Administering the Future of Digital Banking

Banks must adapt their governance, risk management, and overall management capabilities to manage the risks of crypto activities.

FREMONT, CA: The rapid pace of technological development makes the present era thrilling. It is referred to as the technological renaissance and it is clear that digital transformation in societies and economies is rapidly gaining momentum. Even the banking industry is not immune to these trends, and this has significant implications for both the banking business and supervisory authorities.

The primary focus is on the supervision of banks' digital transformation, as well as the outcomes of digitalisation, which offers a glimpse into the current state of progress. Following this, the broader challenges will encounter while implementing effective regulatory and supervisory measures for the new frontiers of digital finance.

Stay ahead of the industry with exclusive feature stories on the top companies, expert insights and the latest news delivered straight to your inbox. Subscribe today.

Supervising Banks’ Digital Transformation

Technological advancements have been influencing the banking industry for hundreds of years. The distinction of the present scenario arises from the convergence of three tendencies in present-day market conditions. The primary trend is that customers are progressively seeking digital options to perform their routine tasks, aided by the global prevalence of mobile phones, and the abundant availability of apps for carrying out transactions and payments. The second trend is the rapid rate of technological progress, which makes it more convenient and affordable for banks to digitise their operations and procedures, and harness the potential of data to gain a competitive edge. The third trend is connected to the long-standing challenge of obtaining a competitive edge, where new market players are amplifying the constant competitive pressures.

Given these trends, banks now perceive digital transformation to be both an essential strategy and a strategic risk.

As supervisors, the primary focus is not to defend banks' market shares. However, it is in the best interest to ensure that supervision encourages banks to formulate and implement robust digital transformation strategies, particularly if these strategies result in cost-effectiveness, enhancing their profitability and overall business models.

Although the comparison of banks to dinosaurs was once suitable, it is no longer accurate as digital transformation is well underway in the euro area. Nevertheless, the concern is that many banks may not be fully aware of the rapid pace of technological innovation and the pressing need for digital transformation. Recent advancements in artificial intelligence, such as generative AI language models, have the potential to revolutionise many industries. However, banks are making some changes, in the nature, velocity, and scope of their transformation will determine their ability to manage their business models, strategic risks, and operational resilience.

The Status of Banks’ Digital Transformation

Banks aim to enhance profitability through these strategies by improving customer experience and operational efficiency. On average, 5.2 per cent of banks' staff is allocated to digital transformation projects. Despite launching various initiatives and projects, banks find it challenging to measure the revenue and cost impact of these strategies because of their multifaceted nature. Moreover, banks dedicate only a limited budget of around four per cent of their operational costs to digital transformation.

Most banks are utilising cloud and application programming interface technologies, and 60 per cent of them are using AI, with additional use cases in progress. However, only a small percentage of banks are using distributed ledger technologies. Nevertheless, due to the increased interest of bank customers in investing in crypto-assets, this issue needs further investigation. Another important aspect is that banks may be linked to crypto activities through lending products and counterparty arrangements, so it is essential to ensure transparency in these links.

Banks are increasingly relying on outsourcing and partnerships with external companies as part of their digital transformation strategies. However, this practice also presents several risks such as third-party dependency, money laundering, fraud, and cybersecurity. The need to fill gaps in internal technical skills, and the resulting competition for talent, also contribute to the increased reliance on third parties.

The implementation of a digital transformation strategy in a bank requires a comprehensive approach that goes beyond the transformation of individual operations, products, and processes. The entire business model and corporate culture must also transform to achieve success. However, the cultural change of going digital is often more challenging to accomplish than implementing new technology.

To achieve successful digital transformation, banks need to adopt a holistic approach. This means that not only the operations, products and processes of a bank must transform, but also its entire corporate culture and business model. However, cultural change is often more difficult than implementing new technology. Furthermore, in addition to the digital business, investment and resources, banks should also transform their governance and risk management frameworks to achieve this cultural change. As supervisors, it is important to assess the sustainability of a bank's business model and ensure that it has established appropriate governance and risk management arrangements. These arrangements should enable the bank to identify, manage and mitigate risks associated with the use of innovative technologies.

Supervising the New Frontiers of Digital Finance

Over the last 20 years, supervisors of banks and security markets have regularly discussed and analysed the features of financial products and the different ways in which they are delivered, using definitions and classifications of business models to allocate regulatory responsibilities. Although, the challenges that are faced today are more complex due to digital transformation, which has blurred the lines between different financial activities, including those that have traditionally been separated.

The present difficulty is in assigning a home country banking supervisor or establishing an equivalency regime in the securities oversight arena. The lack of a traditional central entry point presents challenges for our current regulatory and supervisory approaches.

The current individual regulatory regimes in different jurisdictions may not be enough, and there is a need for a more integrated global framework to address the new developments in digital financing. Without such a framework, regulatory arbitrage may increase, leading to potential customer losses and even a threat to financial stability.

Europe is currently leading the way in developing regulation for the crypto market with the introduction of markets in Crypto-Assets Regulation (MiCA), which is gaining consensus. However, despite this progress, MiCA alone may not be enough to address all potential gaps, especially if similar levels of oversight do not exist in other major jurisdictions. This may lead to regulatory arbitrage by firms seeking to take advantage of different frameworks, resulting in oversight gaps. Nonetheless, within the EU, it is hoped that MiCA will help to establish effective cross-border cooperation and information exchange among all involved authorities, putting an end to regulatory arbitrage.

The banking industry has always experienced technological innovation throughout its history. The increased demand from consumers, competition, and rapid technological innovation has made digital transformation a strategic necessity for banks. While transforming their business models digitally is crucial, banks must also adapt their governance, risk management, and overall management capabilities accordingly. The speaker emphasizes the need for international regulatory convergence and cooperation in overseeing crypto activities to address potential gaps in oversight. They note that this is not a task of conquering frontiers of outer space, but rather a matter of managing the risks that exist on Earth.