A Banking system based on Digital Currency: Possible?
According to a report published by the Bank of England, there are significant barriers to any digital currency, as currently designed, becoming the dominant form of money in an economy. This also presents significant challenges to the emergence of a banking system denominated in a digital currency.
Notwithstanding, it is at least conceivable that a financial institution could issue IOUs to the public that were denominated in a digital currency. If an institution issuing such claims were to back them one-for-one with actual digital currencies, it would amount to a form of ‘narrow banking’ — the general public’s holdings of assets denominated in the digital currency would not have changed.
In such a setting, and if the digital currency were somehow to achieve widespread usage, then if demand for that digital currency were to grow while its supply remained fixed, an incentive would exist for financial institutions to create extra instruments (for example, by extending loans) that were not fully backed. This would create a form of fractional reserve banking, with the digital currency playing the role of base money and the total claims on issuers the role of broad money. An important question that would then emerge is
whether banks could be constrained in their creation of broad money without regulatory oversight or central bank involvement in the management of the underlying base currency.
In this vein, there are some parallels with historical episodes of free banking, in which relatively unregulated banks were able to issue their own banknotes as a form of private money. The record shows that while some free banks did act with restraint, there is a risk of uncontrolled inflation (that is, a fall in the purchasing power of the banknotes) if private issuers overuse their ability to create currency at a very low marginal cost.
Modern-day advocates of a return to free banking, like promoters of digital currencies, have been motivated in part by their disapproval of monetary management as practiced by central banks. Advocates suggest that free banks should be obliged to redeem their notes at par against official currency.
Any over-issuance would, it is said, simply flow back to them. If free banks’ notes were not convertible into an official currency, banks would compete to produce the most ‘useful’ notes — ones that maintained their purchasing power. By contrast, the safeguard offered by digital currency schemes amounts to an undertaking to issue and to recognize new currency only as indicated by an algorithm, which can be amended only with the assent of a majority of computing power on the relevant network.