European Commercial banks and the Digital Euro: Inaction not an option

A lot has already been written on the launch of a digital euro. The ECB is continuously talking about the urgent need of it and the various benefits it could bring, including improved payment efficiency, greater financial inclusion, and increased resilience of the financial system. But what is important is how to involve banks in this project. Commercial banks are increasingly talking about the various challenges and risks they will be confronted with when a digital euro is a reality, including major financial, resource, and operational hurdles.

In the meantime various reports have been launched on the impact of a digital euro on banks with different outcomes. The recent published studies by the ECB and the PWC, but also some other might give some insight.

In this blog we aim to answer what impact the introduction of a digital euro could have on commercial banks. We will outline the strategic challenges for financial institutions, the main complaints from the banking sector, the outcomes of the most controversial studies by the ECB and PWC, and outline durable solutions to give banks a more comfortable feeling. But also what banks should think about when prepare to enable a successful implementation of the digital euro.

What may the digital euro involve?

When a digital euro is launched banks should play a key role in its distribution, acting as the main point of contact for individuals, merchants and businesses for all digital euro-related issues and performing all end-user services. According to the European Commission, so-called “basic services”- including account maintenance, as public money, euro-to-digital-euro transfers, and digital euro transactions – would be free of charge to use and accepted everywhere. At the same time, the payment service providers could provide additional digital euro payment services for a fee.

To mitigate potential risks to financial stability, the digital euro design will embed features such as a holding limit on digital euro accounts, and the facility to link digital euro wallets to bank accounts to allow a seamless funding and de-funding. The proposal also foresees the issuance of physical payment cards or wallets to prevent the exclusion of non-digital users. And there would come both an online and an offline version. The latter to enable also using the digital euro in times of crisis or electric problems.

What may a digital euro bring?

According to the ECB a digital euro may strengthen the resilience and autonomy of Europe’s payment ecosystem and preserve the relevance of European banks and the euro in the global financial system. The digital euro also affords an opportunity for European banks to progress their digitalisation strategies in a coherent and integrated way. According to the ECB, credit and payment institutions should see the digital euro as an opportunity to complement the digital financial services that they are providing.

The digital euro could also provide additional business opportunities, by enabling full reach throughout the entire euro area, going beyond most private innovations which have tended to focus on specific domestic markets or a limited number of countries. In this way, the digital euro can serve as a platform to foster innovation and competition in the digital payment markets space.

Growing concerns of commercial banks

Despite these ambitions from the ECB, the digital euro faces fierce opposition from European commercial banks and bank associations. According to them a digital euro may bring various serious challenges to commercial banks. It will have a notable impact on them when it is implemented. European commercial banks claim that such a project could fundamentally change the financial system They fear that the digital euro could undermine commercial banks, if citizens chose the ECB as the safer option, affecting both their profitability and their lending capacity towards the economy, hurting their main business models.

This will inevitably push commercial banks into a marginal role, creating a dangerous concentration of financial power in the hands of policymakers and technocrats.

Main challenges

Firm deposit Outflows

One of the main risks related to the introduction of the digital euro has been considered to be a decrease in the deposits of credit institutions. Critics warn of potential runs on banks if depositors rapidly shift funds to digital euro wallets during crises, toward a simple, free cross-border payment system run by the ECB. This might especially hit smaller banks for two reasons:  their customers tend to have lower levels of deposits, leading to a larger share of deposits being withdrawn; and they are more dependent on retail deposit funding. Big outflows of deposits from credit institutions could have a negative effect on the banking sector. The Association of German Banks has warned that deposit outflows could weaken customer relationships.

Affect the volumes of current digital payment solutions.

In addition to the volume of deposits, the introduction of the digital euro enabling digital payment, could also have an impact on the volumes of current digital payment solutions. The loss of revenues from payment transactions could negatively affect banks and other payment service providers such as payment card companies to the extent that digital euro use replaces other means of electronic payment.

The European Savings and Retail Banking Group said that the digital euro could capture over a third of card transactions and erode banks’ revenue from payment fees.

High refinance costs and funding gap

Facilitating digital euro wallets for consumers would directly affect liquidity and potential capital requirements. As deposits are an important refinancing source for retail and universal banks, refinancing costs of banks could increase if customer deposits are partly withdrawn due to a change of payment behaviour in favour of a digital euro. The resulting funding gap would have to be closed by other, usually more expensive, financing instruments such as the issuance of bonds or refinancing through ECB facilities. This may lead to an increase in funding costs, making it harder for financial institutions to lend and prioritising credit to governments over loans to families and businesses. This may curtail the volume of bank credit to the economy, especially long-term financing that is backed with stable deposits, potential inability to replace the lost deposits from the market especially in times of stress;

High costs for infrastructure readiness

The ECB plans to deploy it using a hybrid distribution model, in which authorized banks and payment service providers will play a central role. Since it will be legal tender, banks will be required to integrate with the digital euro infrastructure, serving as gatekeepers for the new platform. This will demand significant technical adjustments to guarantee compatibility with the new digital currency framework.

Participating institutions will need to set up a new technical infrastructure, including the transfer of euro to digital euro and vice versa. They will also need to maintain separate digital euro accounts, increasing administrative complexity. This may lead to high costs for infrastructure readiness.

Higher compliance responsibilities

At the same time, compliance responsibilities will increase, as banks and payment service providers must navigate complex regulatory requirements. Maintaining digital euro wallets as part of a two-tier (or ‘hybrid’) model will require commercial banks to fulfil a role as gatekeeper. Commercial banks will need to ensure that all digital euro-specific privacy requirements are met, even during transaction monitoring and filtering. Also, depending on potential implementations of an offline digital euro, transaction monitoring may need to be performed ex-post.

This requires extensive KYC and AML capabilities, in addition to those they currently have or are currently developing.

Disintermediation

For banks and payment service providers (PSPs), the most significant challenge may be the redefinition of their role as intermediaries. The introduction of the digital euro may trigger bank disintermediation, because citizens would be able to keep money directly in digital wallets, without the mediation of commercial banks, leading to erosion of fee revenue to non-domestic bank or non-bank providers, or a diminution of banks’ client or services base.

The evolution of the payments landscape, with a retail digital euro, presents disintermediation challenges, e.g. with potential wider impacts on banks’ business models, limiting the potential monopoly power of the firms at the center of private sector payment networks.

Affect profitability

The digital euro is likely to increase pressure on banks’ profitability given the investments required, declining revenues from existing payment methods, the necessity for additional liquidity management, and limited additional income opportunities with an erosion of related revenue streams. Banks warn that the introduction of a digital euro would mean a huge cost, thereby weakening bank profitability, particularly in the initial phase, while digital euro accounts guaranteed by the ECB could lead private banks to incur losses, potentially destabilizing the financial industry.

Stifle innovation

And what is even more important, the introduction of a digital euro could stifle future innovation by dictating the future direction of the EU’s payment industry. The investment and recurring costs of implementation of such a complex and large-scale project, may cause a firm reduction of innovation capacity and therefore of competitiveness for banks.

Some interesting studies

Though at this moment it would be very speculative to estimate the size of one-time investments and additional operating costs required to integrate a digital euro into existing payment processes, there are a number of interesting studies from respected organisations that could give more insight in the real consequences. Here we restrict ourselves to the most controversial ones: the studies from the ECB and PWC.

ECB Reports

Conducted at the request of European lawmakers, who expressed concerns about its adverse effects on banks’ financial health, the ECB launched two reports, on how a digital euro would affect banks and consumers: one focussing on the implementation costs and a second one on deposit flight. The study, was aimed to evaluate the risks that a digital currency would pose to the banking sector under different scenarios, including a hypothetical “flight to safety”.

Study on implementation costs

The first study of the ECB focused on the costs of implementing a digital euro by Eurozone banks. The study found that they may spent between €4–5.8bn over the four-year implementation phase. Banks would face annual expenditures of €1 bn to €1.44bn between now and full rollout. This is roughly 0.7% of the sector’s annual net income and 3.4% of significant banks’ yearly IT upgrade budgets. This is broadly comparable to those costs incurred under PSD2, which forced banks to open up customer data to third parties, and lower than the costs of the roll-out of SEPA, which harmonised euro payments across borders the paper notes.

For a sector whose combined net income nears €200 billion, not much according to the study. This is far less and with minimal risks than PWC’s earlier estimates, whose analysis for the European Banking Federation had suggested far higher figures. The ECB’s modelling, challenges PwC’s assumptions, arguing that they overstate costs by ignoring existing infrastructure and shared outsourcing models.

The ECB study said the burden could shrink further if institutions leverage synergies in investment costs, through intensive collaboration in the industry. If banks adopt common infrastructure or rely on collective providers then overall costs could fall by up to 40%. ECB Commissioner Piero Cipollone described the findings as evidence that “using the digital euro for daily payments will not harm financial stability.”

Study on bank deposit withdrawal

A second study by the ECB examined whether the introduction of the digital euro could trigger deposit flight or liquidity stress across the European banking system, destabilising the financial system. The ECB thereby tested several “holding limit” scenarios, ranging from €500 to €3,000. Overall, the ECB emphasized that holding limits can effectively maintain financial system stability and support appropriate monetary policy formulation and implementation.

Under a “business-as-usual” scenario, the estimated deposit outflows are modest. Even under the most extreme hypothetical flight-to-safety scenario, if a limit on individual holdings was set at €3,000 limit, total deposit outflows from Euro-zone banks to park them in  digital euros, could reach 700 billion, accounting for 8.2% of retail current deposits or about 2.2% of total banking sector assets, well below regulatory liquidity assumptions.

The introduction of a digital euro might disproportionately affecting smaller financial institutions. Under this scenario, which the ECB described as highly unlikely, 13 of the 2,025 banks in the analysis would deplete their mandatory cash buffer. These figures may be an overestimation as they don’t consider the fact that some depositors have account in several banks, so the actual outflow of deposits may turn out to be significantly lower.

In a more realistic “business as usual” scenario, in which users would not use the maximum digital euro limit, banks would face an outflow of only about 100 billion euros. Such an amount could be easily absorbed by the system without any major problems, leaving the sector well within liquidity requirements. The ECB finds that banks liquidity coverage and funding ratios would remain well above 100%, meaning the system could absorb the shock. The ECB also simulated lower  individual holding limits of 500 euros, 1,000 euros and 2,000 euros, resulting in reduced withdrawal amounts.

PWC Study: High change costs and resource requirements

The  study by global consultancy Price Waterhouse Cooper (PwC) commissioned by a number of European banking groups, examined the anticipated change costs and resource requirements associated with the issuance and distribution of the digital euro, as well as the technology required to process digital euro payments. This study was aimed to provide insights into the important financial and operational implications and provide a first estimate of the related costs for an initial period of 4 years, that the potential introduction of a digital euro would entail, as a contribution to the ongoing policy dialogue.

The study, which surveyed 19 European retail banks and banking groups in the Euro-zone, reveals that, on average, each of these participating banks would face initial costs of about € 110 million per bank. They would need to spend this amount to implement the necessary changes, excluding costs related to offline functionalities, multiple accounts, and merchant acquiring. Collectively, the banks in the study would need to spend over € 2 billion in total costs. If applied to the entire eurozone, the total estimated expenditure could amount to approximately €  18 billion. Total change costs could rise up to as much as € 30 billion in a more expansive scenario.

According to the study, main cost drivers relate to technical adjustments, including automated teller machines (ATMs), point-of-sale (POS) terminals, and e-commerce infrastructure. They account for around three quarters (75%) of the estimated total costs of participating banks, or more than € 1.5 billion. Other adjustments include commercial related such as basic marketing activities as well as customer relationships, and operational comprising core back-office processes, such as fee calculation, reporting, and payment statistics, to support the seamless integration of the digital euro.

These findings suggest that banks face big financial, resource, and operational issues with the digital euro, which could limit their ability to innovate, especially over the long-term when running costs come into play, according to PWC. To ensure long-term viability, and considering the broad impact of the digital euro, the total cost must be significantly reduced. This can be done by leveraging existing infrastructure and following industry standards, helping enhance efficiency while avoiding conflicts with private-sector initiatives.

Solutions

To give commercial banks a more comfortable feeling and make the proposed digital euro worthwhile, a number of solutions will be described, including a fair compensation model for banks, global standards for sovereign digital innovation, low amount in a digital wallet, prevent bank disintermediation and conduct a constructive dialogue.

Fair compensation model for banks

To make it worthwhile for banks and other providers to distribute the digital euro, a reasonable and sustainable profitability of the European banking sector is crucial to financial stability in Europe and beyond. For that reason banks should be fairly compensated to help offset investment burdens and maintain competitiveness in innovation by the European banking sector.

Against this background, the ECB has agreed upon the basic elements of a compensation model that needs further elaboration. Such a model should provide banks and other PSPs appropriate incentives for marketing and distributing the digital euro to ensure broad use by retail customers. The European authorities and the ECB should keep a close eye on a fair and balanced compensation model for banking services associated with the adoption and use of a digital euro.

Global standards for sovereign digital innovation

To ensure long-term viability, and considering the broad impact of the digital euro, the total cost must be significantly reduced. This can be done by leveraging existing infrastructure and following industry standards, helping enhance efficiency while avoiding conflicts with private-sector initiatives. As the ECB advances, the project could set a global standard for sovereign digital innovation, blending decentralization with oversight in a way that democratizes access while safeguarding stability. The introduction of the digital euro and standardized implementation criteria for basic services are expected to accelerate the convergence of bank accounts and payment services.

Reasonable limit the amount in a digital wallet

Due to this, there are plans to limit the amount that a natural person can hold as digital euros in their digital wallet. The amount discussed so far has been 3,000 euros but the exact amount is yet to be determined. At their recent meeting in Copenhagen where the Ministers of Finance agreed a pathway to set limits on how much digital euro an individual can hold. They , decided to set a limit when there is an official decision to continue the digital euro project. While sceptics argued the ECB’s power to impose caps on holdings could destabilize private banks, ECB Commissioner Cipollone dismissed the claims, saying the limits would be based on  “rigorous analysis”, stressing that in a true crisis, capital would flee to foreign stablecoins long before the digital euro.

Prevent bank disintermediation

The Eurosystem should place particular emphasis on the safeguards to control the take-up of the digital euro and prevent bank disintermediation. These safeguards should be calibrated in such a manner to strike the right balance between ensuring a substantial level of usage, which is necessary to achieve the policy objectives of the digital euro, and mitigating the risks for bank disintermediation and financial stability from a large and rapid take-up of the digital euro.

Constructive dialogue

To overcome the various challenges, a deeper and more constructive partnership between public and private actors is necessary for the next phases of the project. As the digital euro project is now finalising the preparation phase, the European Banking Federation (EBF) considers it vital to pursue a constructive dialogue between the co-legislators, the ECB and the banks, to find the balance that will ensure the success of the digital euro, along with the introduction of robust mitigating measures for all the above mentioned risks. This underlines the importance to conduct a comprehensive impact assessment on infrastructure and the payments retail banking business models. This additional assessment is necessary for the co-legislators and the ECB to define the limit on digital euro holdings per individual, as well as other relevant limits; the impact on existing payments market and the implementation of appropriate countermeasures, including infrastructure related aspects; and the overall suitability of the compensation model.

Final remarks: Inaction Is Not an Option

The digital euro will fundamentally transform the European payments landscape.  Although there are still various uncertainties and its introduction is not expected until at least 2029, for banks and payment service providers, now is the right time to prepare strategically for the upcoming changes. Delaying preparation may put commercial banks at risk of non-compliance with legal requirements, and the danger of falling behind competitors  A thorough cost-benefit analysis is essential for design development and targeted implementation. To gain early insights into the implementation costs associated with introducing the digital euro and assess the potential for additional earnings, banks should conduct a scenario-based preliminary study immediately.

The preliminary study for the digital euro should begin with a candid assessment of current capabilities, including existing instant payments infrastructure and existing payment processes and components, alongside a clear definition of the bank’s ambition level and risk profile. With regard to earnings potential, particular attention must be paid to factors like customer acceptance, the level of competition between banks, the role of the Eurosystem app, and the compensation model for basic and value-added services. So, inaction by commercial banks is not an option anymore.