While rapid deployment of Artificial Intelligence and Machine Learning (AI/ML) in finance is promoting efficiency gains, redefining client interfaces, augmenting forecasting accuracy, and improving risk management and compliance, it also carries potential risks, said the RBI.

The central bank cautioned that advances in AI/ML in finance, however, carry potential risks arising out of embedded biases in these systems and the lack of transparency in their outcomes.

Furthermore, the technology potentially embodies new sources and transmission channels of systemic risks capable of undermining financial stability.

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“It is, therefore, imperative to strike a balance between benefits and risks by strengthening the capacity of REs (regulated entities) and surveillance by oversight authorities, formulating/updating relevant legal and regulatory frameworks, proactively engaging stakeholders to identify possible risks, and expanding consumer education,” per RBI’s ‘Report on Trend and Progress of Banking in India 2022-23.’

The Reserve Bank has emphasised that the algorithm used for underwriting should be based on extensive, accurate and diverse data to rule out any prejudices.

Algorithm should be auditable to point out minimum underwriting standards and potential discrimination factors.

Further, lenders should adopt ethical AI which focuses on protecting customer interest, promotes transparency, inclusion, impartiality, responsibility, reliability, security and privacy.

Model-based lending

The central bank said increased collaboration of banks and NBFCs with FinTechs has facilitated introduction of model-based lending.

However, banks and NBFCs need to be careful in relying solely on pre-set algorithms on which the models operate.

These models should be robust and their resilience should be tested periodically. It is necessary to be watchful of any undue risk buildup in the system due to information gaps, which may cause dilution of underwriting standards.

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With the adoption of new technology, which has helped banks and non-banks generate additional revenue, reduce expenses, and manage risk exposure better, the risks of fraud and data breaches have also increased, RBI said.

“Concerted efforts by all stakeholders including regulators, banks and customers are required to protect the system from these threats. On its part, the Reserve Bank has been striving to update the regulations to protect customers while ensuring that innovations are not stifled,” it added.