Under the Hood: Tech complexity spurs enhanced risk measures

Advances in digitalization and machine learning are sparking a need for lenders to revisit operational risk management protocols. In the wake of the financial crisis, and again throughout the pandemic, lenders worked diligently to rein in the risk of losses resulting from external events and inadequate internal processes, people and systems. They prepped for operational risk triggers like employee errors, technological failures, natural disasters and fraud events. But in recent years, operational complexity has intensified. Data, analytics and IT architecture drive workflow automation and digital risk management. Fintech partnerships offer the potential for expanding products and services — often in short timeframes — but they also open the door to increased cyber-risks and single points of failure. And while machine learning and artificial intelligence reduce costs and increase efficiencies, they could also raise issues of decision bias and the ethical use of customer data. This confluence of factors has the Office of the Comptroller of the Currency taking notice. The regulator described operational risk as “elevated” in a December 2023 report outlining risk management pitfalls that pose threats to banks’ safety and soundness and their compliance with applicable laws and regulations. On the heels of the report, the agency initiated an enforcement action against City National Bank , fining the Los Angeles-based financial institution $65 million for systemic deficiencies in risk management and internal controls. Other regulators have clamped down on lenders for similar risk management violations. In April 2023, the Federal Deposit Insurance Corp. issued a consent order against Cross River Bank alleging weaknesses in the oversight of its fintech lending partners . In that case, the FDIC required the bank to implement a series of compliance reforms and obtain the agency’s approval before inking any new fintech partnerships. For auto financiers, core operational risk threats center on cybersecurity, new-product adoption and third-party providers, according to the OCC. Specifically, sophisticated data breaches and phishing emails against financial services firms, which are becoming more prevalent, could render critical data inaccessible or leak confidential customer data. In its report, the OCC urged lenders to fine-tune protocols to monitor threats and vulnerabilities and to implement security measures like multifactor authentication. Industry guidance also urges financiers to reevaluate policies for securing and disposing of consumers' sensitive personal information. On the innovation and new-product front, lenders would be wise to revisit the integration of technologies that enable real-time payments , mobile and digital technologies, application programming interfaces and data-aggregation services with their existing legacy systems. An important consideration is the balance between the benefits and enhanced capabilities afforded to customers versus the associated risk threats. Additionally, as banks increasingly seek fintechs and other third-party providers to deliver innovative financial products and services, they must ensure effective management and oversight of those partners. For instance, as financiers increasingly adopt cloud services, they must bolster their third-party assurance reviews. Specifically, service organization controls reviews, penetration tests and vulnerability assessments can help lenders determine whether their providers comply with applicable laws. Third-party risk management extends beyond collecting documents during onboarding and conducting annual reviews. Regulatory examiners are demanding that financiers review and assess third-party risk throughout the lifecycle of the relationship. Meanwhile, though the uses for AI continue to evolve and expand, the OCC cautioned lenders about the potential for AI-related bias and discrimination. Granted, the agency acknowledged that effective AI can lower costs and enhance efficiencies; improve products, services and performance; strengthen risk management; and expand access to credit. Combined with advances in computing capacity, AI use-cases have multiplied, running the gamut from customer chatbots, fraud detection and credit scoring. But on the flip side, AI can create new risks, like a lack of explainability or the potential for bias. For instance, an AI system that is improperly trained or is used with data sets that reflect past biases could perpetuate historical discrimination, the OCC noted. Further, widespread adoption of AI could present significant challenges relating to compliance risk, credit risk and reputation risk. As technology and digitalization continue to advance, financial institutions should double down on operational risk procedures. Efforts to hone protocols should entail identifying, measuring, monitoring and controlling risks to steer clear of regulators that appear ready to step up enforcement. Early-bird registration is now available for the second annual Auto Finance Summit East 2024 , May 1-3 in Nashville, Tenn., which gathers lenders, dealers and fintech innovators in an event designed to bring the power of technology to a cross-section of industry players. Early-bird pricing ends March 15. Visit AutoFinance.Live to learn more.

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