Core Focus: The historical and institutional logic of the two-tier monetary system, how it has traditionally mitigated financial stability risks, and the challenge CBDCs pose to this structural separation.

In-Depth Notes:
The modern monetary system is built on a two-tier structure: central bank money (reserves and physical cash) sits at the top, while commercial bank money (deposits) forms the second tier. This separation between public and private money has been a crucial structural mitigant of financial stability risks for decades. The two-tier system reflects a stable institutional outcome that emerged over time, eliminating the inconsistency that central banks could at some point compete with commercial banks . The supply of deposit-like instruments for savings by governmental institutions with policy powers was thus discarded, and the only public money available to non-banks was banknotes .

The Classical Ecosystem of Money:
The balanced working of the classical ecosystem of money throughout decades was due to two main reasons: (1) technological complementarity between banknotes and deposits, and (2) the increasing cohesiveness brought about by financial stability-oriented policies. Banknotes face an intrinsic limitation to be an instrument that competes with bank deposits without frictions. The transaction and holding costs associated with physical banknotes limit the conditions under which a run on deposits is attractive . Physical banknotes have traditionally been viewed as a sort of “safety valve” for the money system in the sense that a drawdown of deposits to banknotes faces frictions that may automatically limit further outflows and ultimately offer some leeway to gain time to stabilise the system .

The Challenge of CBDCs:
CBDCs could potentially alter the balance of the money ecosystem by piercing the layering of money beyond what is strictly safe. The relationship of complementarity between bank deposits and banknotes can be transformed into one of substitution in relation with CBDCs . The financial stability risks of allowing outright competition between fragile commercial bank money and an unrestrained form of CBDC would be high if operational, financial, and safety attributes of CBDCs would strictly dominate over the ones of bank deposits. Under these conditions, the policy-based cohesion of the money and credit system might be compromised and need a thorough revision of what is acceptable and what is not .

The “Safety Valve” Function of Cash:
The traditional role of physical banknotes as a safety valve is threatened by CBDCs. An unrestrained CBDC could be used to evade limitations on holding and transacting in banknotes. The ease of digital transacting and holding would erase the natural frictions inherent in physical cash, potentially accelerating deposit outflows during times of stress and making bank runs faster and harder to contain.