Central Bank Digital Currencies and Financial Inclusion

In January 2022, the UK’s House of Lords added to the growing discussion on the viability of, and prospects for, a domestic central bank digital currency (CBDC).  Joining a long line of earlier commentators (such as Waller (2021) for the US), the august body agreed with others before it that CBDCs were ‘a solution in search of a problem’.  In addition to the UK and the US, no real case for a CBDC has been made in Singapore and Japan will not issue a CBDC anytime soon either. But even after conventional arguments in favour of CBDCs have been shown to fall short, CBDC proponents still have an ace up their sleeve: financial inclusion, i.e., facilitating access to financial services for the under- or unbanked.  Currently, 1.7 billion people either do not have access to a transaction account operated by an authorised and/or regulated payment service provider (World Bank (2018)) or are excluded from the formal financial system.  Who could seriously argue against providing access to the financial sector and all the benefits this entails, such as a transaction account to safely store some value, send and receive payments and perform most, if not all, payment needs, especially as a CBDC is apparently all that is needed?  How would a CBDC enhance financial inclusion?  The implicit assumption seems to be that the under- or unbanked primarily need a better way to access financial services and would therefore readily use a CBDC for that purpose.  But many of the details are left unspecified.  It appears that everyone with a mobile phone will simply download the necessary digital wallet and app and be instantly financially included.  By doing so, everyone would have the equivalent of a bank account into which funds could be deposited by the government and from which utility companies and others could be paid.

While the case for introducing a CBDC differs around the world to reflect the prevailing economic circumstances and the efficiency of national payments systems, for many emerging market economy central banks financial inclusion is one of the key drivers for considering CBDCs (Boar et al. (2020)).  But many of the required policies for enhancing financial inclusion are well-known and centre around a basic and low-cost bank account, a robust digital identification (ID), a method of storing balances and some form of payment infrastructure.  All of these could be tackled by bolstering the digital financial tools already available and do not require a CBDC.  Rather than the promised instant panacea, a CBDC would – at best – be a complement to what is required.  Once these policies have been put into place, a CBDC could be introduced towards the end of the process to safeguard the steps towards financial inclusion already achieved.

Causes of financial exclusion

The reasons for financial exclusion are well-known and diverse, with some being involuntary and others voluntary.  In no particular order, these can be summarised by:

• Geography: In countries with remote or sparsely populated areas, parts of the population may be geographically distant from the nearest bank branch.
• Regulatory requirements: One of the biggest hurdles to financial inclusion has to do with compliance in the form of verifiable personal ID.  Auer et al. (2020, p. 4), citing research by the McKinsey Global Institute (2019), report that an estimated 1 billion people worldwide do not have basic identification credentials, and many more have IDs that cannot be trusted because they are of poor quality or cannot be reliably verified.  Roughly another 3.4 billion people have some form of ID but with limited ability to use it in the digital world.  And even the 3.2 billion people with a legally recognised identity may not be able to use that ID effectively and efficiently online.
• Bank requirements: In order to offer profitable services, banks may impose excessive minimum balance requirements and too high or too unpredictable bank account fees, while some customers may have previous credit or bank account problems that prevent them from being able to open a bank account.
• Access problems: An increasingly digital world may result in an inability to access digital services due to the cost of obtaining connection devices and data, lack of mobile or internet coverage and a lack of digital and financial literacy (Klapper et al. (2015)).  An additional factor for access is an uninterrupted electricity supply.
• Trust and privacy concerns: In many surveys of the under- or unbanked, a lack of trust in banks features prominently.  The same is true for privacy concerns.  Finally, many have never had a bank account and do not feel that they need one, making this a matter of personal choice rather than economic or financial sense.

Whether in advanced economies such as the US (49 per cent according to the FDIC (2019)), emerging market economies like the Philippines (45 per cent according to the BSP (2019)) or the world more generally (two-thirds of unbanked respondents in the World Bank’s (2017) Global Findex survey), surveys show that the predominant reason for financial exclusion from the above list is the hurdle of meeting minimum balance requirements.

What needs to be done?

Policies to deal with financial exclusion and enhance financial inclusion are well-known and many of the required payment system requirements are addressed by PAFI (2017).  As outlined in the study, certain financial and other relevant infrastructures that are necessary for an efficient national payment system also form the basic foundations for financial inclusion:

• a large-value interbank settlement system;
• an interbank system for retail payments, in specific electronic funds transfers;
• a payment card processing platform or platforms;
• an effective and efficient identification infrastructure;
• credit reporting and other data-sharing platforms also play an important role; and
• a robust communications infrastructure and power supply system.

CBDC design

Now that we know about some of the financial exclusion issues and potential remedies, we can turn to the question of how a CBDC can help financial inclusion, which naturally leads to the issue of CBDC design.  As implied by its name, the general-purpose CBDC that seems to be favoured by policymakers will have to be ‘all things to all men’.  As such, it will need to address several domestic (and potentially one or two international) objectives simultaneously.  These objectives, motivations and risks will differ across jurisdictions, and advanced and emerging economies will undoubtedly see the case for CBDCs differently based on variations in financial systems, economic structures, societies and legal structures.  In fact, there is no single overarching objective that a majority of central banks is trying to achieve: the most prominent ones are increases in efficiency, robust and secure payment systems, modernisation or digitisation, efficient cross-border transfers, lower costs and financial inclusion (AMRO (2022, p. 2)).  This leads to trade-offs in CBDC design (Auer and Böhme (2020)), meaning that it is unlikely that a future CBDC will be created to meet just the financial inclusion objective.  As a result, a CBDC does not exist in a vacuum and will have to form part of larger changes to enhance financial inclusion.

The conviction of CBDC proponents concerning the important role of CBDCs in financial inclusion is puzzling, seeing that we have not yet converged on a CBDC blueprint.  It is impossible to evaluate how a CBDC might help the unbanked without precisely defining the CBDC and seeing the unbanked problem clearly in conjunction with CBDC design.  Specifically, a general purpose CBDC could enhance financial inclusion only to the extent that inclusion features prominently in its design from the outset.

In terms of the CBDC path ahead, we seem to be converging to an account-based system built on digital ID.  Under this preferred model, CBDCs are ‘…best designed as part of a two-tier system, where the central bank and the private sector each play their respective role (BIS (2021, p. 79))’.  In this scenario, the central bank operates the system’s core, ensuring the safety and efficiency, while the private sector, such as banks and payment service providers, innovates and actually serves customers by providing digital wallets and apps for the public to use.  This account-based approach allows for verifying users’ identity ‘rooted’ in a digital ID scheme, and thus preserves privacy, but does not provide the full anonymity of cash in payments.

How would a CBDC address the causes of financial exclusion?  The portents are not good.  For a start, a CBDC will be an imperfect substitute for cash.  There are those in society who value the physical nature of cash, perhaps on account of concerns around security or fraud.  The introduction of a CBDC is therefore unlikely to impact their payment behaviour.  These agents use cash for reasons that will not be affected by the creation of a CBDC.  Equally, those that do not have an account because of their concerns about privacy or lack of trust in either financial institutions or the government will not be convinced to use a government-issued and private-sector managed CBDC with a much lower degree of anonymity than cash.  Finally, some percentage of the public is simply not at all or not very interested in having a bank account as a matter of personal preference.  Why should this suddenly change with a CBDC?

Important role of government

We have seen that CBDC design cannot be separated from the environment in which it will operate.  To a large extent, a CBDC is as much a social issue as it is an economic one and financial inclusion is frequently one of the stated objectives of government policy.  This means that the government plays – and will have to play – an important role.  To enhance financial inclusion, it is essential that public bodies (rather than the private sector) determine the architecture of the system.  For example, the government’s role should be to find the right balance between promoting innovation and managing risks.

In particular, the government should provide an equal foundation for everyone – the private sector can then add innovation to a level playing field.  As such, the government could provide a payment infrastructure on top of which private payment providers can innovate and provide efficient payment services with a guarantee of interoperability and easy access. This is especially important because the small merchants that the underbanked deal with are likely to be the last to go digital. They may not understand or be able to offer the new technology, or they may not wish to go digital in order to keep transactions and income invisible from the tax administration or other authorities.

One could easily imagine additional important enabling roles for government, such as the provision of a verifiable digital ID, ensuring open and affordable access to the digital infrastructure, providing regulatory and legal frameworks that do not impede access to payment services, and enhancing financial and digital literacy.  Along those lines, a widely used general purpose CBDC could complement efforts by government or private sector entities (under public oversight) to establish a universal digital ID system leading to greater financial inclusion.  Given the novelty of CBDC product and the related complexities of the digital world (nicely described in Tett (2021)), a CBDC can be expected to invite financial and/or online fraud, security breaches and data theft, trying to capitalise on financial and digital illiteracy.  The most vulnerable in poorer countries to such are undoubtedly going to be the worst affected.  A universal and verifiable digital ID issued by some combination of the government and the private sector would counteract such problems.

That being said, a digital ID raises a number of issues that must be resolved for it to work, especially around governance. A digital ID built around a private sector’s product and service offerings creates a closed-loop system that does not contribute to financial inclusion. National ID systems may raise questions of trust, e.g., how will the government use the data and information and will such data be safely stored? Furthermore, how will migrants, refugees, stateless and other displaced people be included because they are unable to present any ID or unable to procure a qualifying ID in the country in which they are currently located.

A CBDC can worsen financial exclusion

Advocates of a CBDC in support of financial inclusion often forget the adverse implications of more digital payment innovations.  The latter undoubtedly offer convenience, but they also raise concerns about how they may further exclude a population already marginally attached to the economy.  One concern is that a future CBDC might have the perverse effect of helping to aggravate financial exclusion.  

Even in the absence of a CBDC, the economy in general, and the financial system in particular, have become increasingly digital.  This increasing digitalisation and reliance on mobile banking services has left some sections of society behind as potential barriers around trust, digital literacy, access to IT and data privacy concerns have created a digital divide or gap.  The latter has been laid bare even in advanced economies, where the COVID-19 pandemic has illustrated the problems associated with providing access to online education for students at all levels during the various lockdowns.  The digital gap in emerging market and developing economies is a similar issue in the digitalisation of the economy and the ensuing consequences for inclusion.

Financial inclusion as envisaged by the proponents of a CBDC presupposes digital inclusion, such as access to infrastructure (digital devices and the internet), skills (the knowledge and confidence to use the devices and an understanding of how the internet works) and accessibility (assistive technology and accessible design for those with disabilities or additional needs).  The increasingly digital nature of the economy means that people who are not digitally literate need a simple means of making payments and it is not clear whether a CBDC is the simplest way of fulfilling that role.

Finally, as outlined in Eichengreen (2021), many public and private-sector companies provide more favourable terms to the banked because they can be expected to be paid more promptly and regularly.  The unbanked pay more because credit providers see possession of a commercial bank account as a signal of financial stability, probity, literacy and reliability.  This signalling value of a bank account would be lost under a CBDC that is available to everyone unconditionally. 

Conclusions

It is worth keeping in mind that financial inclusion is ultimately a promise and not a guarantee (Duffie (2021)).  The idea that a complex social problem like financial inclusion can be solved by technology is certainly seductive, if a bit simple. A CBDC may be a solution to the problem of financial inclusion, but it is unlikely to be the only one.  For a CBDC to increase financial inclusion, it must address the causes of exclusion, which vary by jurisdiction and are often complex.  Given the complexity of this issue and possible underlying obstacles to digital inclusion (e.g., financial and digital illiteracy), any CBDC initiative would likely need to be embedded in a wider set of reforms, such as the ones outlined by the CPMI-World Bank (2020).  In consequence, a general purpose CBDC will enhance inclusion in the medium term only if the inclusion dimension features prominently in its design from the very start.  In that way, a widely used general purpose CBDC would lock in government and private sector efforts to enhance financial inclusion.  And it goes without saying that a CBDC system should avoid reinforcing barriers to financial access and should not introduce any unintended sources of exclusion.

A case can be made for the introduction of a CBDC at the end of the financial inclusion process rather than at the beginning, i.e., avoiding putting the technological cart before the horse (Fanusie (2021)).  A CBDC could thus reinforce a framework through which the provision of simple, affordable, non-bank alternatives could be provided to households and individuals without bank accounts.  While a CBDC is not a prerequisite for such services, it is likely that this functionality would be a feature of any CBDC that the central bank designed.

Even though, more can be done to exploit the opportunities that are still to be seized in many countries by bolstering the digital financial tools available and rolling out a robust digital financial infrastructure on a large scale.  In other words, the solution may not be a CBDC but the wider range of successful technology in the payments area that could achieve the same ends.  This also argues against the myth of leapfrogging.  One often-heard rationale for the use of a CBDC is the prospect of leapfrogging to the head of the queue in terms of financial inclusion.  But it is unlikely that one can avoid doing the hard work, as set out in the principles for payment infrastructure design by PAFI (2017).  It may therefore be apt to close with the House of Lords as well, who stated that ‘It is likely that there are more straightforward and targeted ways to support access to financial services than to launch a CBDC (p. 19)’.

My thinking on this issue originated following an invitation by De La Rue to participate in a webinar on CBDCs on 14 September 2021. Discussions with my colleagues Mark McKenzie, Ayse Sungur and Glenn Tasky were, as always, very helpful (and enjoyable).