After completing this reading, you should be able to:

 Describe historical evolution and common types of AI-based applications used in the
financial sector.
 Explain the advantages of implementing AI-based applications to the banking services
companies and their customers.
 Discuss the disadvantages and difficulties for financial companies using AI.
 Clarify the specific issues faced by banks and regulators arising from utilizing AI in
modeling and valuation.

Historical Evolution and Types of AI in the Financial

Sector

The Inception of AI and Its Growth in Finance

Artificial Intelligence (AI) as a concept dates back to the mid-20th century, originating from
the thoughts of influential figures such as mathematician and cryptographer Alan Turing.
Turing sparked the AI discussion with his 1950 essay on the potential of machines to imitate
human intelligence. This intellectual curiosity gave rise to significant AI milestones, such as
IBM’s Deep Blue defeating chess champion Garry Kasparov in 1997. Since then, AI has
experienced a surge in growth and capabilities, primarily through the advancement of
machine learning (ML) methodologies, including the development of digital neural networks.
These neural networks have become prevalent in classifying various types of data, including
text and images, which has facilitated AI implementation in numerous industrial applications
and consumer services—ranging from Google searches to Netflix recommendation
algorithms. In recent developments, ML has become fundamental to the creation of
innovative generative AI applications, like ChatGPT. These programs are engineered to
perform various tasks, including engaging in productive dialogues with people. This
advancement is particularly notable in the context of U.S. financial institutions.

AI’s Foray into the Financial Sector

The U.S. financial industry has actively engaged with AI technology, applying it for a
multitude of functions. Despite this, the sector has exhibited a cautious and measured
approach to full AI integration. In a 2019 study, McKinsey & Co. discovered that the
adoption of AI in the financial services industry was quite limited. Only about 36% of those
surveyed said their companies used AI to automate back-office tasks. The usage of AI in
customer service chatbots and for detecting fraud or assessing creditworthiness was even less
common, at 32% and 25%, respectively. Cornerstone Advisors, another consultancy,
conducted a similar survey in 2022 among bank and credit union leaders. Their findings were
even more striking, revealing that a mere 25% had implemented AI for process automation,
and just 18% had introduced AI-based chatbots. The moderate uptake suggests an industry
that is still in the process of comprehensively embracing AI’s potential.

The Spectrum of AI Applications in Finance

Financial institutions in the U.S. have developed and deployed AI for various purposes,
signaling a steady growth and potential expansion in the role of AI within the sector.
Awareness of this trajectory has prompted bank regulators to keep a keen eye on how banks
use AI. This oversight has materialized in actions such as the Request for Information (RFI)
issued in March 2021 by key bank regulators like the Comptroller of the Currency (OCC) and
the Fed Board of Governors, which sought to gather more insights into the banks’ current and
future practices related to AI. It elucidates a commitment to adapt regulatory measures as AI
continues to evolve within the landscape of the financial industry.

Advantages of AI Implementation in Banking

 Enhanced efficiency and customization: In the financial sector, adopting AI

technology has led to substantial improvements in operational efficiency and service
customization. Banks deploy machine learning (ML) to streamline back-office tasks,
enhance customer service through chatbots, and increase the precision of fraud
detection and credit evaluations. The introduction of AI allows for sophisticated data
analysis, leading to the identification of fraudulent transactions and minimizing false
positives.
 Proactive Problem solving and improved customer interaction: AI-based
applications within banking operations facilitate proactive problem-solving by
highlighting suspicious patterns that warrant further investigation. Tools employing
AI provide banks with the capacity to monitor transactions dynamically, aiding in the
prevention of financial crimes with their enhanced detection capabilities. Moreover,
customer interactions are significantly improved through AI with services such as
efficient chatbots that can handle a high volume of queries, leading to a better overall
customer experience. In addition, AI systems utilizing pattern recognition have
enabled clients to remotely deposit checks, eliminating the need for additional visits
to physical bank branches.
  Credit evaluation: AI applications are revolutionizing credit evaluation and loan
underwriting, particularly within the retail sector, including credit card and
automobile financing. These AI systems provide enhanced efficiency and accuracy in
credit decisions while ensuring compliance with legal standards like the Equal Credit
Opportunity Act. Despite their complexity and perceived opaqueness, efforts are
being made to explain AI-driven credit decisions, maintaining a balance between
innovative AI models and traditional credit evaluation methods used by banks and
credit bureaus.

Disadvantages and Challenges in AI Use for Financial

Companies

 Explainability and transparency issues: A critical concern surrounding the use of

AI within banking is the explainability and transparency of AI-derived decisions and
models. Large AI models based on machine learning algorithms can be opaque,
lacking the clear-cut variables and interpretable coefficients present in conventional
statistical models. This lack of transparency makes it difficult to discern the reasoning
behind AI system outputs, which is particularly problematic for AI-based credit
models that may unwittingly perpetuate biases such as racism, contravening federal
anti-discrimination laws. A lack of model explainability can hinder banks’ ability to
comply with various regulations, including consumer protection requirements.
 Regulatory compliance and bias mitigation: The difficulty in interpreting AI
models also poses significant challenges in adhering to regulatory requirements,
including consumer protection mandates. Bank regulators emphasize the necessity of
comprehending and explaining how AI models reach conclusions to ensure that these
systems comply with applicable laws and regulations. An overwhelming concern is
that AI systems might reflect or amplify biases in their training data, thereby
inadvertently entrenching discriminatory practices.
 Evolving fraudster methods: AI models are commonly used in banks for fraud
detection, particularly in credit card fraud and identity theft cases. However,
fraudsters continuously innovate their attack methods, leading to an escalating game
of cat and mouse between them and the banks.
 Complexity of AI models: Traditional credit evaluation models, similar to those used
by national credit bureaus, are still employed by most banks. These models typically
use a single formula based on a small group of indicators. In contrast, AI models
 involve multiple layers of complex analysis with numerous quantitative and
qualitative inputs, making them more difficult to understand and interpret.

Issues in AI for Banking Modeling and Valuation

Model Validation, Maintenance, and Data Reliability

As AI models adapt and learn from new data over time, they necessitate continuous
monitoring for model validation, maintenance, and documentation. This includes vigilance to
prevent the incorporation of indicators that function as proxies for prohibited attributes like
race in credit evaluations and other decision-making processes, potentially violating anti-
discrimination laws. Bank regulators emphasize the need for banks to understand the inner
workings of their AI models and explain their results to ensure compliance with laws and
regulations. The concern is not only the difficulty in maintaining AI models but also ensuring
the reliability and quality of the data feeding into these models, given that AI’s performance
is heavily dependent on the data it processes. Banks are exploring “nontraditional” data
sources for AI models, such as rent, utility payments, and cash flow patterns. This raises
concerns about compliance with consumer protection laws. Questions remain about the
effectiveness and privacy implications of such data.

Regulatory Engagement and Prudent Model Evaluation

Regulators express a carefully balanced optimism regarding the potential for AI to enhance
certain credit evaluation aspects. The approach taken by banks involves rigorously testing
new models alongside existing ones before making informative decisions based on the new
systems. The broader view is managing the integration of AI technologies thoughtfully, with
an awareness of their possibilities and pitfalls. Bank supervisors are forward-looking,
acknowledging both the apprehensions and the prospective upsides of leveraging AI in
banking operations.