Europe’s banks, already facing a potential tidal wave of bad loans stemming from the COVID pandemic, could face a new threat to their viability from an unexpected quarter: The European Central Bank’s proposals to launch a digital euro.

The ECB, which sets monetary policy for 340 million people in the 19-nation euro zone, has dangled the prospect of launching a digital euro, which it said would be “an electronic form of central bank money accessible to all citizens and firms.”

The ECB says its proposal is all about creating a free, safe and trusted way to make payments in an increasingly digital world where the pandemic is hastening the decline of cash.

But bank officials make clear that the digital euro would also be the ECB’s counter-punch to the dizzying rise of cryptocurrencies like Bitcoin and Ether, the explosion in commercial adoption of fintech services from PayPal to Revolut, and the advent of digital currencies such as the proposed Facebook-backed Diem (formerly Libra). The ECB spies a danger that big tech could grab a bigger share of Europe’s banking pie, potentially weakening the ECB’s grip on the continent’s financial system.

“We believe a d€ (digital euro) is a pre-emptive response—a crypto kryptonite, a big tech neutralizer,” BofA Securities, Bank of America’s brokerage arm, said in a report last week. Bitcoin has nearly doubled in price this year, sending its total value surging through $1 trillion, as Tesla bought $1.5 billion of Bitcoin and the cryptocurrency continues to attract interest from big institutional investors.

ECB President Christine Lagarde said in January that the bank will decide as early as April whether to push ahead with planning for a digital euro, though she has also said that it could be five years before the digital currency sees the light of day.

But the ECB’s mind seems made up. ECB Vice-President Luis de Guindos said in an interview with Portuguese newspaper Publico this month: “For us, the digital euro is not an option, it’s something we just have to do.” To wit, the Frankfurt-based central bank received more than 8,000 comments on its digital euro plan in a public consultation that ended in January.

“Accessible to all”

The ECB stresses that a digital euro would co-exist with euro notes and coins rather than replace them.

Nevertheless, there is alarm in some quarters over what the plan could mean for the eurozone’s hobbled commercial banks, which, the ECB has warned, in the worst case scenario, is already facing a €1.4 trillion ($1.7 trillion) hit of bad debts as businesses reel from pandemic-related lockdowns.

Going into the pandemic, some banks, particularly in Greece, Cyprus, Portugal and Italy, still had billions of euros of toxic debts on their balance sheets, a hangover from the 2008 financial crisis.

“Collateral damage”

Some experts fear, if the ECB were to introduce a digital euro, that Europeans would rush to open digital accounts at the central bank, sucking trillions out of the current accounts that euro zone banks depend on as a cheap and reliable source of funding and affecting the banks’ income stream.

That would mean the commercial banks would lose out either way—whether big tech eats their lunch, or the ECB takes their deposits.

BofA Securities warned that euro zone banks could be “collateral damage” from any ECB decision to launch a digital euro.

Critically, said BofA, a digital euro would draw money from the bank accounts that people pay their salaries into each month—“the highest quality funding with the lowest liquidity demand.”

Even if the ECB caps individual digital euro holdings at €3,000 ($3,600), as it has suggested, that could still see a trillion euros ($1.2 trillion) flow from banks to the ECB, BofA Securities said. That trillion euros was “the linchpin of the banking system” and its loss would “rock bank foundations,” BofA Securities’ analysts wrote.

The trillion euros of salaries deposited in euro zone banks each month form the cornerstone of €5.4 trillion in deposits that banks use to create €2.3 trillion of longterm investments. If the €1 trillion in salary accounts were moved to the ECB, surplus money that went into bank accounts would be considered less stable deposits. “Now 4.4 trillion euros in deposits creates only 0.7 trillion euros in long-term investments,” BofA Securities said, adding that banks would also have to hold more cash than before.

BofA Securities points out that there is a huge and valuable prize for private-sector players from outside the banking sector if they can seize a larger piece of the payments’ action—a treasure trove of customer data that is not being fully exploited by the banks.

“It is reasonable to imagine a non-bank name finding a way of using the data available in salaries and payments to offer, for example, merchants a payments loop that costs less than the 0.6% of the current system. Some 'killer app' that consumers find more convenient, cheaper, or with better points and discounts could see rapid adoption,” it said.

Beijing pilot scheme

The ECB is far from being the only central bank considering launching a digital currency.

China is in the lead, handing out $30 of its new digital currency each to 50,000 Beijing residents in a pilot scheme last month, and dozens of other central banks around the world are looking at introducing their own digital currencies.

Fed Chair Jerome Powell told Congress last month that the Fed was looking “very carefully at the question of whether we should issue a digital dollar,” calling it a “very high priority project for us,” though he said it raised significant technical and policy questions.

COVID catalyst

Fabio Panetta, ECB executive board member and point person on digital currencies, made clear in a speech last month that the proposed digital euro is partly a response to ECB concern about the growing reach of the tech giants.

“In Europe, the expansion of big tech companies could make us dependent on technologies governed elsewhere … Big techs may contribute to a rapid take-up of stablecoins (a type of cryptocurrency) both domestically and across borders, which could create systemic risks and even endanger monetary sovereignty,” he said.

The ECB is well aware of the risks a digital euro could pose to the eurozone’s commercial banks, including undermining themor even causing bank runs, and has said it would design a system to avoid these dangers.

“A digital euro could … attract payments activity from banks and reduce their payments-related income and customer information. It could also attract deposits, especially if it were offered without limits on individual holdings and at such attractive conditions that the public moved large amounts of deposits from commercial banks to central banks. The concern is that this could lead to less stable and more costly funding, lower bank profitability and, ultimately, lower lending, constraining the financing of the real economy,” Panetta said in the same speech.

A digital euro could pose an even greater risk to banks during crises. “If not properly designed, in times of crisis a digital euro could accelerate ‘digital runs’ away from commercial banks towards the central bank. This risk could even be self-fulfilling, leading savers to reduce their bank deposits and amplifying volatility in normal times too,” Panetta said.

Panetta said these dangers could be avoided by designing a system that allowed digital euros to be used to make domestic and international payments, but that stopped them from being used for investment purposes.

One option, he said, would be to limit people’s holdings of digital euros. “One way of doing this, while allowing the digital euro to be used for large transactions, would be to require incoming funds in excess of a user’s limit to be redirected to a bank account,” he said.

Another option would be to set penalties, such as negative interest rates, on digital holdings above a certain threshold, which he suggested might be €3,000.

In any case, he made clear the ECB had no intention of replacing the commercial banks by dealing directly with potentially hundreds of millions of users of a digital euro.

“Financial intermediaries–in particular banks–would provide the front-end services, as they do today for cash-related operations,” he said.

Of course, central bank oversight of digital payments could give governments a powerful new tool against crime, money-laundering and tax evasion. Drug-traffickers and criminals prefer the anonymity of cash. European economies have huge informal sectors that operate on a cash-in-hand basis.

The ECB decided in 2016 to stop producing its €500 banknote, which at the time accounted for over 30% of the value of all banknotes in circulation in the euro zone, over fears the high-value note was being used to finance terrorism and crime.

The prospect of central banks issuing digital currencies alarms libertarians, who worry about the threat to privacy and the increased scope for autocratic countries to control their people.

“A digital dollar could result in the government having access to each financial transaction by its users…The personal wallets created by the government with blockchain abilities that can store each transaction sounds like a vision out of some libertarian fever dreams,” libertarian author Kristin Tate wrote in an opinion piece for The Hill this month.

“Are you comfortable with your wealth sitting at the mercy of several unelected officials back in Washington?”