The Reserve Bank of India (RBI) said on Monday that the regulations must set boundaries to contain irrational exuberance among participants and ensure a sound institutional framework, promoting financial stability.

In a report titled Currency and Finance for the year 2023-24, themed India’s Digital Revolution, the RBI said, “The rapid digitalisation of the financial sector in India poses significant regulatory challenges, requiring regulators to stay ahead of the innovation curve while balancing financial stability, competition, and customer protection.”

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In the context of peer-to-peer lending, regulations have positively impacted trust-building, thereby enabling financial innovation adoption, RBI report said.

“This necessitates enhancing the capacity of regulated entities, updating legal frameworks, engaging stakeholders to identify risks, and expanding consumer education.”

It further said that loosening entry barriers could promote FinTech lending based on weak business models and inadequate cyber infrastructure.

Unregulated non-bank payment services could disadvantage traditional banks, leading to regulatory arbitrage and deposit disintermediation, it added.

Globally, countries have enacted regulations to strengthen enforcement in FinTech activities to address these challenges.

The report also said that the digitalisation generates vast amounts of data, facilitating the use of advanced models like AI and Generative AI in the financial sector.

The share of India in granted AI patents in the world is also low.

However, balancing financial security through data analytics with individual privacy protection remains a significant challenge, as stated in the report.

The increased use of AI algorithms by financial institutions presents additional challenges such as lack of explainability, potential biases, false signals, and substantial integration costs.

According to the report, Central bankers must also closely monitor quantum computing developments due to growing concerns about the vulnerability of current cryptographic methods in securing financial transactions

Designing responsible and ethical AI solutions for financial services would necessitate consideration of ten principles – fairness; transparency; accuracy; consistency; data privacy; explainability; accountability; robustness; monitoring and updating; and human oversight, the report recommended.