New study urges regulatory oversight on AI technology and shadow banks

A former BoC deputy governor calls on regulators to be more proactive

New study urges regulatory oversight on AI technology and shadow banks

Artificial intelligence and open banking technology have the potential to reimagine the financial services world in general and the mortgage profession in particular, but a report from the C.D. Howe Institute warns that these high-tech solutions carry their own risks.

According to the newly published “The Era of Digital Financial Innovation: Lessons from Economic History on Regulation” David Longworth, former Deputy Governor of the Bank of Canada, details examples when the combination of financial innovations, rapid growth in credit supply and increased reliance on short-term financing crossed paths and led to financial instability and crises. The solution, according to Longworth, is a more proactive role by regulators when the financial services world is quickly adapting new technologies.

Among the recommendations offered in the report is the use of Explainable AI (XAI), which enables human oversight of AI-based decision-making process, thus mitigating the risk of potentially unsafe lending decisions. The report also calls on regulators to take a new look at open banking regulations, including money-moving apps that could increase the likelihood of bank runs resulting from errors in data interpretation or information reporting.

Furthermore, the report recommends that Canadian macroprudential regulators bring more attention to nonbank financial intermediaries (NBFIs), or so-called shadow banks, to ensure they produce quarterly data on lending and short-term financing for regulatory review. This would encompass Silicon Valley behemoths inching into the financial services world, such as Google and Amazon, as well as under-the-radar peer-to-peer lending sites for both households and businesses. Longworth recommends stress tests for the NBFIs in relation to their activities, particularly new financing in the form of uninsured mortgages from these institutions.

“The lessons I draw from historical experience about the likelihood that today’s digital financial innovation will cause financial instability are threefold,” said Longworth. “First, the risk will be higher if it leads to an easing of credit conditions overall that, in turn, leads to a credit supply boom. Based on previous experience, this is likely to be more problematic if the boom is in household mortgage credit. Moreover, it will likely be no less of a problem for the overall economy if it occurs in the NBFI sector.

“Second,” he continued, “the risk will be higher if it leads to increased probability of runs on short-term funding from financial institutions. Third, it will be higher if digital financial innovations cause business to move away from banks to NBFIs, thus reducing bank charter value and earnings cushion. In all three cases, however, regulators need to examine the full context of what is happening.”