered high-quality liquid assets (HQLAs), such as cash and cash equivalents, to cover net cash outflows during a 30-day liquidity stress scenario (Equation 1). The LCR scenario assumes a combined idiosyncratic and market-wide shock similar to the 2007–08 global financial crisis. In Canada, all federally regulated financial institutions are required to report their LCR and maintain a regulatory minimum of 100%.

\(LCR=\frac{High{\text -}quality\ liquid\ assets\ (HQLA)}{Net\ cash\ outflows}\geq100\% \qquad(1)\)

Under the LCR, deposits contribute to cash outflows because some are assumed to run off the balance sheet during a stress event. Since transactional retail deposits are quite stable and therefore unlikely to be withdrawn, banks need to hold only a small amount of HQLAs to cover potential cash outflows. In Canada, under the LCR, these deposits are assumed to have a run-off rate of 3% to 5%. This is low compared with more rate-sensitive retail deposit types, such as brokered deposits or HISAs, which carry run-off rates of up to 40%. Banks need to hold more HQLAs to cover these types of funding sources, making them less attractive from an LCR standpoint.

The NSFR requires banks to maintain a stable funding profile by limiting reliance on short-term funding. It is intended to ensure that, in normal times, banks have sufficient stable funding to cover assets and off-balance-sheet activities that require funding over the next 12 months (Equation 2). Similar to the LCR, NSFR assumes that 5% of retail transactional deposits would run off over a 12‑month period, therefore 95% would remain on the balance sheet as available stable funding (numerator).

\({NSFR}=\frac{Available\ stable\ funding\ (ASF)}{Required\ stable\ funding\ (RSF)}\geq100\% \qquad(2)\)

A CBDC would reduce LCR and NSFR through higher run-off rates in the denominator and numerator respectively, assuming banks maintain the size of their balance sheet and substitute funding is less stable. How sensitive a bank would be to CBDC depends partly on its starting LCR and NSFR. Most Canadian banks hold buffers well above the regulatory minimum of 100% (Chart 2). The weighted-average LCR for the Big Six and seven medium-sized banks stood at 140% and 183%, respectively, in January 2020, and the weighted-average NSFR was at 111% for the Big Six. The larger the buffer, the more room banks will have to react to changes in the stability and availability of transactional retail deposit funding.

The impact of a CBDC on a bank will also depend on how much it relies on transactional retail deposit funding relative to other funding sources and the regulatory liquidity profile of those sources. For instance, the percentage of cash outflows in the LCR from transactional retail deposits was just above 2% for the Big Six and seven medium-sized banks in January 2020 (Chart 2, panel a). The small outflow is both because transactional retail deposits are stable during a short-term stress and because banks rely on them for less than 10% of their funding (Chart 1). Similarly, in the NSFR 20% of available stable funding over a 12‑month period is from deposits that compete with CBDC (Chart 2, panel b).

Chart 2: Canadian banks maintain liquidity buffers significantly higher than the minimum requirements

Chart 2: Canadian banks maintain liquidity buffers significantly higher than the minimum requirements

Notes: Panel a reports the weighted average of the liquidity coverage ratio (LCR), which is computed by taking total high-quality liquid assets divided by net cash outflows (after cap is applied, as established by the liquidity adequacy requirements [Chapter 2, 2.2.B.2. paragraph 124] of the Office of the Superintendent of Financial Institutions [OSFI]). Panel b reports the weighted average of the net stable funding ratio (NSFR) is computed by taking total available stable funding divided by total required stable funding. “Transactional retail deposits” refers to all deposits classified as “stable” in both the LCR and NSFR definitions. CBDC stands for central bank digital currency.
Source: Office of the Superintendent of Financial Institutions’ regulatory returns of the Big Six and seven medium-sized banksObservation date: January 31, 2020

Stress testing the LCR and NSFR under four increasingly severe scenarios

To estimate the impact of a CBDC on bank liquidity, we conduct a hypothetical exercise where we increase the run-off rates on transactional retail deposits funding. We assume that CBDC adoption increases the run-off rates of the deposits that remain on balance sheets (stability mechanism). We also assume that the remaining portion of deposits is replaced with alternatives that have higher run-off rates (volume mechanism). Regardless of the share of funding that remains on balance sheet or is replaced, we assume that the total portion of funding that competes with a CBDC would be less stable and therefore have a higher run-off rate. How much run-off rates increase will depend on the change in deposit behaviour and the substitute funding chosen. We run four hypothetical scenarios with increasing run-off rates based on the run-off rates currently assigned to a variety of funding sources (see the Appendix for run-off rates).

The scenarios are highly stylized and could occur due to a combination of plausible events (Table 1). Scenario 1 could occur if banks:

  • retained 50% of their transactional retail deposit funding—which we assume would have a run-off rate of 10% after the issuance of a CBDC
  • replaced the remaining 50% with funding that has a 10% run-off rate, such as non-transactional retail deposits or certain collateral swaps

Scenario 2 could result from deposits’ run-off rates increasing to 10%, combined with substitute funding with 30% run-off rates, i.e., brokered term deposits.

Scenario 3 could be due to deposits’ run-off rates increasing to 30%, combined with brokered term deposits as substitute funding.

Finally, Scenario 4 could happen if both deposits and substitute funding had run-off rates of 40%, which is that of retail brokered demand and uninsured wholesale deposits.

Table 1: Scenarios

Table 1: Scenarios
Funding that competes with CBDC Value Original run-off rate Liquidity standard stressed Simulated run-off rates
Transactional retail deposits Can$575 billion 3% to 5% LCR and NSFR 10% (Scenario 1)
20% (Scenario 2)
30% (Scenario 3)
40% (Scenario 4)

Note: Here we use “transactional retail deposits” to refer to all deposits that are classified as “stable” in the liquidity coverage ratio (LCR) or net stable funding ratio (NSFR) for the Big Six and the seven medium-sized banks. These deposits are primarily transactional, although they may also include some other non-maturity deposits.

In Canada, the volume of funding across the banking system in January 2020 that could have competed with a CBDC, had one been issued, was approximately Can$575 billion. This amount had a run-off rate of 3% to 5% in the LCR and 5% in the NSFR. As described in Table 1, we conduct stress testing of this funding source for the Big Six and seven medium-sized banks by first increasing the run-off rate to 10%. This amount represents the next regulatory risk bucket and the run-off rate of some of the substitute funding.9

We overestimate the volume of funding that could face competition from a CBDC and how unstable it could become. We do so by assuming all individual and small business transactional retail deposits face competition from a CBDC (Can$575 billion, Table 1). In practice, fewer deposits would be affected or displaced because a CBDC would only provide the same service as cash and would not pay interest.

We also increase run-off rates significantly compared with their current levels. For instance, Scenario 1 assumes run-off rates for transactional retail deposits double or triple, while our most severe scenario, Scenario 4, assumes run-off rates are 8 to 12 times greater than the original rates. The characteristics of the funding sources that would have Scenario 4 run-off rates are quite different than the deposits that would be sensitive to a CBDC and therefore represents an overestimate of the potential increase in run-off rates. Additionally, banks could use multiple alternative funding sources with low run-off rates as substitutes. The scenarios thus simulate an extreme and improbable impact to bank regulatory liquidity from the introduction of a CBDC.

The last assumption we make is that banks do not shrink their balance sheets or change business models in response to a potential reduction in volume or change in behaviour of transactional retail deposits. In essence, the impact is modelled as if a CBDC were introduced today, without notice.10 The overall amount of funding on the balance sheet remains unchanged, but its composition differs. In reality, banks would have time to adjust because the Bank of Canada and the Department of Finance Canada would communicate to the public the progress on the contingency plans to issue a CBDC.

Bank regulatory liquidity could withstand the shock of a CBDC

On average, Canadian banks would continue to meet their LCR and NSFR requirements after a CBDC were introduced. In the most extreme scenario, when run-off rates are increased 8 to 12 times the original rates (Scenario 4), the LCR for the Big Six banks remains, on average, 8 percentage points above the minimum requirement of 100% (Chart 3). Under a less severe scenario (Scenario 1), the LCR remains, on average, 32 percentage points above the 100% requirement, 8 percentage points lower than the starting LCR ratio.

Chart 3: Big Six banks could still meet LCR after a CBDC is introduced

Note: The chart reports the weighted average liquidity coverage ratio (LCR) for the Big Six banks. CBDC stands for central bank digital currency.
Source: Office of the Superintendent of Financial Institutions’ regulatory returns of the Big Six banksObservation date: January 31, 2020

The seven medium-sized banks, on average, are also able to maintain an LCR above the regulatory requirement in all scenarios (Chart 4). However, the starting LCR and overall funding profiles for these banks vary more than those of the Big Six banks. The average is therefore less informative. Nonetheless, as can be expected, a CBDC generally has a greater impact on medium-sized banks that rely more on transactional retail deposits for a large share of funding.11

Chart 4: Most medium-sized banks could withstand the shock of a CBDC

Note: The chart reports the weighted average liquidity coverage ratio (LCR) for the seven medium-sized banks. CBDC stands for central bank digital currency.
Source: Office of the Superintendent of Financial Institutions’ regulatory returns of the medium-sized banksObservation date: January 31, 2020

For both groups of banks, we find that for every 10 percentage point increase in the run-off rate, the LCR decreases approximately 6% versus the original LCR. Given both group’s shares of net cash outflows from transactional retail deposits were almost equivalent before introducing a CBDC, the relative impact of a CBDC on the LCR is expected to be similar.

Turning to the NSFR to understand the effects on banks’ overall funding profile, we find that, on average, the Big Six banks continue to meet their regulatory requirement in all four scenarios (Chart 5). We find that even under the most severe scenario, on average, the Big Six maintain an NSFR above the requirement, at approximately 102%. In Scenario 1, the NSFR ratio decreases by only 1 percentage point, on average, from 111% to 110%. Under the subsequent scenarios, every 10 percentage point increase in run-off rates results in a decrease in the NSFR of approximately 3 percentage points.

Chart 5: Big Six banks would maintain healthy funding profiles following the issuance of a CBDC

Note: This chart reports the weighted average net stable funding ratio (NSFR) for the Big Six banks. CBDC stands for central bank digital currency.
Source: Office of the Superintendent of Financial Institutions’ regulatory returns of the Big Six BanksObservation date: January 31, 2020

For robustness, we ran four additional scenarios not shown, where we assumed transactional retail and rate-sensitive deposits faced competition from a CBDC. We found that even with double the volume of deposits affected, banks in most scenarios could withstand the shock of a CBDC.

Further considerations and conclusion

We perform our analysis using liquidity risk ratios designed in a world without a CBDC. Questions remain around the behaviour of participants in the banking system in a world with a CBDC. For instance, in the case of a systemic risk event, deposit withdrawals from the banking system may be greater than in an environment where no comparable digital alternatives to bank deposits exist (Juks 2020). However, this risk could be mitigated if central banks set caps on CBDC holdings or lend the deposits that were transferred to CBDC back to the banking system, as proposed by some central banks (Bindseil 2020; Juks 2020). Further empirical work is needed to better understand:

  • the implications of a CBDC on bank assets and revenue models
  • whether significant changes to banks could cause negative knock-on effects on financial stability or the real economy

In conclusion, we find that banks could still meet their regulatory liquidity requirements under four increasingly extreme scenarios even if a CBDC was highly competitive with transactional retail deposits. Banks would continue to be able to cover large cash outflows during a short-term stress event and would still have sufficient funding to meet their obligations over the long term. This is the case even under our extreme assumptions where:

  • banks do not adapt their business models and therefore maintain the size of their balance sheets
  • CBDC is highly competitive with transactional retail deposits
  • the central bank does not lend back CBDC deposits to the banking system

Given the severity of the scenarios and assumptions, our analysis presents an upper bound estimate of the potential impact a CBDC could have on bank regulatory liquidity ratios. These findings are in line with previous research conducted by the Bank of Canada (García et al. 2020) and the Bank of England (2021), which also conclude that a CBDC or other forms of digital money do not pose a financial stability threat from a liquidity standpoint.

Appendix

Table A-1: Substitute funding options

Table A-1: Substitute funding options
LCR run-off rates Retail deposits Wholesale funding sources
0% Term deposits with a remaining maturity of greater than 30 days Secured funding with domestic central bank
Secured funding backed by Level 1 assets
Other debt securities with remaining maturity greater than 30 days (e.g., senior unsecured debt)
3% to 5% Stable deposits (transactional retail deposits, i.e., chequing and savings) Operational (transactional) wholesale deposits
10% Less stable deposits (non-transactional, un-insured deposits, relationship HISAs, etc.) Certain collateral swaps
15% Secured funding backed by Level 2A assets
20% Non-relationship non-brokered HISAs Insured wholesale deposits
25% Secured funding backed by Level 2B/non-high-quality liquid assets
30% Brokered term deposits
40% Brokered demand deposits Uninsured wholesale deposits

Note: Recall that the liquidity coverage ratio (LCR) looks at a 30-day stress situation, while the net stable funding ratio (NSFR) considers a 1-year horizon in normal times. NSFR run-off rates for retail deposits align with the LCR. Run-off rates for most other funding sources have a 50% run-off rate, with funding instruments with a remaining maturity of greater than 1 year (i.e., beyond the NSFR time frame) having a 0% run-off rate. The difference in run-off rates between the two ratios reflects the differing stress situations and time frames. HISA refers to high-interest savings account.

References

Bank of Canada. 2020. “Contingency Planning for a Central Bank Digital Currency.” (February 25).

Bank of England. 2021. “New Forms of Digital Money.” Discussion paper.

BCBS. 2013. “Literature Review of Factors Relating to Liquidity Stress—Extended Version.” Basel Committee on Banking Supervision Working Paper No. 25

BCBS. 2013. “Basel III: The Liquidity Coverage Ratio and Liquidity Risk monitoring tools.”

BCBS. 2014. “Basel III: the net stable funding ratio.”

Bindseil, U. 2020. “Tiered CBDC and the Financial System.” European Central Bank Working Paper Series No. 2351.

García, A., B. Lands, X. Liu and J. Slive. 2020. “The Potential Effect of a Central Bank Digital Currency on Deposit Funding in Canada.” Bank of Canada Staff Analytical Note No. 2020-15.

Juks, R. 2020. “Central Bank Digital Currencies, Supply of Bank Loans and Liquidity Provision by Central Banks.” Sveriges RiksBank Economic Review 2: 62–79.

Li, J. 2021. “Predicting the Demand for Central Bank Digital Currency: A Structural Analysis with Survey Data.” Bank of Canada Staff Working Paper No. 2021-65.

Truno, M., A. Stolyarov, D. Auger and M. Assaf. 2017. “Wholesale Funding of the Big Six Canadian Banks.” Bank of Canada Review (Spring): 42–55.

Usher, A., E. Reshidi, F. Rivadeneyra, S. Hendry. 2021. “The Positive Case for a CBDC.” Bank of Canada Staff Discussion Paper No. 2021-11.

Acknowledgements

For helpful feedback and suggestions, we thank Alejandro García, Natasha Khan, Bradley Howell, Xuezhi Liu, Harsimran Grewal, Francisco Rivadeneyra and Maarten van Oordt.

  1. 1. Canada’s Big Six banks are federally regulated financial institutions that have been designated as systemically important to the Canadian financial system by the Office of the Superintendent of Financial Institutions. They are the Royal Bank of Canada, Toronto Dominion Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce and National Bank of Canada.[]
  2. 2. The seven medium-sized banks are the HSBC Bank Canada, Laurentian Bank of Canada, Canadian Western Bank, Equitable Bank, Coast Capital Savings Federal Credit Union, Manulife Bank of Canada and Home Trust Company. All are federally regulated financial institutions each with total assets of approximately Can$20 billion or more.[]
  3. 3. The Bank of England finds that “in aggregate, given existing liquidity resources, the banking system should be able to withstand sudden deposit outflows” due to the introduction of new forms of digital currency (Bank of England 2021).[]
  4. 4. The Bank of Canada is conducting further research on how different CBDC designs could affect the demand for deposits. See Li (2021).[]
  5. 5. Previous literature has found that the probability of a run on retail deposits decreases when customers have an established relationship with the bank or if they use their account for transactions, such as an automatic deposit of a pay cheque, for example (BCBS 2013). Additionally, retail deposits are a relatively inexpensive funding source for banks (Truno et al. 2017).[]
  6. 6. Brokered deposits are those where the depositor has a relationship with a broker rather than with the bank. The broker places a deposit with a bank on behalf of the depositor. These deposits tend to be more rate-sensitive than traditional deposits and are often term rather than demand.[]
  7. 7. Substituting funding sources would also affect bank profitability and could influence the dynamics of the substitute funding market. Alternatively, banks could respond by adjusting their business models or reduce their balance sheets, which could affect the real economy. We focus only on the effects on the LCR and NSFR, assuming banks can and desire to maintain the size of their balance sheets.[]
  8. 8. Canadian definitions of LCR and NSFR are provided in the Liquidity Adequacy Requirements (LAR) guideline Liquidity Adequacy Requirements (LAR) Guideline (chapters 2 and 3) published by the Office of the Superintendent of Financial Institutions. These definitions generally align with international standards published by the Basel Committee on Banking Supervision.[]
  9. 9. As with the overall guidelines, LCR and NSFR run-off rates are developed by the Basel Committee on Banking Supervision (BCBS 2013, 2014) as part of the international liquidity framework (see Basel III: The Liquidity Coverage Ration and Liquidity Risk Monitoring Tools [January 2013] and Basel III: The Net Stable Funding Ratio [October 2014]).[]
  10. 10. If the exercise were repeated with 2022 data, the impact of a CBDC on bank regulatory liquidity would be even less because banks have increased their LCRs and NSFRs since the onset of pandemic.[]
  11. 11. Liquidity ratios can drop below the minimum regulatory requirement during a stress event.[]

Disclaimer

Bank of Canada staff analytical notes are short articles that focus on topical issues relevant to the current economic and financial context, produced independently from the Bank’s Governing Council. This work may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this note are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.

DOI: https://doi.org/10.34989/san-2022-5