Master Thesis Digital Banking & Financial Technology



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Anastasiou MDE2003

what kind of Macroprudential Regulation Framework? | Think Tank | European 
Parliament

[online] 
www.europarl.europa.eu. 
Available 
at: 
https://www.europarl.europa.eu/thinktank/en/document/IPOL_STU(2021)662925. 
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Chapter 2: Digital transformation of the banking system in 
Europe 
2.1. Digital transformation (DT) 
Globally, organisations undergo periods of change for many reasons, such as 
growth, resolving internal issues, adapting to external pressures and adopting 
additional changes for the future (Kanter, 2003). Organizational change is a double-
edged sword, as it is required for organizational viability but it is found to impact the 
workforce negatively and finds resistance (Demerouti et al., 2021: 374). Aravopoulou 
(2016: 19) pointed out that organizational change is a broad term that involves 
changes to a small or large extent. Organizational development affects both the 
internal and external environment of the organization. For this reason, they act as 
"drivers" of change and the two types of influences tend to complement each other. 
Internal environmental changes in an organisation include new equipment, new 
services and products, recruitment of new staff, new structure in the organisation's 
operations and change in strategy. That external environmental changes, according 
to Child (2015), involve new policies from central authority, social and cultural, 
technological, demographic, economic and changes in market forces (Alvesson & 
Sveningsson, 2015: 14). The nature of both the internal and external environment
which is subject to change due to the reason of DT, forces organisations to change 
many departments and areas within the organisation, including their strategy, 
structure, operations, technology and culture (Andrew & Mohankumar, 2015: 302). 
Limerick et al. (1995) defined organizational transformation as a holistic, 
ecological, humanistic approach to a radical, revolutionary change in the entire 
context of an organizational system. Transformational changes alter the basic 
structure, strategy and culture of the organization (including values and norms). It 
requires new learning, an innovative culture and effective leadership for successful 
implementation of DT. Many studies describe organizational transformation as a 
fundamental revolutionary change that occurs in the very structure of the 
organization. Furthermore, DT can be used as a tool for organizational development 
by encouraging operational structure and competitiveness while transforming the 
organization's strategy (Hanelt et al., 2021: 1170). 


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The rapid adoption of new digital technologies and their development over 
time has caused huge changes in almost all organisations and across the globe. 
These large-scale changes are widely known as DT, where it has been the focus of 
many academics and researchers with the development of business research. Vial 
(2019: 118) defined DT as a process that aims to improve an entity by inducing 
changes in its properties through the combination of information, technologies, 
computing, communications and connectivity of these parts. On the other hand, there 
are researchers who support the definition of DT as the enormous changes caused 
by digital technologies in organizations (Hess et al., 2016). 
Hess et al. (2016) highlighted DT for its complex nature and its role in 
transforming the business model of the entire industry. DT encompasses the 
concepts of "process alignment and culture transformation" (Gong & Ribiere, 2021: 
2). According to these changes, improvements in productivity, performance and 
profitability of an organization can be achieved. Although Chatzopoulos and Weber 
(2021: 75) reported that DT improves organizations in areas such as customer 
experience and operations, which Westerman et al. (2014) agree with, however the 
latter added that success could only be achieved at the individual, organizational and 
financial levels if strong leadership skills are used to transform the organization and 
its culture in conjunction with strengthening the areas of business development. 
Parise et al. (2016: 2) focused on the consumer-focused definition of Digital 
Transformation, in which digital technologies are used to enhance the customer 
experience. While Horlacher & Hess (2016: 5133) pointed out that DT occurs when 
values and revenues are created due to digital technologies. On the other hand, 
Lundberg et al. (2020: 4347) described DT as "innovations" that provide changes in 
"structures, practices, values and beliefs". van Tonder et al. (2020: 116) defined the 
areas that were transformed during the transformation process that include business 
models, products, services, operations, processes, networks, skills, new talent 
development and culture production. While, Gurbaxani et al. (2019: 209) added that 
transformation can occur through vision development, strategy and change in the 
structure of the organization. 
It is necessary to distinguish between digitisation and DT. First, the former 
can be achieved through the application of technological methods, while the latter 
requires radical and holistic changes (Fischer at al., 2020: 2). Second, although each 
of the two terms has a different meaning, some authors use the two terms 
interchangeably (Legner at al. 2017: 3). Digital innovation is considered the cause of 
digital penetration (Rodríguez-Abitia & Bribiesca-Correa, 2021: 1). However, DT is 
considered the change process caused by both digital penetration and digital 


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innovation. At the same time, DT is also considered as a result of digital innovation 
(Skog et al., 2018: 432).
According to Tilson et al. (2010: 2), digital technologies have paved the way 
for digitisation, digital innovation, penetration and digital media. Due to the use of 
digital technologies, organizations must simultaneously make changes at multiple 
levels, including its strategy and culture (Ismail et al., 2017).
The implementation of digital transformation is linked to strategies where 
organisations seek to set and redefine key objectives that are in line with increased 
customer expectations. Essentially, companies implementing digital transformation 
can innovate and optimise their operations by upgrading their business model. In 
addition, the culture of the organisation is directly linked to digital transformation, as it 
can accelerate its implementation or, conversely, be a problem and a cause of delay. 
The consumers themselves also play a key role in the implementation of digital 
transformation, as digital transformation comes to be linked to their real needs, as 
well as to the requirements they express. Finally, it should be mentioned that through 
the applications of digital transformation, the levels of interaction between the human 
resources and the organization are enhanced, as well as between the customers and 
the organization itself (Ministry of Digital Governance, n.d.). 
2.2. The cost-benefit regulation on the traditional banking 
operations 
Regulation ideas have been founded on two basic paradigms: public interest 
and private interest theories. The assumption behind public interest regulatory 
theories is that regulators have sufficient knowledge and enforcement powers to 
successfully promote the public interest. Thus, regulation is provided in response to 
public demand for the correction of inequitable or inefficient market processes 
(Baumol, 2004). The implication is that regulations are designed to serve society as a 
whole rather than popular vested interests. 
According to the public interest viewpoint, regulation supports the efficient 
operation of banks by simply avoiding market failures for the benefit of larger civil 
society (Whynes and Bowles, 1981). Because regulators are regarded as neutral 
arbiters, they would not be hampered by information market failures, and they could 
more easily package information to establish the point at which the marginal cost of 


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intervention equals the marginal social benefits (Asch, 1988). As a result, the public 
interest would be served if the banking system allocated resources in a socially 
optimal manner that maximizes production while minimizing variations, i.e. 
maximizes social welfare. In contrast, the private interest theory of regulation is more 
skeptical of regulators' motivations and behavior, viewing regulation as socially 
ineffective. The regulators are supposed to be under-informed about cost, demand, 
quality, and other aspects of corporate behavior. They are also vulnerable to 
regulatory capture by advocacy or special interest groups. As a result, when it comes 
to controlling enterprises or societal activities, they can only do it imperfectly, if at all 
(Den Hertog, 2010: 20). 
2.2.1. Capital Requirements and Cost Efficiency 
Bank capital adequacy is critical in mitigating financial insolvency. Several 
studies have found that tight capital requirements improve bank cost-efficiency 
(Haque and Brown, 2017: 7; Chortareas et al. 2012: 297). Other studies, on the other 
hand, have claimed that strict financial market regulation has the potential to harm 
banks' performance by prohibiting them from enjoying economies of scale and scope 
through a more diverse variety of banking products or a bigger scale of operations 
(Barth et al., 2013: 26-27). In this situation, regulations may result in inefficient 
resource allocation; thus, deregulation allows and pushes banks to use more efficient 
manufacturing practices (Claessens & Laeven, 2004: 5).
According to Anginer, Demirguc-Kunt, and Zhu (2014: 21), prudential capital 
requirements appear to have a favorable influence on bank stability in banking 
sectors with (1) relatively weak supervision and monitoring and (2) underdeveloped 
institutions. Furthermore, he established that banks in transition nations saw a surge 
in demand for bank loans during the research period because the majority of those 
countries had seen sustained growth and low inflation rates for over two decades. 
However, the presence of regulatory capital requirements has constrained banks' 
ability to develop. 
When controlling for other supervisory and regulatory policies, Barth et al. 
(2004) discover that, while stringent capital requirements are associated with fewer 
nonperforming loans, capital stringency is not robustly linked with banking sector 
stability, development, or bank performance (measured with overhead and margin 
ratios). Furthermore, in determining whether greater capital requirements are 
worthwhile, D’Erasmo (2018: 5) discovered that higher capital requirements cause 


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major banks to grow larger, placing pressure on small banks to combine or collapse. 
As huge banks' market clout develops, they extract higher profits by hiking lending 
rates, which tightens credit and depresses the economy's productivity. Furthermore, 
fewer fail while taking more risks because their charter value is higher under the 
tighter capital requirements. 
2.2.2. Liquidity Requirement and Cost Efficiency 
Liquidity is crucial to the stability of the banking system, given that it 
represents the ability to fund assets and satisfy obligations when they fall due. 
According to Ryan et al. (2014: 28), tougher liquidity laws would compel banks to 
change both their asset and liability organizations in order to meet these new criteria. 
This suggests that their policies tend towards improving their share of high-quality 
liquid assets and funding from more stable non-financial deposits while at the same 
time, strive to lower the short-term intra-financial loans share and short-term 
wholesale funding. Corporate lending rates and interbank funding costs are also 
influenced by the liquidity ratio. Bonner and Eijffinger (2012) discovered that Dutch 
banks who fell short of their liquidity targets did not impose a higher interest rate on 
business loans. Furthermore, the banks paid higher interest rates on unsecured 
interbank loans, despite the fact that this regulatory information was not made public. 
2.2.3. Interest Rate and Cost Efficiency 
According to Eregha (2010: 41), interest rates have a favorable impact on 
domestic loan demand in the short term but a detrimental impact in the long run. 
Increases in actual lending rates may not have an immediate impact on credit 
demand; nevertheless, in the long run, they may lead to a decrease in credit demand 
and vice versa. As a result, the possibility that interest rate regulation is an 
unproductive policy choice emerges. According to Maimbo and Gallegos (2014: 23), 
interest rate caps are ineffective at addressing the underlying causes of high rates, 
such as a lack of market competition, market inefficiency, large fiscal deficits, and 
legal bottlenecks that prevent customers from switching banks, and they introduce 
additional distortions into the system as banks attempt to circumvent caps. 


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2.2.4. Quality of Funding and Cost Efficiency 
According to Arnould et al. (2021: 2), excessive funding costs caused by 
bank-specific vulnerabilities can erode banks' revenues and deplete banks' capital 
buffers in bad times or slow their build-up in good times. This means that excessive 
funding costs caused by bank vulnerabilities might harm banks' ability to absorb 
macroeconomic shocks and jeopardize the banking sector's overall stability. 
Furthermore, Arnould et al. (2021: 11) believe that if increased funding costs are 
carried through to higher lending rates, the real economy will suffer by decreasing 
demand for new lending, causing deleveraging, and resulting in weaker economic 
activity. Ellis and Flannery (1992: 485) demonstrated the relationship between capital 
levels and interest rates. They give empirical evidence that lower capital levels are 
connected with higher interest rates on uninsured deposits. 
2.2.5. Security Market Regulation and Cost Efficiency 
The creation of an informationally and financially efficient market is aided by 
the security market. According to Avgouleas and Cullen (2014: 8), countries with 
underdeveloped capital markets and inefficient legal frameworks make market 
discipline an inadequate instrument for improving banking sector efficiency. 
Furthermore, a lack of openness in financial transactions and poor information quality 
cause principal/agency relationships to fail, resulting in severe restrictions in 
comprehending and assessing risks, rendering traditional models of corporate 
governance useless. In opposite, Barth et al. (2013) believe that regulatory scrutiny 
has been severely influencing the efficiency of the banks by imposing expenses, 
including higher origination standards, slower loan growth, compliance costs and 
inefficiencies. 
2.2.6. Bank size and Cost Efficiency 
Bank size, which is frequently assessed by total assets, determines both the 
scope of activity and the type of clients it serves. Huge banks, for example, have a 
customer that is more stable, such as governments, large enterprises, and 
international corporations. Small banks, on the other hand, primarily serve 
disadvantaged and low-income households and their microenterprises. Larger banks 


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are more efficient, according to Tecles and Tabak (2010: 1592). On the contrary, Isik 
and Hassan (2002: 731). 
2.2.7. Macroeconomic Environment and Cost Efficiency 
Economic growth increases cost-efficiency, whereas inflation increases cost-
inefficiency. The negative relationship between GDP growth and cost inefficiencies is 
that increased disposable income leads to increased demand for goods and services 
produced by enterprises. Increased sales would, in turn, enhance enterprises' and 
consumers' debt service capabilities, resulting in a decrease in non-performing loans. 
Rinaldi and Sanchis-Arellano (2006: 6) discovered that rising inflation impairs the 
performance of the bank loan portfolio, implying a positive (negative) link between 
inflation and cost inefficiencies. In studies to capture the effect of the macroeconomic 
environment, inflation and GDP growth rate have been utilized (Osoro & Kiplangat, 
2020: 10). 
Mulidy (2021) estimated the Bank regulation - Cost inefficiency nexus at 
Industry-level. According to the findings, rigorous capital requirements have a 
favorable and statistically significant influence on bank cost efficiency. This finding 
indicates that banks' cost-cutting behavior is positively related to capital-requirement 
tightening. The findings are consistent with those of Barth et al. (2013), Haque and 
Brown (2017) and Chortareas et al. (2012), who found that rigorous capital 
requirements improve bank cost efficiency. 
Coefficient 
T-ratio 
Constant 
16.387 
5.00 
Capital adequacy 
-3.9519 
-4.21 
Liquidity Ratio 
5.4464 
9.60 
Interest Rate 
-0.00005 
-1.36 
Quality of Funding 
-0.31717 
-1.31 
Size 
-0.93942 
-2.89 
Security Market Dummy 
0.67314
1.11 
GDP Growth Rate 
-18.9698 
-1.90 
Inflation rate 
-4.0909 
-1.46 
Table 1 Bank Regulation - Cost Inefficiency Nexus at Industry-Level (Mulindi, 2021) 
According to Cambis (2012), since the 1960s and 1970s, with the seminal 
work of Phelps, Friedman, and Lucas, inflation expectations have been a central 


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factor in models of inflationary dynamics, and they play a crucial role in New 
Keynesian dynamic stochastic general equilibrium (DSGE) models used to inform 
and evaluate monetary policy. In many inflation models utilized by central banks
inflation is driven by three primary factors: some measure of a resource utilization 
gap (such as the output gap or unemployment rate gap) or marginal cost of 
production; lagged inflation, which captures the inertia in the inflation process; and 
inflation expectations. According to Coibion, Gorodnichenko, and Ropele (2019), 
enterprises do base pricing decisions on their inflation forecasts, and their research 
demonstrates that firms boost prices in response to rising inflation expectations. 
Additionally, the OECD Composite Leading Indicators (CLIs), which are 
designed to predict economic activity reversals over the next six to nine months, 
continue to indicate a deteriorating picture in the majority of the world's largest 
nations. The CLIs continue to foresee a loss of growth momentum in the majority of 
significant OECD nations, as they are weighed down by historically high inflation, 
poor consumer confidence, and falling share market indexes. The OECD composite 
leading indicators are cyclical indicators based on a variety of forward-looking 
measures, including order books, building permits, confidence indicators, long-term 
interest rates, and new vehicle registrations, among others (Cambis, 2022). 


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References 
Alvesson, M., & Sveningsson, S. (2015). 

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