U.S. Treasury Secretary Yellen said on Thursday that U.S. regulators will make artificial intelligence and the threats it may pose a top priority in 2024. At a meeting of the U.S. Financial Stability Oversight Council (FSOC), Yellen said the committee would focus on monitoring evolving technologies and related risks. The committee was established after the 2008 financial crisis to address systemic risks and also includes the heads of the Federal Reserve and the Securities and Exchange Commission (SEC).
"This year, the committee specifically identified the use of artificial intelligence in financial services as a vulnerability of the financial system," Yellen said before the committee released its annual report. "Supporting responsible innovation in this area allows the financial system to reap benefits such as increased efficiency, but existing risk management principles and rules should also apply."
In its annual report, the Financial Stability Oversight Council outlined some of the risks that AI could introduce or amplify at financial institutions, including the potential for it to apply discriminatory biases in lending, particularly for AI programs that operate like "black boxes" whose outputs are difficult to interpret.
“Of particular concern is the potential for AI systems with interpretability challenges to produce and potentially mask biased or inaccurate results,” the report said. This could impact, but is not limited to, consumer protection considerations such as fair lending. "
Despite the new focus on artificial intelligence, the report lacks specific regulatory recommendations and provides only vague direction to member institutions and financial firms.
"The committee recommends that financial institutions, market participants, and regulators further build expertise and capabilities to monitor innovation and use of artificial intelligence and identify emerging risks," the report said.
In her comments, Yellen also mentioned several other risks to financial stability that the committee is watching closely, from high interest rates (including commercial and residential real estate) to climate change and cyber threats. She also singled out "areas in the financial system where leverage is rising."
The phrase was an unabashed reference to hedge funds, whose leverage has become a concern for regulators.
In its report, the Financial Stability Oversight Council described the role of leveraged hedge funds involved in certain trades during the brief liquidity crisis that rocked the U.S. Treasury market in March 2020.
"In the current economic environment, disorderly unwinding of underlying cash futures positions of leveraged funds could pose a risk to financial stability if fund unwinding harms market functioning, as occurred in March 2020," the report said.
The committee added that two cross-departmental working groups were "considering policy options" to address vulnerabilities.
Financial companies are generally healthy but regulators should remain vigilant, Yellen said as she assessed the risks facing 2023, which included the collapse of three high-profile banks that affected the banking industry.
She said: "FSOC member institutions acted quickly to mitigate the serious risk of contagion and maintain confidence in the banking system. But these failures also highlight that vulnerabilities remain."
The report reviews March banking events in more detail, focusing on lessons learned. The report, similar to one released by the Federal Reserve earlier this year, placed much of the blame on mismanagement by affected banks, which ignored risks associated with interest rates and uninsured deposits. But it also commented on the unprecedented pace of bank runs in March.
"These rapid runs have been exacerbated by a highly concentrated depositor base, technological advances in digital banking, and the increased speed at which information is disseminated via social media. The contours of these recent failures provide important lessons for managing and responding to operational risks going forward," the report said.