Davis Polk partner Gabe Rosenberg was quoted in American Banker discussing financial institutions’ use of AI and its potential regulation. He said that until regulators fully understand the back-end mechanics of AI models and uses they will be unlikely to give their blessing.

“If you think about regulation and examinations, generally they are a study of what financial institutions do and how to incentivize them to do the right things, but if you don’t really know why they’re doing what they’re doing, that becomes really difficult,” he said. “I think there are concerns that the AI would be making decisions based on the wrong things, like that they’d be looking at correlation between events rather than causation.”

He noted the potential that a wide swath of banks will make similar decisions as a result of relying on similar AI models – a phenomenon often referred to as herd behavior. While not a new risk, he said, regulators will be eyeing this closely, noting remarks recently made by SEC Commissioner Gary Gensler calling for regulators to be attentive to the potential for herd behavior.

“Herd behavior is a concern anywhere traders all look at the same signals,” he said. “If everyone does the same thing at the same time, that can lead to both bubbles, as we see in the meme stocks and crashes, when people do the same thing. It reminds me of the run on repo during the 2008 financial crisis, where everyone had set up the same risk web and [did] the same thing at the same time, which caused a lot of problems.”

Gabe also noted that there is still significant uncertainty as to the extent to which generative models can predict unprecedented edge-case scenarios, something even human examiners struggled to anticipate in the 2008 financial crisis and bank failures this year. AI is trained on historical data, so it may have a blindspot towards less-predictable outcomes.

“By definition, tail risks either are super uncommon, or there’s something we just think about and don’t know about in advance,” he said. “Just like the financial regulators, the industry sees things in retrospect that should have been obvious, people are worried the same will happen to AI and won’t be able to react to them in real time.”

Given regulatory uncertainty, banks will take tentative steps to embrace AI,” American Banker (November 7, 2023) (subscription required)