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Digital Currency and Banking-Sector Stability

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  • William Chen
  • Gregory Phelan

Abstract

Digital currencies provide a potential form of liquidity competing with bank deposits. We introduce digital currency into a macro model with a financial sector in which financial frictions generate endogenous systemic risk and instability. In the model, digital currency is fully integrated into the financial system and depresses bank deposit spreads, particularly during crises, which limits banks’ ability to recapitalize following losses. The probability of the banking sector being in crisis states can grow significantly with the introduction of digital currency. While banking-sector stability suffers, household welfare can improve significantly. Financial frictions may limit the potential benefits of digital currencies (Working Paper no. 23-01).

Suggested Citation

  • William Chen & Gregory Phelan, 2023. "Digital Currency and Banking-Sector Stability," Working Papers 23-01, Office of Financial Research, US Department of the Treasury.
    • Handle: RePEc:ofr:wpaper:23-01
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    More about this item

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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