A new government report has for the first time identified artificial intelligence as a potential risk to the country's financial stability.
The Financial Stability Oversight Council (FSOC), a group charged with monitoring potential vulnerabilities in the financial sector and which includes among its members Treasury Secretary Janet Yellen, Federal Reserve Chairman Jerome Powell, and the Securities and Exchange Commission Chairman Gary Gensler acknowledged this risk, along with 13 others, in your annual reportwhich was released on Thursday.
“AI systems' reliance on large data sets and third-party vendors introduces operational risks related to data controls, privacy, and cybersecurity,” the report reads.
In recent years, rapidly developing technology has been used more widely in the financial sector to help identify patterns. Gensler, however, warned of inherent risks and said it could increase financial fragility.
“There are challenges with respect to explainability, bias and accuracy,” Genseler said, according to comments prepared for the FSOC open meeting on Thursday. “AI can also be used by bad actors to mislead people in the markets.”
In May, an AI-generated image purported to show an explosion near the Pentagon. The image, which was determined to be fake, spread across social media, shaking the stock market and causing a brief sell-off.
In her prepared remarks for the meeting, Yellen predicted that AI adoption will become widespread and said its use must be carefully managed.
“Supporting responsible innovation in this area can allow the financial system to realize benefits such as greater efficiency, but there are also principles and rules for risk management that should be applied,” Yellen said.
Silicon Valley bank collapse
The report also offers an autopsy on the March collapse of the Santa Clara-based building.which was the second largest bank failure in US history and triggered a regional banking crisis.
On March 10, the FDIC seized SVB as well as the New York-based company.– and guaranteed deposits after a bank run caused customers to withdraw $42 billion in a single day. Additional actions taken by the Federal Reserve and the Treasury Department helped contain the fallout.
The report cited poor risk management and heavy reliance on uninsured deposits among the reasons for the bank's failure. Rising interest rates also left the bank in a vulnerable position, preventing it from meeting its deposit obligations. A separate review in May by the Federal Reserve found that its own regulatory standards were not sufficient.
Looking ahead, the FSOC “recommends that banking agencies closely monitor uninsured deposit levels and depositor composition and collect additional data as necessary.”
Still, despite new recommendations and aggressive measures taken in the spring, some risk remains.
“When two regional banking firms and one global financial firm failed last March, FSOC member agencies acted quickly to mitigate the serious risk of contagion and maintain confidence in the banking system,” Yellen said. “But the rulings also underscored that vulnerabilities remain.”
Vulnerabilities in the commercial real estate sector
The report also identifies another vulnerability for regional and community banks: their “significant concentrations” in the commercial real estate sector. Commercial real estate loans are estimated to total around $6 trillion, and half of them are held by banks.
According to the report, delinquency rates on some commercial real estate loans, especially those backed by office properties, increased in the first half of 2023. Banks expect delinquency rates to continue rising as demand for office space has continued to fall since the pandemic. Commercial developers are struggling to keep up with their mortgages because office vacancies remain high.
In addition, so-called refinancing risk (when borrowers are unable to restructure their debt) is high “due to the considerable number of upcoming maturities in 2024,” according to the report. “These factors can create potential risks to financial stability if they cause financial difficulties among financial institutions and investors that spill over to other financial institutions and the system as a whole.”
Other risks: vulnerabilities in cybersecurity, climate and cryptography
Other risks identified in the report include cybersecurity, climate and cryptocurrency vulnerabilities.
Cyber risk is “pervasive across the economy,” according to the report, and the council says greater partnership between state and federal agencies and private companies, including information sharing, could be key to mitigating the risk.
FSOC is also developing a framework to identify and assess climate risk and recommends that “state and federal agencies continue to coordinate to identify, prioritize, and acquire the data necessary to monitor climate-related financial risks.”
Digital assets (or cryptocurrencies) also pose risks, given the volatility of asset prices. The FSOC recommended in its report that Congress pass legislation to regulate stablecoins (which are stable cryptocurrencies pegged to reserve assets such as the dollar or gold) and other crypto assets.
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