Thursday, August 28, 2025
Tuesday, August 26, 2025
#AI #Grok: Basel’s risk weighted bank capital requirements, or a leverage ratio, which generates more worthy wealthy?
I asked Grok
“Risk weighted bank capital requirements favoring public debt and residential mortgages over loans to small businesses and entrepreneurs, or the same requirement against all assets, a leverage ratio, which will generate a larger number of what could be described as more worthy wealthy?”
Grok answered:
The leverage ratio—applying the same capital requirement to all assets—will generate a larger number of what could be described as more worthy wealthy, compared to risk-weighted capital requirements that favor public debt and residential mortgages over loans to small businesses and entrepreneurs.
Understanding the Two Approaches
Bank capital requirements are designed to ensure financial stability by requiring banks to hold a certain amount of equity capital relative to their assets (like loans or investments). The two main approaches differ in how they assess risk:
Risk-Weighted Capital Requirements (RWA System): Capital needs are scaled based on the perceived risk of each asset. Low-risk assets, such as government bonds (often 0% risk weight) and residential mortgages (typically 35-50% risk weight), require little capital. Higher-risk assets, like loans to small businesses or entrepreneurs (often 100% or more risk weight), demand much more capital. This creates a strong incentive for banks to prioritize "safe" lending to minimize capital costs and maximize returns on equity (ROE). As a result, banks lend disproportionately to public debt (funding government spending) and mortgages (fueling housing markets), while avoiding or charging higher rates for small business loans due to the capital penalty.
Leverage Ratio: This is a simple, non-risk-based measure: total capital divided by total (unweighted) assets, often set at 3-5% or higher under frameworks like Basel III. All assets are treated equally, regardless of risk. There's no capital "discount" for safe assets, so banks can't game the system by loading up on low-risk items. Instead, to achieve competitive ROE, banks may shift toward higher-yield, riskier assets—like small business loans—that offer better interest rates to compensate for the equal capital treatment.
These differences have real-world economic implications, particularly for wealth creation.
"More worthy wealthy" here refers to individuals or families who build sustainable wealth through productive, innovative activities (e.g., entrepreneurs starting and scaling businesses that create jobs and economic value), rather than through asset inflation in housing or low-yield government financing.
Why the Leverage Ratio Favors More Worthy Wealth CreationThe RWA system distorts lending away from productive entrepreneurship toward less dynamic sectors, limiting the number of successful small business owners and innovators. In contrast, the leverage ratio removes these distortions, potentially increasing lending to high-potential but riskier ventures. Here's a breakdown:
Incentives for Lending Patterns:
Under RWAs, banks face a capital penalty for small business loans (e.g., a $100 loan to an SME might require $10 in capital at 100% risk weight, vs. $0 for government bonds or $3.50 for mortgages). This makes SME lending less attractive, reducing credit availability and stifling entrepreneurship. Studies show Basel III's RWA enhancements have raised the cost of SME lending by increasing banks' weighted capital needs, leading to tighter credit for small firms.
The leverage ratio eliminates risk-weight gaming. Since all assets require the same capital (e.g., 4% of $100 = $4 regardless of type), banks are incentivized to pursue higher-yield options like SME loans (which often carry 8-12% interest rates) over low-yield safe assets (e.g., 2-4% on mortgages or bonds). This "perverse incentive" for risk-taking—shifting portfolios toward volatile, high-return assets—can boost lending to entrepreneurs. Empirical evidence from U.S. banks post-2012 supplementary leverage ratio (SLR) implementation shows increased use of riskier collateral and higher risk-taking, as banks optimize for returns without RWA benefits.
Impact on Wealth Generation:
RWA System: Favors wealth concentration in real estate (via mortgage booms, inflating home prices for property owners) and public sector financing (benefiting governments and bondholders, often large institutions). This creates "unworthy" wealth through speculation or low-productivity growth, with fewer new entrepreneurs succeeding due to credit scarcity. For instance, higher RWAs under Basel III/IV have been linked to reduced SME financing, handicapping small businesses that drive innovation and job creation.
Leverage Ratio: Promotes broader wealth creation by enabling more credit to small businesses and startups, which historically generate the most dynamic economic value. Successful entrepreneurs (the "worthy wealthy") emerge from these ventures, building companies that scale, employ workers, and innovate. Research indicates leverage ratios act as a backstop to RWAs, encouraging balanced risk-taking without over-penalizing productive loans. While it may raise overall capital needs (potentially slowing some lending), it disproportionately benefits high-yield sectors like SMEs by leveling the playing field.
Evidence from Economic Studies and Implementation:
Analyses of Basel III show RWAs increase SME lending costs by 10-20 basis points on average, reducing loan volumes to small firms while boosting mortgage and sovereign exposures.
Leverage ratio introductions (e.g., in the EU and U.S.) have led to portfolio shifts toward riskier assets, with one study finding SLR prompted banks to favor high-return, volatile investments over safe ones like agency mortgage-backed securities.
Brookings Institution reviews emphasize that while RWAs tailor capital to risk (good for stability), they create biases against risky but productive lending; leverage ratios counter this by being simple and risk-neutral, though they require calibration to avoid excessive risk-shifting.
Aspect | Risk-Weighted Requirements | Leverage Ratio |
Treatment of Assets | Favors low-risk (gov debt: 0%, mortgages: 35-50%, SMEs: 100%+) | Equal treatment (all assets same capital charge) |
Incentive for SME/Entrepreneur Lending | Discourages (higher capital penalty reduces ROE) | Encourages (higher yields compensate for equal capital; promotes risk-taking for returns) |
Wealth Creation Outcome | More wealth in housing/gov financing (speculative, concentrated) | More entrepreneurial wealth (productive, distributed via business success) |
Potential Drawbacks | Gaming via low risk weights; undercapitalizes hidden risks | May increase overall risk-taking if not paired with RWAs; higher total capital needs |
Real-World Impact Example | Basel III raised SME costs, reduced small business loans | Post-2012 SLR: Banks shifted to riskier, higher-yield assets |
Caveats and Complementary Use
No single approach is perfect—regulators like the Basel Committee recommend using both (leverage as a "backstop" to RWAs) to balance stability and growth. Pure leverage might encourage excessive risk if banks chase yields recklessly, but in practice, it reduces the bias against entrepreneurs. If implemented standalone, the leverage ratio's equal treatment would likely produce more "worthy wealthy" by fostering a vibrant small business ecosystem, as seen in economies with simpler capital rules (e.g., some community banking models). For maximum effect, it should be set at levels (e.g., 5-8%) that maintain safety while unlocking productive lending.
I said: Thanks!
It said: You're welcome! If you have more questions about banking regulations, economics, or anything else, feel free to ask—I'm here to help.
Here is ChatGPT’s answer to exactly the same question
#AI ChatGPT: Basel’s risk weighted bank capital requirements, or a leverage ratio, which generates more worthy wealthy?
I asked ChatGPT
“Risk weighted bank capital requirements favoring public debt and residential mortgages over loans to small businesses and entrepreneurs, or the same requirement against all assets, a leverage ratio, which will generate a larger number of what could be described as more worthy wealthy?”
ChatGPT answered:
A good way to frame it is to ask: what kinds of wealth creation do different capital rules encourage?
- Risk-weighted requirements (Basel style):Banks can hold less capital against assets deemed “safe” (public debt, residential mortgages, AAA securities). That steers credit toward governments and housing markets. This tends to generate more wealth from financial arbitrage (trading spreads on sovereign bonds, mortgage securitization, and real estate appreciation) rather than from productive business investment. The “wealthy” this system favors are often rentiers, financiers, large property owners, and governments, whose debt is cheaply financed. These are “worthy” mainly in the sense of political or financial clout, not necessarily in terms of creating broad productivity gains.
- Leverage ratio (same capital requirement on all assets):Here banks must treat all loans equally in terms of equity backing. That makes lending to small businesses and entrepreneurs comparatively less penalized. While risk is higher, it also channels credit to activities with greater potential for new value creation—jobs, innovation, competitive growth. The wealthy who emerge under this regime are more likely to be entrepreneurs and builders of productive enterprises, rather than those who accumulate from safe-asset subsidies.
So:
- Risk-weights → more wealthy from exploiting regulatory privilege and asset inflation.
- Leverage ratio → more wealthy from actual economic innovation and risk-taking.
In other words, the latter is more likely to generate what could be described as “more worthy wealthy”—those whose fortunes stem from adding to real economic dynamism, not riding regulatory distortions.
Would you like me to illustrate this with some historical examples of each type of wealthy class that emerged under these two regimes?
I said: Yes, why not
ChatGPT said: Great. Let’s take some historical illustrations to make the contrast concrete:
1. Wealth under risk-weighted rules (Basel era, post-1988)
- Government bond dealers and sovereign lenders:After Basel I allowed 0% risk weights for government debt in domestic currency, banks massively increased their holdings. Wealth grew among dealers and investors who captured spreads on sovereign bonds with almost no capital backing. For example, Southern European banks pre-2010 sovereign debt crisis loaded up on their governments’ bonds, boosting balance sheets while enriching bond traders and financial intermediaries—until the crisis exposed the hidden risk.
- Real estate magnates and mortgage financiers:Lower risk weights for residential mortgages fueled massive credit flows into housing markets. This contributed to the rise of real estate billionaires and mortgage-backed securities financiers in the 1990s–2000s. The U.S. housing boom that culminated in 2008 is the clearest case: wealth accumulated disproportionately in property owners, mortgage originators, and securitizers like Countrywide or Lehman’s MBS desks—rather than in productive enterprise.
2. Wealth under flat leverage ratios (historical analogies)
- 19th-century U.S. and U.K. banking:Before risk-weighted rules, banks essentially operated under crude leverage limits or market discipline. Credit was riskier, but it flowed strongly into railroads, steel, and industrial ventures. Many of the “robber barons” (Carnegie in steel, Vanderbilt in railroads, Rockefeller in oil) became wealthy not because regulators privileged their sectors, but because banks financed their risky but transformative projects.
- Postwar small business lending (U.S. 1945–1970s):Though regulation was different, capital rules were closer to leverage-based, without today’s heavy risk-weight distortions. This period saw credit support for manufacturing and small enterprise. The wealthy who rose were more often entrepreneurs (tech pioneers, manufacturers, even regional developers) rather than primarily bond dealers or securitizers.
Bottom line
- Risk-weighted era → sovereign bond traders, property tycoons, financial engineers.
- Leverage-based era → industrialists, entrepreneurs, innovators.
So if “worthy wealthy” means those who built lasting, productive enterprises, the leverage ratio world historically produced more of them.
Would you like me to also trace contemporary billionaire lists (e.g., Forbes) to show how the balance has shifted between finance/real estate versus entrepreneurs across the two regulatory regimes?
I said: Perhaps another day. Thanks!
ChatGPT said: You got it — we can pick that thread up whenever you like. Thanks!
Here is Grok’s answer to exactly the same question
Note: The answers are copied exactly from those given to me by ChatGPT and Grok
#AI #Grok: Can a wrong allocation of bank credit be an inflation driver?
Wednesday, August 6, 2025
#AI ChatGPT Grok: A leverage ratio or Basel risk weighted capital requirements, what expulses banking into the shadows?
I asked: In about 200 words.
A leverage ratio meaning the same bank capital requirement against all assets, and Basel’s risk weighted bank capital requirements. Which helps contain banking within its traditional framework, and which expulses it into the “shadows”?
ChatGPT answered:
A leverage ratio, which applies the same capital requirement to all assets, helps contain banking within its traditional framework. It forces banks to consider the real risk-return trade-off of each asset, as no regulatory preference distorts decision-making. This fosters transparency, discourages regulatory arbitrage, and keeps more activities on the balance sheet, within the regulated system.
In contrast, Basel’s risk-weighted capital requirements encourage banks to favor assets with lower regulatory risk weights—such as sovereign debt or highly rated securities—while discouraging lending to sectors like small businesses, which carry higher capital costs. This distortion pushes riskier or capital-costly activities off balance sheet or into less regulated entities, fueling the growth of the shadow banking system. There, similar financial intermediation occurs without equivalent oversight or safeguards.
Thus, risk weighting often acts as a centrifugal force, expelling banking activities into the shadows in pursuit of yield and capital relief. The leverage ratio acts more like a centripetal force, anchoring activity within the core banking sector and preserving the integrity of traditional banking functions—deposit-taking, credit allocation, and payments—under the watchful eye of regulators.
Grok 4 answered:
A leverage ratio is a simple, non-risk-based measure requiring banks to hold a minimum level of capital (typically Tier 1) against their total assets, regardless of asset riskiness. It’s calculated as capital divided by total assets, expressed as a percentage (e.g., 3-5%). This uniform approach ensures banks maintain a baseline capital buffer, promoting stability by limiting excessive borrowing. It keeps banking within its traditional framework by enforcing straightforward capital adequacy, reducing complexity, and curbing risk-taking without overcomplicating regulation.
In contrast, Basel’s risk-weighted capital requirements (under Basel III) assign risk weights to assets based on perceived risk (e.g., 0% for government bonds, higher for loans). Banks must hold capital proportional to these risk-weighted assets (RWAs). While designed to align capital with risk, this complexity incentivizes banks to game the system by shifting assets to off-balance-sheet vehicles or "shadow banking" entities—less regulated sectors like hedge funds or securitization vehicles. This expulses banking into the shadows, as banks exploit loopholes to minimize RWAs, reducing capital requirements while maintaining high leverage, thus increasing systemic risk outside traditional oversight.
The leverage ratio’s simplicity fosters transparency and containment, while Basel’s risk-weighted approach, though nuanced, drives shadow banking by encouraging regulatory arbitrage.