Why rapid innovations pose risks to financial stability

Regulators urged to gather data on ‘shadow banks’ and to recognise the dangers of A.I.’s decision-making process

Why rapid innovations pose risks to financial stability

The rapid pace of digital innovation in finance through the likes of A.I. and open banking is taking the industry to new levels – but the speed of change poses risks to financial stability, according to a new report from the C.D. Howe Institute.

In “The Era of Digital Financial Innovation: Lessons from Economic History on Regulation” David Longworth, former Deputy Governor of the Bank of Canada, analyses the major macro-level risks arising from current and future digital financial innovation and what the implications are for Canadian regulators.

Longworth believes that economic history gives us many examples of instances when financial innovations, rapid growth in credit supply and increased reliance on short-term financing have led to financial instability and crises. Therefore, at a time of rapid changes in the financial sector, not to mention market meltdowns in bear territory, he said it’s important that regulators pay close attention to what is happening and take appropriate action.

The report documents the dominant influence of credit supply booms as precursors to crises, and the financial innovations that helped fuel them. It recommends requiring the use of Explainable AI (XAI), which employs techniques that allows human oversight of the AI’s decision-making process. Right now, AI is being used in lending decisions at both regulated and largely unregulated institutions. If not properly examined by internal risk managers, it can lead to unsafe lending decisions, according to Longworth.

The report also urges regulators to take care with open banking regulations, for example regarding money-moving apps that could increase the likelihood of bank runs in response to errors made in posting their interest rates or to errors the apps make in interpreting the information.

The report points out that regulators need to take seriously the fact that they have little or no data on non-bank financial intermediaries (NBFIs), or shadow banks. It recommends regulators ensure that quarterly data on lending and short-term financing are gathered for each type of lender, whether regulated or not. Special attention should be paid to lending from Big Tech companies – such as Google and Amazon – especially to small and medium-sized businesses, as well as online, peer-to-peer lending for both households and businesses.

Finally, Longworth advocates for extending the coverage of stress tests to examine stresses related to rapid new borrowing from NBFIs that are not prudentially regulated. Such stress tests should take into account, for instance, substantial 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, 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.”