Top US Regulators Sound Alarm on AI Risks for Financial Stability

By: Financial News Correspondent

Top US regulators view artificial intelligence as a looming vulnerability for financial stability, underscoring Washington’s mounting concern over systemic dangers posed by the burgeoning technology.

Treasury Secretary Janet Yellen on Thursday signaled that US watchdogs would make AI, and the threats it could pose, a top priority in 2024. In October, President Joe Biden signed an executive order to establish standards for security and privacy protections for the technology in what the White House heralded as necessary regulation.

During a meeting of the Financial Stability Oversight Council, which also includes the heads of the Federal Reserve and Securities and Exchange Commission, Yellen said the group would focus on monitoring evolving technologies and related risks. The panel known as FSOC was set up after the 2008 financial crisis to deal with systemic risks.

“This year, the council specifically identified the use of artificial intelligence in financial services as a vulnerability in the financial system,” she said ahead of the release of the group’s annual report. “Supporting responsible innovation in this area can allow the financial system to reap benefits like increased efficiency, but there are also existing principles and rules for risk management that should be applied.”

Wall Street giants embraced artificial intelligence this year, adding to their ranks with data engineers and quantitative analysts. The potential impact of AI on finance has spurred warnings from senior regulators, including SEC Chair Gary Gensler and the Fed’s Michael Barr.

In its annual report, the council outlined a number of risks that AI could introduce or amplify at financial institutions, including its ability to apply discriminatory bias in lending, especially for AI programs that operate as “black boxes,” making their output difficult to explain.

“A particular concern is the possibility that AI systems with explainability challenges could produce and possibly mask biased or inaccurate results,” the report said. “This could affect, but not be limited to, consumer protection considerations such as fair lending.”

For all the new attention to AI, the report was short on specific regulatory proposals, offering only vague direction to member agencies and financial firms.

“The Council recommends financial institutions, market participants, and regulatory and supervisory authorities further build expertise and capacity to monitor AI innovation and usage and identify emerging risks,” it said.

In her comments, Yellen also mentioned several other risks to financial stability the council is watching closely, from high interest rates — including to commercial and residential real estate, to climate change and cyber threats. She also made a point of mentioning “areas of the financial system where leverage is increasing.”

This was a not-so-veiled reference to hedge funds, where leverage has emerged as a concern for regulators.

In its report, FSOC took pains to describe the role played by leveraged hedge funds engaged in a particular trade in the brief liquidity crisis that gripped the market for US Treasuries in March 2020.

“A disorderly unwinding of leveraged funds’ cash-futures basis positions in the current economic environment could pose a risk to financial stability if fund liquidations impair market functioning, as they did in March 2020,” the report said.

It added that two interagency working groups were “considering policy options” for addressing vulnerability.

Taking stock of risks faced in 2023, including three prominent bank failures that rocked the banking sector, Yellen said financial firms were broadly sound, but regulators ought to remain vigilant.

“FSOC member agencies acted quickly to mitigate the serious risk of contagion and to maintain confidence in the banking system,” she said. “But the failures also underscored that vulnerabilities remain.”

The report reviewed the March banking episode in more detail, with a focus on lessons learned. The report, similar to one earlier this year from the Fed, put most of the blame on poor management at the affected banks, which ignored the risks associated with heavy exposure to interest rates and uninsured deposits. But it also remarked on what it termed the unprecedented speed of the March bank runs.

“These rapid withdrawals were exacerbated by the highly concentrated depositor base, technological advances in digital banking and the increasing speed of information transmission through social media,” the report said. “The contours of these recent failures provide important lessons for managing and responding to run risk going forward.”

The report recommended that banking regulators monitor uninsured deposit levels but made no specific proposals that might address the speed of modern bank runs.