Leading U.S. financial regulators are increasingly recognizing artificial intelligence as a potential threat to financial stability, reflecting a growing concern in Washington about the systemic risks presented by this advancing technology.

U.S. Treasury Secretary Janet Yellen announced that in 2024, AI and its associated risks will be a primary focus for U.S. financial watchdogs.

At a Financial Stability Oversight Council (FSOC) meeting, which includes leaders from the Federal Reserve and the Securities and Exchange Commission, Yellen emphasized the need to monitor emerging technologies and their associated risks. FSOC, established post-2008 financial crisis, has now identified AI use in financial services as a key vulnerability in the financial system.

Yellen highlighted the balance between encouraging responsible innovation in AI, which could bring benefits like enhanced efficiency, and applying existing risk management principles and rules.

Wall Street Quant Trumps All

Major Wall Street firms have significantly integrated AI this year, hiring data engineers and quantitative analysts. This integration has prompted senior regulators, including SEC Chair Gary Gensler and the Fed’s Michael Barr, to issue warnings about AI’s potential impact on finance.

The FSOC annual report outlined several risks AI could introduce or exacerbate in financial institutions. These include discriminatory bias in lending from AI programs that operate as “black boxes,” whose outputs are challenging to explain.

The report expressed concern about AI systems that could produce and potentially conceal biased or inaccurate results, impacting areas like fair lending.

Only Guidance

Despite the new focus on AI, the report lacked specific regulatory proposals, providing only general guidance to member agencies and financial firms. It recommended building expertise and capacity to monitor AI innovation, usage, and emerging risks.

Yellen also pointed to other financial stability risks, such as high interest rates affecting real estate, climate change, cyber threats, and increasing leverage in certain financial sectors, particularly hedge funds.

The FSOC report detailed the role of leveraged hedge funds in the March 2020 liquidity crisis in the U.S. Treasury market and mentioned that two interagency groups are exploring policy options to address these vulnerabilities.

Regulate or Not?

Reflecting on 2023’s challenges, including three significant bank failures, Yellen acknowledged that financial companies are generally robust but emphasized the need for regulatory vigilance. She noted that FSOC member agencies acted swiftly to prevent contagion and maintain confidence in the banking system, yet vulnerabilities persist.

The report reviewed the March banking crisis, attributing most blame to poor management at the affected banks. It also noted the unprecedented speed of the bank runs, exacerbated by technological advances in digital banking and rapid information spread through social media. The report offered insights for managing and responding to future risks but did not propose specific measures to address the accelerated pace of modern bank runs.

That is because in our opinion, there is nothing government can do to regulate AI and we don’t expect to see anything anytime in 2024. The EU passed The AI Act and then quickly withdrew their recommendation based on that same premise. Even if the west passes legislation that will force compliance with transparency rules around LLM training and GenAI architectures, they will only apply to closed systems.

And they will only apply in legally enforceable environments, excluding Russia, China, Iran and North Korea for now.

The net result will translate to a competitive advantage to our adversaries and an innovation speed bump to our developers. That result is in no one’s best interest, even in an election year.