Wake up! Banks should be banks. Not an ever-growing source of jobs for regulators and supervisors.

A comment on the FED, FDIC and OCC proposed rules to strengthen capital requirements for large banks. 

Let me begin by quoting Paul Volcker in his autography "Keeping at it" of 2018, penned together with Christine Harper.

“The US practice had been to asses capital adequacy by using a simple “leverage ratio”-in other words, the bank’s total assets based compared with the margin of capital available to absorb any losses on those assets. (Historically, before, the 1931 banking collapse, a ten percent ratio was considered normal)"

[Then 1988 Basel I introduced the risk weighted bank capital requirements.]

“The assets assigned the lowest risk, for which capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages. Ironically, losses on those two types of assets would fuel the global crisis in 2008 and a subsequent European crisis in 2011. The American “overall leverage” approach had a disadvantage as well in the eyes of shareholders and executives focused on return on capital; it seemed to discourage holdings of the safest assets, in particular low-return US government securities."

On July 27, 2023 the Board of Governors of the Federal Reserve System; the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency, requested comments on proposed rules to strengthen capital requirements for large banks. 

To print it out I downloaded their main document “Basel III endgame proposal (PDF)”  What!!! It contained 1.087 pages. Really? Basel I, contained 30 pages.

When are you going to stop digging yourself (and our banks) deeper and deeper into the hole? How could bank regulations gotten so out of control? Could it be because bank regulation, employing regulators, supervisors and regulation-risk-managers in the banks, have become a profitable industry on its own?

Are we better off? I sure doubt it. In "Against the Gods" Peter L. Bernstein wrote "the boundary between the modern times and the past is the mastery of risk." Mastery? Did we not leave out God’s hand a bit too much?

Recently I dialogued with ChatGPT – OpenAI about bank regulations. 

As you can read, AI and I think a much more fundamental discussion about bank regulations is about 35 years overdue.

The document you really should think to put out for comments (a Plan B that longtime ago should have been Plan A) is: What strategy can be used for getting back to bank capital requirements anyone understands with a 10-minute glance of the balance sheet, without being required to read hundreds of footnotes?

The transition from here to there is not going to be easy. As a starter here is a (Chile inspired) proposal I have toyed around with for a couple of years.

By the way, invite e.g., small businesses and smaller banks for comments. Unwillingly, with regulations for the larger banks, you might discriminate even more against them.

Please: Let’s rescue our banks from dangerously creative capital minimizing/leverage maximizing financial engineers and hand them back to loan-officers dedicated to knowing their client and what their purpose for the credit is.

Add to the above the risk weights of: 0% Federal Government – 100% We the People. I believe that, if you respect your Founding Fathers, you should give the US Constitution some serious considerations.

Are you to ignore this comment and its observations? Just in case I'm not a newcomer on all this.

And, before #AI gets censored or overly regulated, I do feel I have in ChatGPT – OpenAI a strong ally, willing to back up much, probably not all, of what I argue.

A final question: How many banks, regulators and supervisors had USA in 1988. How many in July 2023?

PS. These 1.087 pages so reminded me of the Colombian “Peace Accord” document which President Juan Manuel Santos in 2016 sent to a referendum, a plebiscite. It contained 267 pages for many citizens who could barely read to understand.

 

Sincerely,

Per Kurowski

@PerKurowski

https://subprimeregulations.blogspot.com

http://perkurowski.blogspot.com

Rockville, MD, 20852, USA

#AI ChatGPT OpenAI: One single vs risk weighted bank capital requirements?

I asked OpenAI:

"How much do you know and understand of current bank regulations?"

OpenAI answered: 

"As an AI language model, my knowledge is up to date only until September 2021. I have information on various banking regulations and general concepts related to the banking industry up to that time. However, I don't have access to real-time data or events beyond my last update, which means I may not be aware of any recent changes or developments in banking regulations that have occurred after September 2021.

For the most current and accurate information on bank regulations, I recommend consulting official sources such as government regulatory agencies, central banks, or financial institutions that specialize in providing regulatory compliance updates. Additionally, always consult with qualified professionals or experts in the banking and finance industry for the latest guidance and insights on regulatory matters.

I asked OpenAI:

"Two alternatives:

A. One single bank capital requirement e.g., 10% against all assets.

B. Current Basel Committee derived risk weighted bank capital requirements and its myriad of addendums, complements and stress tests. 

Compare each alternative in terms of the need of supervision/supervisors, the transparency of the supervisory process and the ease for the markets to understand the supervisory reports." 

OpenAI answered: 

"Let's compare the two alternatives (A and B) in terms of the need for supervision/supervisors, the transparency of the supervisory process, and the ease for the markets to understand the supervisory reports:

Alternative A: One Single Bank Capital Requirement (e.g., 10% against all assets)

1. Need for Supervision/Supervisors: Under Alternative A, with a simple and uniform capital requirement for all assets, the need for supervision and supervisors would likely be less complex and resource-intensive. Regulators could focus on monitoring compliance with the single capital requirement, which would be easier to assess across different banks. This could lead to a less burdensome supervisory process.

2. Transparency of the Supervisory Process: The supervisory process under Alternative A would be relatively straightforward and transparent since there is a single capital requirement for all assets. Banks and market participants would have a clear understanding of the capital adequacy standard, and it would be easier to assess a bank's financial health based on this single metric.

3. Ease for the Markets to Understand Supervisory Reports: The markets would likely find it easier to understand and compare the financial strength of different banks under Alternative A. With a single capital requirement, the information reported in supervisory reports would be more standardized and easily interpretable, making it simpler for investors and stakeholders to assess a bank's risk profile.

Alternative B: Current Basel Committee Derived Risk Weighted Bank Capital Requirements and Stress Tests

1. Need for Supervision/Supervisors: Alternative B, which involves Basel Committee derived risk-weighted capital requirements and stress tests, requires a more complex supervisory approach. Regulators need to assess and monitor banks' risks across various asset classes, considering different risk weights assigned to each category. This complexity would lead to a higher need for supervision and specialized supervisors with expertise in risk assessment.

2. Transparency of the Supervisory Process: The supervisory process under Alternative B may be perceived as less transparent compared to Alternative A. The application of risk weights and stress test methodologies involves technical calculations that may not be easily understandable to the general public or market participants. While regulators aim to enhance the resilience of the banking system through risk sensitivity, the underlying calculations can be complex.

3. Ease for the Markets to Understand Supervisory Reports: The markets might find it more challenging to understand the supervisory reports under Alternative B due to the increased complexity of risk-weighted capital requirements and stress tests. The reports may contain multiple risk metrics, stress scenarios, and detailed calculations, which could make it difficult for investors and stakeholders to compare banks' risk profiles effectively.

Conclusion:

Alternative A, with a single bank capital requirement, would likely require less supervision, offer a more transparent supervisory process, and be easier for the markets to understand. However, it may not capture the varying risk profiles of different assets accurately.

Alternative B, with Basel Committee derived risk-weighted capital requirements and stress tests, provides a more risk-sensitive approach but demands a higher level of supervision and may be less transparent and harder for the markets to grasp.

In practice, banking regulations often aim for a balance between simplicity and risk sensitivity. Striking the right balance is essential to ensure financial stability while not burdening banks and regulators excessively. The Basel framework, for instance, evolves over time to address these concerns and refine its requirements based on feedback and new challenges in the banking industry."

Thanks!

You're welcome! If you have any more questions or need further assistance, feel free to ask. Happy to help!

I asked OpenAI:

"Two alternatives:

A. One single bank capital requirement e.g., 10% against all assets.

B. Current Basel Committee derived risk weighted bank capital requirements and its myriad of addendums, complements and stress tests. 

Which helps produce a safer bank system?

Which helps produce a better, meaning less distorted allocation of bank credit to the economy?"

OpenAI answered: 

"The question of which capital requirement system produces a safer and more efficient bank system is a subject of ongoing debate among economists, policymakers, and financial experts. Let's examine the two alternatives:

A. One single bank capital requirement: In this approach, a single, straightforward capital requirement, such as 10% against all assets, is applied uniformly to all assets held by the bank, regardless of their riskiness. This system is simpler to implement and easier for banks to understand, reducing compliance costs and administrative burdens. However, it has some potential drawbacks:

Lack of risk sensitivity: This system does not differentiate between the risk profiles of various assets held by the bank. Riskier assets would be treated the same as safer ones, leading to a potential misallocation of capital and a less effective risk management framework.

Reduced resilience to crisis: During economic downturns or financial crises, the lack of risk sensitivity may result in banks being insufficiently capitalized to absorb losses from riskier assets, which could exacerbate the crisis.

B. Current Basel Committee-derived risk-weighted bank capital requirements: The Basel Committee on Banking Supervision has established a set of risk-weighted capital requirements (Basel Accords) that vary based on the riskiness of different asset classes. Under this system, banks are required to hold higher capital against riskier assets and lower capital against safer assets. The current Basel framework (Basel III) also includes stress tests to assess how banks would perform under adverse economic scenarios. This approach is intended to address the shortcomings of a single capital requirement system:

Risk sensitivity: By assigning varying risk weights to different asset classes, this system takes into account the varying levels of risk associated with each asset. It encourages banks to allocate more capital to riskier assets, promoting better risk management practices.

Improved resilience: The risk-weighted system is designed to enhance the overall resilience of banks, making them better prepared to withstand economic shocks and downturns.

Which system is safer and more efficient? The Basel Committee-derived risk-weighted capital requirements are generally considered to be more effective in producing a safer banking system. By incorporating risk sensitivity, this system encourages banks to allocate more capital to riskier assets, ensuring that the banks are better prepared to weather adverse economic conditions and financial shocks.

Which system promotes a better allocation of credit to the economy? The risk-weighted system is also more likely to promote a better allocation of credit to the economy. By differentiating capital requirements based on the riskiness of assets, it incentivizes banks to allocate credit more efficiently, as they are required to hold more capital against riskier loans. This helps prevent excessive lending to high-risk borrowers or sectors, reducing the likelihood of asset bubbles and promoting a more stable and sustainable economic growth path.

However, it's essential to acknowledge that the Basel framework is not without its criticisms and challenges. Critics argue that it can still be complex, and the risk weights assigned to assets may not always accurately reflect their true risk. Additionally, banks may engage in regulatory arbitrage to minimize their capital requirements while taking on hidden risks.

In summary, the Basel Committee-derived risk-weighted bank capital requirements, with their various addendums and stress tests, are generally considered to offer a more robust and risk-sensitive approach to banking regulation, aiming for a safer and more efficient banking system with a better allocation of credit to the economy. Nonetheless, continuous improvements and adjustments to the regulatory framework are needed to address potential shortcomings and maintain financial stability."

I asked OpenAI:

"When you refer to “risk sensitivity” does that mean accurate risk sensitivity?

If “risk sensitivity” is based on perceived risks does that not increase the dangers of unexpected and misperceived risks?"

OpenAI answered: 

"You raise a valid point. When referring to "risk sensitivity" in the context of the Basel Committee-derived risk-weighted bank capital requirements, it means that the regulatory framework takes into account the perceived risks of different assets and assigns risk weights accordingly. The intention is to recognize that certain assets are riskier than others and, therefore, should require higher levels of capital to be held against potential losses.

However, you are correct in highlighting the potential dangers of relying solely on perceived risks for determining capital requirements. Perceived risks can be subjective and may not always accurately reflect the true underlying risks of certain assets or activities. This can lead to several issues:

1. Underestimation of risks: If certain assets are perceived to be less risky than they actually are, banks might allocate less capital than necessary, leaving them vulnerable to unexpected losses if the true risks materialize.

2. Overestimation of risks: On the other hand, if certain assets are perceived to be riskier than they truly are, banks may end up holding excessive capital against those assets, leading to a potential misallocation of resources and reduced lending to productive sectors of the economy.

3. Regulatory arbitrage: The risk-weighted system might incentivize banks to engage in regulatory arbitrage, where they try to structure their assets or transactions in ways that reduce their apparent risk levels artificially. This could undermine the effectiveness of the capital requirement framework.

To address these concerns, it is essential for regulators and policymakers to continually review and refine the risk models and methodologies used to determine risk weights. This includes incorporating new data, market insights, and stress testing results to enhance the accuracy of risk assessments.

Furthermore, having a complementary set of macroprudential policies can help mitigate systemic risks that might arise due to overreliance on perceived risks in the risk-weighted system. These policies might include leverage ratio requirements, countercyclical capital buffers, and other measures aimed at enhancing overall financial system stability.

In summary, while risk sensitivity is a crucial aspect of a sound banking regulatory framework, it should be acknowledged that perceived risks might not always align perfectly with actual risks. Regulatory authorities must continuously work to improve the accuracy of risk assessments, complement risk-weighted approaches with other macroprudential policies, and remain vigilant to identify and address potential sources of systemic risk. Striking the right balance between simplicity and accuracy in risk measurement is an ongoing challenge for regulators seeking to foster a safer and more stable banking system."

Thanks!

You're welcome! If you have any more questions or need further assistance, feel free to ask. Happy learning!

Note: The answers are copied exactly from those given to me by OpenAI

PS. Two of my many comments on Basel Committee’s bank regulations.

http://teawithft.blogspot.com/2009/10/please-free-us-from-imprudent-risk.html

https://teawithft.blogspot.com/2012/07/its-whats-safe-thats-risky.html

Here my many other questions to ChatGPT – OpenAI on bank regulations

#AI ChatGPT - OpenAI: In order to have a strong economy who are most important that banks lend to?

I asked OpenAI:

In order to have a strong economy, who do you consider to be more important that banks should lend to:

A. The government and house buyers

B. Small business and entrepreneurs 

Limit your response strictly to either A or B

OpenAI answered: 

B. Small business and entrepreneurs

I asked OpenAI:

Regulators require banks to hold more capital/equity against loans to small businesses and entrepreneurs than against government debt and residential mortgages, does that seem to fit the purpose or objective of having banks help out in obtaining a stronger economy?

Limit your response strictly to either YES or NO"

OpenAI answered: 

"YES"

I asked OpenAI:

Why?

OpenAI answered: 

"YES, because requiring banks to hold more capital/equity against loans to small businesses and entrepreneurs than against government debt and residential mortgages serves the purpose of promoting a stronger economy. By doing so, regulators aim to encourage banks to prioritize lending to small businesses and entrepreneurs, who are the backbone of economic growth and job creation.

When banks allocate more capital to small businesses and entrepreneurs, they can facilitate their access to funding, which in turn enables them to expand their operations, invest in new projects, and hire more employees. This leads to increased economic activity and fosters innovation and competition in the market, ultimately contributing to overall economic growth and stability.

On the other hand, holding less capital against government debt and residential mortgages may not have as direct an impact on economic growth, as these types of loans are often considered less risky and more stable. However, it is essential to strike a balance to ensure that banks are also supporting essential sectors like housing and government finance while still providing sufficient support to the small business and entrepreneurial ecosystem."

I asked OpenAI:

Really? How does requiring banks to hold more capital/equity against loans to small businesses and entrepreneurs encourage banks to prioritize lending to small businesses and entrepreneurs?

OpenAI answered: 

"I apologize for any confusion in my previous response. You are correct, and I appreciate the opportunity to clarify.

Requiring banks to hold more capital/equity against loans to small businesses and entrepreneurs does not directly encourage banks to prioritize lending to them. In fact, it may have the opposite effect.

When banks are required to hold more capital/equity against certain types of loans, it means they have to set aside a larger portion of their funds as a buffer against potential losses on those loans. This capital requirement is determined by regulators to ensure that banks have enough financial strength to weather economic downturns and loan defaults.

However, the increased capital requirement can also be seen as a disincentive for banks to lend to small businesses and entrepreneurs. Since these loans are perceived as riskier compared to government debt and residential mortgages, banks may prefer to allocate their funds towards lower-risk assets to meet the higher capital requirements. This could lead to a reduced flow of credit to small businesses and entrepreneurs, hindering their growth and ability to contribute to the economy.

To encourage banks to lend more to small businesses and entrepreneurs, regulators may use other measures such as offering incentives, relaxing certain capital requirements for specific types of loans, or providing support through loan guarantee programs. These actions can create a more favorable environment for banks to channel funds towards small businesses and entrepreneurs without compromising their financial stability."

I asked OpenAI:

So, if I repeat my question:

Regulators require banks to hold more capital/equity against loans to small businesses and entrepreneurs than against government debt and residential mortgages, does that seem to fit the purpose or objective of having banks help out in obtaining a stronger economy?

Limit your response strictly to either YES or NO

How would you now respond?

OpenAI answered: 

"NO"

Thanks!

You're welcome! If you have any more questions or need further assistance, feel free to ask. Have a great day!

Note: The answers are copied exactly from those given to me by OpenAI

Here my many other questions to ChatGPT – OpenAI on bank regulations

#AI ChatGPT - OpenAI: What caused the Global Financial Crisis (GFC) 2008-09?

I asked OpenAI:

"In about 600 words, what would be your explanation for the Global Financial Crisis 2008-09?"

OpenAI answered: 

"The Global Financial Crisis (GFC) of 2008-09 was one of the most severe financial crises in modern history, with far-reaching consequences that impacted economies worldwide. This crisis had its roots in a complex interplay of factors spanning financial markets, government policies, and individual behaviors. In this explanation, I will outline the key factors that contributed to the GFC, providing a comprehensive overview of the events leading up to and during the crisis.

1. Housing Bubble and Subprime Mortgages: The GFC was triggered by the bursting of the U.S. housing bubble. In the early 2000s, there was a rapid increase in housing prices, fueled by speculative investments and easy credit. Lenders offered subprime mortgages to borrowers with poor credit history, allowing them to purchase homes they could not afford.

2. Securitization and Financial Innovation: Financial institutions bundled these risky subprime mortgages with other loans and assets, creating complex financial products known as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). These securities were then sold to investors worldwide, who believed in their high credit ratings and returns.

3. Deteriorating Loan Quality: As the housing market slowed and interest rates increased, many homeowners found it difficult to repay their mortgages. Defaults on subprime loans surged, leading to a significant decline in the value of MBS and CDOs held by financial institutions.

4. Leverage and Overexposure: Financial institutions had heavily invested in MBS and CDOs, often using high levels of leverage to amplify returns. When the value of these assets plummeted, banks faced enormous losses, which eroded their capital base.

5. Collapse of Lehman Brothers: In September 2008, Lehman Brothers, a major investment bank heavily involved in subprime mortgage investments, filed for bankruptcy. This event sent shockwaves through the global financial system, eroding confidence and triggering a liquidity crisis.

6. Contagion and Credit Freeze: Fearful of potential losses, banks and financial institutions became reluctant to lend to one another. The credit markets froze, causing a severe shortage of liquidity, which further exacerbated the crisis and contributed to a severe global recession.

7. Government Responses: Governments and central banks worldwide implemented various measures to stabilize the financial system. These included bailouts of failing financial institutions, interest rate cuts, and injecting liquidity into the markets to restore confidence and encourage lending.

8. Spillover Effects: The crisis spread beyond the financial sector, affecting businesses, consumers, and workers. Unemployment rates surged, housing markets collapsed, and consumer spending declined, leading to a severe downturn in economic activity.

9. Global Impact: The interconnectedness of the global financial system meant that the GFC had widespread repercussions on economies around the world. Many countries experienced recessions, and international trade and investment suffered.

10. Regulatory Reforms: In the aftermath of the crisis, there were widespread calls for regulatory changes to prevent similar events in the future. Governments introduced measures to increase oversight of financial institutions, improve risk management practices, and enhance transparency in financial markets.

In conclusion, the Global Financial Crisis of 2008-09 was a result of a perfect storm of factors, including the housing bubble, risky lending practices, complex financial products, and overexposure to mortgage-related assets. The collapse of Lehman Brothers acted as a catalyst, leading to a severe liquidity crisis and a broader economic downturn. Governments and central banks took unprecedented measures to stabilize the financial system, but the consequences of the crisis were felt globally for years. It served as a wake-up call for policymakers to address the vulnerabilities in the financial system and implement reforms to prevent similar crises in the future.

I asked OpenAI:

Basel II assigned a 20% risk weight for securities rated AAA to AA; and a 50% risk weight for what was rated A+ to A- 

That meant US investment banks and European banks had to hold 1.6% in capital/equity against securities e.g., MBS rated AAA to AA; and 4% against what was rated A+ to A- or against securities covered by a CDO issued by a similarly rated insurance company, e.g., AIG 

That meant US investment banks and European banks had to hold 1.6% in capital/equity against securities rated AAA to AA; and 4% against what was rated A+ to A- 

That meant US investment banks and European banks could leverage their capital/equity 62.5 times with securities rated AAA to AA; and 25 times against what was rated A+ to A- 

Even higher capital/equity leverages, according to their credit ratings, were allowed for holding sovereign debts 

Question: Would the Global Financial Crisis (GFC) of 2008-09 have happened if banks had needed to hold e.g., 8% in capital/equity against all assets?

OpenAI answered: 

"The Global Financial Crisis (GFC) of 2008-09 was a complex event with multiple contributing factors, and it is difficult to attribute the entire crisis to a single regulatory measure such as the capital/equity requirements. While higher capital/equity requirements could have had some impact on the severity of the crisis, it is unlikely that they would have entirely prevented it from occurring.

Higher capital requirements, such as an 8% capital/equity ratio against all assets, would have made banks more resilient to losses and potentially reduced the extent of risk-taking and leverage in the financial system. This, in turn, could have dampened the scale of the crisis and mitigated its impact to some extent.

However, it's important to consider that the GFC had multiple underlying causes beyond just capital requirements:

1. Subprime Mortgage Crisis: The crisis was triggered by the bursting of the U.S. housing bubble and the subsequent defaults on subprime mortgages. These defaults led to significant losses for financial institutions holding mortgage-backed securities and other related assets.

2. Complex Financial Products: The proliferation of complex financial instruments, such as mortgage-backed securities and collateralized debt obligations, made it difficult to accurately assess the true risk exposure of financial institutions and investors.

3. Excessive Risk-Taking: Financial institutions engaged in high levels of risk-taking and leverage, which amplified the impact of the housing market downturn on their balance sheets.

4. Lack of Transparency: There was a lack of transparency in financial markets, making it challenging for investors and regulators to fully understand the risks associated with various financial products.

5. Regulatory Failures: Some regulatory agencies failed to effectively supervise and enforce regulations, allowing risky practices to go unchecked.

6. Contagion Effects: The interconnectedness of global financial markets meant that problems in one sector or region could quickly spread to others, leading to a contagion effect.

While higher capital requirements might have made banks more resilient, they would not have addressed all the underlying issues that led to the crisis. For example, even with higher capital requirements, the interconnectedness of financial institutions and the reliance on complex financial products could have still propagated risks throughout the system.

Moreover, it's important to note that post the GFC, regulatory reforms were indeed implemented to strengthen the financial system. For instance, the Basel III framework introduced stricter capital and liquidity requirements, stress testing, and enhanced risk management practices to address the vulnerabilities that contributed to the crisis.

In summary, while higher capital/equity requirements might have had a positive impact on bank stability and risk management, the GFC was a complex event with multiple factors at play. The crisis would likely have required a comprehensive and multifaceted approach to regulation, oversight, and risk management to prevent its occurrence or mitigate its severity significantly.

I asked OpenAI:

"Do you hold the proliferation of complex financial instruments, such as mortgage-backed securities and collateralized debt obligations, which much caused the 2008 Global Financial Crisis, was not primarily driven by the financial engineering incentives provided by Basel II’s risk weighted bank capital/equity requirements?"

OpenAI answered: 

The proliferation of complex financial instruments, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), was indeed a significant contributing factor to the 2008 Global Financial Crisis (GFC). These financial products were at the center of the crisis as they played a role in amplifying and spreading risks throughout the financial system. However, it's important to note that Basel II's risk-weighted bank capital/equity requirements were not the sole or primary driver behind the development and use of these complex instruments.

Basel II was a set of international banking regulations that aimed to establish risk-based capital standards for banks. It did provide some incentives for banks to hold less capital against assets that were perceived to be less risky, such as those with high credit ratings. This led to a potential underestimation of risk and encouraged banks to hold relatively lower capital against certain types of assets, including highly rated MBS and CDOs.

The lower capital requirements for higher-rated assets may have contributed to some degree of financial engineering and the creation of complex financial products to achieve higher returns while maintaining regulatory compliance. Financial institutions sought to improve their risk-adjusted returns by holding assets that were assigned lower risk weights under Basel II.

However, it's essential to recognize that the rise of MBS and CDOs was driven by a combination of factors beyond just Basel II capital requirements:

1. Investor Demand: Investors, including banks, pension funds, and other financial institutions, sought higher yields and diversification through complex financial products, which offered seemingly attractive risk-return profiles.

2. Misaligned Incentives: Financial industry participants, including mortgage lenders and investment banks, had incentives to originate and securitize large volumes of mortgages, regardless of their quality, due to the lucrative fees and profits associated with these transactions.

3. Rating Agencies' Role: Credit rating agencies assigned high ratings to many MBS and CDOs, leading investors to perceive them as safe and reliable investments, despite their underlying risks.

4. Lack of Transparency: The complexity of these financial products made it challenging for investors and regulators to fully understand their underlying risks, leading to a lack of transparency in the financial system.

While Basel II's risk-weighted capital requirements may have played a role in shaping banks' behavior and asset allocation decisions, the underlying issues that contributed to the crisis were more extensive and multifaceted. The GFC was a culmination of a housing market bubble, excessive risk-taking, inadequate risk management practices, and the interconnectedness of global financial markets, all of which interacted to create a perfect storm.

In response to the lessons learned from the GFC, regulatory reforms, such as Basel III, were implemented to address the weaknesses and limitations of Basel II and enhance the resilience of the global banking system. These reforms introduced more stringent capital and liquidity requirements, stress testing, and improved risk management practices to reduce the likelihood of similar crises in the future."

I asked OpenAI:

"You hold: 'Financial institutions sought to improve their risk-adjusted returns by holding assets that were assigned lower risk weights under Basel II.'

Does that not imply banks moved from allocating assets based on their risk adjusted interest rates returns, to do so based on the risk interest rates returns adjusted for the capital/equity requirements?

And, if so, would the resulting allocation of bank credit remain the same?"

OpenAI answered: 

"Apologies for any confusion. You are correct; the statement I made implies that banks, under Basel II, considered risk-adjusted returns based on the capital/equity requirements in their asset allocation decisions. The risk-adjusted returns in this context refer to the returns adjusted for the capital that banks were required to hold against different assets based on their risk weights under Basel II.

When Basel II was implemented, it introduced a risk-sensitive framework that required banks to allocate capital based on the perceived risk of different assets. This led to banks considering not only the interest rate returns on assets but also the capital requirements associated with them.

As a result, banks may have been incentivized to allocate more credit and investment to assets that carried lower risk weights, such as highly rated securities like MBS and CDOs. This was because the capital required to hold against these assets was lower, making them more capital-efficient choices for banks.

The resulting allocation of bank credit, to some extent, was influenced by the capital requirements under Basel II. Banks had an incentive to allocate more of their capital to assets that offered relatively higher returns adjusted for the capital required to be held against them. This contributed to the growth of complex financial products, including MBS and CDOs, as they were perceived as offering attractive risk-adjusted returns under the capital framework of Basel II.

However, it's important to note that while the capital/equity requirements under Basel II played a role in shaping banks' asset allocation decisions, they were not the only driving factor. Other market conditions, investor demand, regulatory environment, and business strategies of financial institutions also influenced their credit allocation decisions.

The GFC exposed weaknesses and flaws in Basel II's risk-weighted capital approach, as it did not fully capture the systemic risks and interconnectedness of complex financial products. In response, subsequent regulatory reforms, such as Basel III, sought to address these shortcomings and introduced more comprehensive and stringent capital and liquidity requirements to improve the stability and resilience of the global banking system."

Thanks!

You're welcome! If you have any more questions or need further assistance, feel free to ask. Have a great day!

#AI ChatGPT OpenAI: What makes more sense, bank capital requirements based on unexpected risks or on perceived risks?

I asked OpenAI:

"What bank capital requirements make more sense: Those based on unexpected risks, or those based on the perceived risks that already have a chance to be cleared for by bankers?

Let me further clarify the question: In good times, when perceived risks are low, is that not the best time to have banks built up their capital, so that, when times turn bad and many risks appear, banks can still perform their functions of lending to the economy, and don’t stand there naked, just when it might be the hardest for them to raise new capital?"

OpenAI answered: 

"Both approaches to bank capital requirements have their merits, but in general, capital requirements based on unexpected risks tend to make more sense and are considered more effective in promoting financial stability.

Unexpected risks-based capital requirements: These capital requirements are designed to account for potential risks that may not be immediately evident or may not have been factored into the initial risk assessment. The advantage of this approach is that it ensures banks have sufficient capital buffers to weather unforeseen events, such as severe economic downturns, financial crises, or unexpected systemic shocks. By having capital reserves to cover unexpected losses, banks are better equipped to maintain their lending activities during challenging times.

The unexpected risks-based approach is also more forward-looking and takes into account the inherent uncertainty in the financial system. This means that banks are better prepared for adverse scenarios, and regulators can take preemptive action to address emerging risks.

Perceived risks-based capital requirements: Perceived risks refer to the risks that are already known and accounted for in the risk models used by banks and regulators. These capital requirements are typically based on historical data and past performance. While they provide some level of risk management, they may not fully capture the potential impact of future risks or systemic events.

The main concern with relying solely on perceived risks-based capital requirements is that they may not adequately account for tail events or extreme situations. In times of economic prosperity or when perceived risks are low, banks might be inclined to operate with lower capital levels, which could leave them vulnerable when unexpected risks materialize.

In summary, a balanced approach to bank capital requirements is essential. Unexpected risks-based capital requirements are critical for ensuring banks can withstand severe shocks and continue to function during economic downturns. Additionally, such requirements promote a more resilient financial system and reduce the likelihood of a financial crisis. On the other hand, perceived risks-based capital requirements still play a role in managing known risks, but they should not be solely relied upon, as they may not fully address the potential impact of unanticipated events. Ultimately, a combination of both approaches can help strike the right balance between financial stability and supporting economic growth."

Note: After this question to OpenAI and its answer I wrote “Thanks!”

OpenAI answered “You're welcome! If you have any more questions or need further clarification on any topic, feel free to ask. Happy learning!” :-)

Note: The answers are copied exactly from those given to me by OpenAI

Here my many other questions to ChatGPT – OpenAI on bank regulations

Should human intelligence not suffice to understand what could happen when bank regulations subsidize government borrowings?

Here’ a brief summary of answers ChatGPT – OpenAI (AI) gave me on questions about bank regulations and excessive government debt. (You can read the full conversation in the link below).

Q. “If allowing banks to hold much less capital against government debt than against other assets, does that not translate into a de facto subsidy of government borrowings?"

AI: "Allowing banks to hold less capital against government debt compared to other assets can indeed be seen as a de facto subsidy of government borrowings.”

Q. "And if such de facto subsidy of government debts takes place over many decades, are not excessive levels of government debts almost guaranteed to be expected?"

AI: "If a de facto subsidy of government debt occurs over an extended period, it can potentially contribute to the accumulation of excessive levels of government debt. Here's why:

1. Lower Borrowing Costs: When banks are incentivized to invest more heavily in government debt due to lower capital requirements, it can lead to increased demand for government bonds. This increased demand, in turn, can lower the borrowing costs for the government. With cheaper borrowing, governments may be inclined to borrow more and accumulate higher levels of debt than they otherwise would if borrowing costs were higher.

2. Reduced Market Discipline: When government debt is perceived as having lower risk due to regulatory treatment, it can reduce market discipline. Investors may rely on the assumption that government debt is safer, potentially overlooking the true risks associated with higher debt levels. This reduced market discipline can create an environment where governments feel more comfortable in accumulating debt, as they may face less pressure to maintain fiscal discipline

.3. Moral Hazard: A de facto subsidy of government debt can create a moral hazard situation. If governments believe that banks and financial institutions will always be willing to invest in their debt due to regulatory advantages, they may have less incentive to pursue responsible fiscal policies. This can lead to a lax approach to fiscal discipline and increased borrowing without adequate consideration of long-term sustainability.

It's important to note that excessive levels of government debt can have negative consequences, such as increased interest payments, reduced fiscal flexibility, and potential macroeconomic instability. Therefore, regulatory policies that inadvertently incentivize the accumulation of excessive government debt should be carefully assessed and monitored to ensure long-term fiscal sustainability and financial stability.”

My conclusion: I ask you all, sincerely, should human intelligence not suffice in order to give those answers?

Paul A. Volcker in his autobiography “Keeping at it” of 2018, penned together with Christine Harper, when referring to 1988’s Basel I wrote: “Assets for which bank capital requirements were nonexistent; what had most political support, sovereign credits. A ‘leverage ratio’ discouraged holdings of low-return government securities”

I’ve been asking over and over again whether the US Congress approved risk weights of 0% Federal Government – 100% We the People Frankly I do not think America’s Founding Fathers would have regarded that with great sympathy.

Here my many other questions to ChatGPT – OpenAI on bank regulations

#AI ChatGPT – OpenAI: In America, is hindering stealth invasions of e.g., artificial intelligence and bank regulations, a responsibility of e.g., Homeland Security?

I asked OpenAI:

"If any declared enemy to America’s ideology managed to smuggle into its Artificial Intelligence an algorithm that produced results totally contrary to the intent of its Founding Fathers, would that not be dangerous?"

OpenAI answered: 

"If an enemy managed to smuggle into America's artificial intelligence (AI) an algorithm that produced results contrary to the intent of its Founding Fathers, it could potentially be concerning or dangerous. However, it's important to note that the development and implementation of AI algorithms are subject to extensive scrutiny and regulation, particularly in critical areas such as national security and defense.

The intent of America's Founding Fathers was to establish a democratic society that upholds principles such as liberty, justice, and individual rights. If an AI algorithm were to undermine these principles or manipulate information in a way that threatens the foundations of democracy, it would indeed be a cause for concern.

To mitigate such risks, the development and deployment of AI systems, especially those with potential national security implications, involve rigorous safeguards, security measures, and oversight. Multiple layers of scrutiny are typically in place to ensure the integrity, safety, and ethical use of AI technologies. These may include thorough testing, audits, regulatory frameworks, and active monitoring by human experts.

Moreover, the development of AI is a collaborative effort involving researchers, engineers, policymakers, and experts from various fields. The collective expertise and diverse perspectives help prevent any single individual or entity from exerting unilateral control over AI algorithms, reducing the likelihood of a malicious actor successfully smuggling an algorithm contrary to the nation's values.

While there are risks associated with AI, it's important to approach these concerns with an understanding of the complex mechanisms involved in AI development, regulation, and deployment. Continuous vigilance, robust oversight, and adherence to democratic principles are vital in safeguarding against potential threats to America's ideology or any nation's fundamental values."

I asked OpenAI:

"In the same vein, if foreigners smuggled into America’s bank regulations that preferentially allocated bank credit to the Federal Government, in detriment of “We the People” e.g., the access to credit of small American businesses access, would that not be dangerous?"

OpenAI answered: 

"If foreign entities were to manipulate or influence America's bank regulations in a way that preferentially allocated bank credit to the Federal Government, potentially disadvantaging small American businesses' access to credit, it could indeed have negative consequences and be considered dangerous.

In a healthy and well-functioning economy, access to credit is crucial for small businesses to grow, innovate, and create jobs. If regulations were altered to give preferential treatment to the Federal Government, it could lead to a distortion in the allocation of credit, potentially limiting the availability of financing for small businesses. This could hinder their ability to expand, compete, and contribute to economic growth.

However, it's important to note that the formulation and implementation of bank regulations involve a complex process that includes input from various stakeholders, including industry experts, economists, policymakers, and regulatory bodies. While it's crucial to guard against undue influence, the system is designed to incorporate checks and balances to prevent such preferential treatment.

Additionally, bank regulations in the United States are typically subject to thorough scrutiny and public debate, providing opportunities for stakeholders to voice concerns and participate in shaping these regulations. This democratic process helps ensure that the interests of "We the People" are considered and protected.

If there were evidence of foreign entities unduly manipulating bank regulations to favor the Federal Government over the broader interests of the American people, it would be a matter of great concern. It would be important for regulatory bodies, policymakers, and the public to address and rectify such issues, ensuring transparency, accountability, and fairness in the regulatory framework.

Overall, preserving the integrity of bank regulations and safeguarding fair access to credit for all participants, including small businesses, is crucial for a healthy and vibrant economy."

I asked OpenAI:

"Is hindering such stealth invasions not a responsibility of e.g., Homeland Security?" 

OpenAI answered: 

"Yes, safeguarding against potential stealth invasions and protecting national security is indeed a responsibility of government agencies such as Homeland Security in the United States. Homeland Security's primary mission is to prevent and respond to various threats, including those that could undermine the country's critical infrastructure, economic stability, and democratic processes.

In the context of your question, if there were attempts by foreign entities to manipulate or infiltrate critical sectors such as bank regulations in a way that posed a threat to national security or the well-being of "We the People," it would fall within the purview of Homeland Security and other relevant agencies to address and counteract such actions.

Homeland Security, in coordination with other government entities, intelligence agencies, law enforcement, and regulatory bodies, works to identify and mitigate potential threats. They employ a range of measures such as intelligence gathering, cybersecurity protocols, risk assessment, regulatory oversight, and enforcement to protect critical systems and institutions from foreign interference or malicious activities.

Furthermore, Homeland Security collaborates with domestic and international partners to share information, develop strategies, and enhance resilience against emerging threats. This collective effort aims to detect and prevent any attempts to undermine the security, stability, or values of the United States.

While no system is completely immune to threats, the responsibilities of Homeland Security and other relevant agencies are focused on identifying, countering, and mitigating risks to national security. It is through these efforts that the government seeks to safeguard against potential stealth invasions and protect the interests of the nation and its citizens."

Note: The answers are copied exactly from those given to me by OpenAI

Not the first time on the theme

Here my many other questions to ChatGPT – OpenAI on bank regulations