Payment System Externalities and the Role of Central Bank Digital Currency

Abstract

We construct a model to examine how the payment processing role of banks affects their lending activity. In our model, banks operate in separate zones, and issue claims to entrepreneurs who purchase some inputs outside their own zone. Settling bank claims across zones ex post incurs a cost to a bank that is a net payer. We show that, in equilibrium, a liquidity externality arises when zones are sufficiently different in their outsourcing propensities. That is, a bank may restrict its own lending as a result of the need to hold liquidity against claims issued by another bank. The settlement cost dampens the size of this externality. We interpret wholesale Central Bank Digital Currency (CBDC) as a device that reduces the settlement cost, and show that it exacerbates lending inequalities across zones. Retail CBDC unambiguously increases lending in the model, and also increases the effectiveness of monetary policy implemented through reserves.

Keywords: Payment Systems, Banks, Central Bank Digital Currency

JEL Classification: G21, E51