Impact of Central Bank Digital Currency (CBDC) Activity on Bank Loan Loss Provisions

Impact of Central Bank Digital Currency (CBDC) Activity on Bank Loan Loss Provisions

Peterson K. Ozili, Kingsley Obiora
DOI: 10.4018/979-8-3693-0082-4.ch012
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This article explores the potential effect of central bank digital currency activity on bank loan loss provisions. The authors show that the effect of CBDC activity on bank loan loss provisions depends on the nature of CBDC activity and whether CBDC activity is regulated or non-regulated. As more people use CBDCs, it could lead to shortfall in bank deposits and increase funding risk and liquidity risk and generate a pass-through to credit risk which would require banks to increase loan loss provisions in anticipation of loan loss arising from CBDC activity. CBDC regulation may dampen this effect.
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1. Introduction

CBDC is a new digital innovation in central banking. CBDC is the digital equivalent of cash or paper money. A CBDC is issued by a central bank and may be distributed to users in partnership with banks or without involving banks (Bofinger and Haas, 2020). Customers can choose to convert their existing bank deposits to CBDC units, and the converted deposits may be held in a wallet or token; just as physical money is held in one’s pocket or in a physical wallet or purse (Ozili, 2022a). A CBDC held in a wallet or token may not be available to commercial banks for financial intermediation purposes (Ozili, 2023b). Similarly, if bank deposits are migrated to CBDC deposits, the migrated deposits may not be available to commercial banks for financial intermediation. The implication is that CBDC activity could affect banks through the migration from CBDC deposits to bank deposits and from bank deposits to CBDC deposits. The migration of deposits may give rise to risks such as liquidity risk, funding risk or credit risk.

Credit risk is the single most important determinant of the size of loan loss provision (LLP) in banks (Bhat, Ryan, and Vyas, 2019). Other than credit risk, many factors also have an indirect effect on LLP such as economic policy uncertainty (Danisman, Demir and Ozili, 2021), competition (Dou, Ryan, and Zou, 2018), regulation (Nicoletti, 2018) and SDG activities (Ozili, 2023a), among others. However, one factor that has been ignored in the literature, but could have a significant effect on LLP – although indirectly – is central bank digital currency (CBDC) activity. By CBDC activity, we mean three major CBDC activities – (i) CBDC-to-CBDC transactions, (ii) bank deposit to CBDC deposit migration, and (iii) CBDC deposit to bank deposit migration. In this paper, we show how CBDC activity might affect bank LLP.

But why is LLP important? Loan loss provision, also known as provision for credit loss, is important because it is a crucial indicator of the expected loss on bank loans (Ozili, 2018). LLP affects bank profit because LLP is a direct charge on the net interest income of banks (Ozili and Outa, 2017). If LLP is too large, it will significantly deplete bank profit and make banks unstable. If LLP is too low, it will increase bank profit and expose banks to credit risk. Therefore, finding the right size of loan loss provisions is quite difficult because bank supervisors want banks to keep sufficient loan loss provisions while bank managers want to keep few loan loss provisions. This is a major reason why there are contentions about what the size of loan loss provisions should be (Pandey, Tripathi and Guhathakurta, 2022; Ozili and Outa, 2017; Nicoletti, 2018). Bank supervisors want banks to increase LLP to make banks safe from a regulatory standpoint, but the resulting reduction in profit caused by high LLP could send a bad signal to bank shareholders and could increase the risk of bank managers losing their job (Kanagaretnam, Lobo and Mathieu, 2003; Nicoletti, 2018). On the other hand, bank managers want to keep very low LLP to increase the probability of receiving contractual rewards that depend on the size of bank profit. This conflict makes LLP an important accounting number in the banking sector and in the banking literature.

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