Managing Risks Related to Artificial Intelligence in Banking: Insights from Federal Reserve Governor Waller

According to reports, Federal Reserve Governor Waller stated on April 20th that as more and more financial institutions use artificial intelligence for customer service applications, fraud monitoring, and underwriting, the Federal Reserve and its regulated banks have had “regular discussions” on managing risks related to artificial intelligence. Waller warns that although artificial intelligence can bring new efficiency to banking processes, it also involves new risks. Waller also stated that so-called smart contracts – or automated transactions on the blockchain, whose results depend on pre programmed inputs – can bring “considerable hope” for the modernization of transaction settlement. However, he pointed out that smart contracts also bring risks, such as network vulnerabilities.

Federal Reserve Waller: The Federal Reserve is discussing managing artificial intelligence risks with banks

As financial technology continues to evolve, more and more financial institutions are using artificial intelligence (AI) for various applications such as customer service, fraud monitoring, and underwriting. While AI undoubtedly brings new efficiencies to banking processes, it also poses new risks that regulators must learn to manage.
On April 20th, 2021, Federal Reserve Governor Waller spoke about the need to manage these risks in a speech to a virtual conference on the Future of Payments. According to reports, the Federal Reserve and its regulated banks have had “regular discussions” on this topic. Here, we will take a closer look at what Waller had to say about the potential risks of AI in banking, and how policymakers can address these risks.

The Promise and Risks of Smart Contracts

One area of AI-related innovation that Waller mentioned is smart contracts. These are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exists on a public blockchain network which helps to provide immutability of records and therefore builds more trust between both parties involved.
In terms of modernizing transaction settlement, Waller saw smart contracts as offering “considerable hope.” However, he also pointed out that these contracts come with their own set of risks. For example, network vulnerabilities could be exploited by hackers to manipulate smart contracts, leading to substantial losses for users. Regulators must learn to manage these risks just as they would with any other financial innovation.

Balancing Efficiency and Risk Management

According to Waller, financial institutions must prioritize the issue of risk management when it comes to adopting new technologies such as AI. This requires striking a balance between the efficiencies brought by AI and the need to manage AI-related risks.
One approach to managing these risks is to develop clear guidelines and regulatory frameworks for AI use in banking. These frameworks should address issues such as data privacy, algorithmic bias, and transparency in AI-based decision-making processes. Moreover, there should be ongoing monitoring and review of AI systems to ensure compliance with these guidelines on a regular basis.
Another way to manage risks associated with AI is to increase collaboration between financial institutions, regulators, and the broader tech industry. This cooperation can help to identify new risks and devise appropriate solutions while minimizing potential damage.

Conclusion

In conclusion, Federal Reserve Governor Waller’s remarks about managing risks related to artificial intelligence in banking underscore the importance of exploring the promises and challenges of AI. Smart contracts, as an example of AI in finance, offer exciting possibilities for modernizing transaction settlement, but require vigilance on the part of regulators and businesses to ensure their sound use. Ultimately, creating effective frameworks which balance efficiency and transparency in AI-based decision-making will be critical to unleashing the full potential of these powerful new technologies in finance.

FAQs

**1. What are smart contracts, and how do they work?**
Smart contracts are self-executing contracts with the terms of agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist on a public blockchain network that helps to provide immutability of records and therefore builds more trust between both parties involved.
**2. What risks do smart contracts pose to the financial industry?**
Smart contracts come with their own set of risks, primarily in the form of network vulnerabilities that could be exploited by hackers to manipulate smart contracts, leading to substantial losses for users.
**3. How can regulators mitigate the risks of AI use in banking?**
Regulators can mitigate the risks of AI use in banking by developing clear guidelines and regulatory frameworks for AI use in finance. Additionally, ongoing monitoring and review of AI systems to ensure compliance with these guidelines on a regular basis is crucial. Collaboration between financial institutions, regulators and the broader tech industry can also help minimize potential risks associated with AI.