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FRM Part II · FRM Exam Part II · The Financial Stability Implications of Artificial Intelligence

Ten banks each use one of two foundation model providers for trading signals: 8 banks use Provider X and 2 use Provider Y. A flaw in Provider X's model update causes similar erroneous signals during a stress. Which outcome most plausibly illustrates the amplification channel the FSB associates with this setup?

The most plausible outcome is correlated trading behaviour among the eight banks using Provider X, which amplifies herding, volatility and liquidity strain. Common models and data produce similar actions simultaneously, so concentration turns a single vendor flaw into a market-wide stability problem.

  1. AIdiosyncratic losses that offset each other across banks
  2. BCorrelated trading behaviour among the 8 banks, increasing herding, market volatility and liquidity strainCorrect
  3. CLower systemic risk because Provider Y's banks hedge Provider X's error
  4. DReduced procyclicality because models are standardised

Explanation

Common models or data across firms can cause similar positions and simultaneous reactions, increasing herding and procyclicality in stress. Standardisation does not reduce correlation; it raises it. Provider Y's 2 banks are too few to offset the effect.

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