Digital Currency and Banking-Sector Stability

Abstract

We introduce digital currency into a macro model with a banking sector in which financial frictions generate endogenous systemic risk and instability. In the model, digital currency is fully integrated into the financial system. Issuance of digital currency significantly increases the probability of a banking-sector crisis because it depresses bank deposit spreads, particu- larly during crises, which limits banks’ ability to recapitalize following losses. While banking- sector stability suffers, household welfare can still improve significantly. Financial frictions nevertheless limit the potential benefits of digital currencies. The optimal level of digital cur- rency could be below what would be issued in a competitive environment.

Keywords: Financial stability, Macroeconomic instability, Financial frictions, CBDC, Stablecoins