Has the Basel Committee calibrated the risk weighted bank capital requirements to a mirage… to an illusion... to a dream?

Definition: A well-diversified portfolio: one that includes a variety of securities so that the weight of any security is small. The risk of a well-diversified portfolio closely approximates the systematic risk of the overall market, and the unsystematic risk of each security has been diversified out of the portfolio.

The following is extracted from “An Explanatory Note on the Basel II IRB Risk Weight Functions”, published by the Basel Committee on Banking Supervision in July 2005, and available in the Bank of International Settlements BIS web site.

"The current risk weighted bank capital requirements are portfolio invariant; meaning the capital required for any given loan depend on the perceived risk of that loan and does not depend on the portfolio it is added to. This is so because; taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would have been a too complex task for most banks and supervisors alike.”

The desire for portfolio invariance, however, makes recognition of institution-specific diversification effects within the framework difficult: diversification effects would depend on how well a new loan fits into an existing portfolio. As a result, the Revised Framework was calibrated to well diversified banks. If a bank fails at this, supervisors would have to take action under the supervisory review process (Pillar 2). "

So, just for a starter here are four questions.

1. With risk weighted capital requirements banks can leverage more with what's perceived or decreed as safe than with what's perceived as risky. Does that not introduce distortions in the allocation of credit, that impede the existence of that well diversified portfolio on which the Revised Framework was calibrated? 

2. What is here a “well-diversified”-bank-portfolio? One where regulators ex ante decide how much exposures bank should have to each type of assets; or one where a free and unincumbered market have banks allocating credit, as best as possible, based on their perceived risk adjusted returns, on the one and only bank capital/equity required against all assets?

3. Supervisors for which: “Taking into account the actual portfolio composition when determining capital for each loan - has been deemed a too complex task”, why should they suddenly be able to better do so in “the supervisory review process” Pillar 2?

4. Can anyone name any bank that has or has ever had a well-diversified portfolio as defined above? If not have the Basel Committee's risk weights been calibrated to a mirage, to a dream?

And to top it up: Calibrated to the risk perceived the morning after a crisis, not to the risks of the building up of too large dangerous exposures… to what’s perceived as safe.

PS. Here's a 2015 post on this issue.

PS. Here's my 2019 letter to the Financial Stability Board - FSB

PS. Here's a post in which, with the example of the recent SVB crisis, I try to explain some difficulties of banks and their supervisors in applying the Supervisory Review Process – Basel Pillar 2.

PS. I asked #AI ChatGPT – OpenAI: Could you help recalibrate bank capital requirements risk weights, so as to make these more portfolio variant? Sadly, it is not ready to do so... yet.

#AI ChatGPT – OpenAI: Could you help recalibrate bank capital requirements risk weights, so as to make these more portfolio variant?

Background: The current portfolio invariant risk weighted bank capital requirements are, in theory at least, calibrated to well diversified banks. The reason for this has been explained in terms of that the task of taking into account the actual portfolio composition when determining capital for each loan - as is done in more advanced credit portfolio models - would be a too complex task for most banks and supervisors.

I asked OpenAI:

"If you had real time access to data on a bank’s portfolio, and following some instructions on how to do it, would you be able to continuously recalibrate the risk weights and inform supervisors about the new level of capital requirements for that bank?"

OpenAI answered:

"I don't have real-time access to external data or the capability to perform real-time calculations or actions. My responses are based on the information available up to my last training data in September 2021, and I don't have the ability to access or process real-time data.

Continuously recalibrating risk weights for a bank's portfolio and informing supervisors about new capital requirements is a complex and dynamic process that typically involves sophisticated financial models, data analysis, and regulatory compliance. This process is typically carried out by financial institutions and regulatory authorities using specialized software and expertise.

If you have questions about risk-weighted capital requirements or related topics, I can provide general information and explanations based on my training data, but for real-time or specific applications, you would need to consult relevant financial experts and systems."

Thanks! 

"You're welcome! If you have any more questions or need further assistance in the future, feel free to reach out. Have a great day!"

Comment: In 2015 I had speculated about artificial intelligence helping out precisely on this issue. Sadly, it does not yet look ready to do so. Currently it cannot even comment or opine about specific documents, e.g., those of the Basel Committee.

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 about the impact of risk weighted bank capital/equity requirements on the risk-free interest rate?

I asked OpenAI:

"What is the rate normally used as identifying the “risk-free” interest rate?"

OpenAI answered:

"The rate typically used to represent the "risk-free" interest rate is the yield on government bonds, especially those issued by financially stable governments. In the United States, for example, the yield on U.S. Treasury bonds is often considered the closest approximation to the risk-free rate.

Government bonds are often considered risk-free because they are backed by the full faith and credit of the government. This means that investors generally believe there is very little risk of default when lending money to a government that can issue its own currency and has a stable economic and political environment. As a result, the yield on government bonds is often used as a benchmark to measure the minimum return an investor should expect for taking on no credit risk.

However, it's important to note that even though government bonds are considered risk-free in terms of credit risk, they are not entirely free from risk. They still carry other risks, such as interest rate risk (the risk that bond prices will fall when interest rates rise) and inflation risk (the risk that the purchasing power of the returns will be eroded by inflation). Nonetheless, for many financial and economic analyses, government bond yields are used as a reference point for risk-free rates because they are among the safest investments available."

I asked OpenAI:

"So, if bank capital/equity requirements are then lowered against government bonds, what effect could this have on such “risk-free” interest rate reference?"

OpenAI answered:

"If bank capital/equity requirements are lowered specifically for government bonds, it could potentially have several effects on the "risk-free" interest rate reference, which is typically represented by the yield on government bonds. Here are some potential effects:

1. Increased Demand for Government Bonds: Lower capital requirements would make it more attractive for banks to invest in government bonds, as they would require less capital to hold these assets. This increased demand for government bonds could drive up their prices and push down their yields. Bond yields and prices have an inverse relationship, so when bond prices rise, yields fall.

2. Lower Yields on Government Bonds: As a result of increased demand, the yields on government bonds could decrease. This would mean that the "risk-free" interest rate, represented by government bond yields, would be lower than it would be with higher capital requirements.

3. Impact on the Yield Curve: Lowering capital requirements for government bonds could also influence the shape of the yield curve. The yield curve represents the yields on bonds of different maturities. If banks shift more capital into shorter-term government bonds due to reduced capital requirements, it could put additional downward pressure on short-term interest rates, potentially flattening the yield curve.

4. Market Expectations: The perception of government bonds as even safer assets due to lower capital requirements might reinforce the idea that they are a risk-free benchmark, leading to lower yields. Market expectations and sentiment can play a significant role in determining interest rates.

5. Policy Implications: Central banks and policymakers may need to consider the implications of lower yields on government bonds when setting their monetary policies. Lower risk-free interest rates could impact borrowing costs, investment decisions, and economic growth.

It's important to note that the actual impact of lower capital requirements on government bonds and the risk-free interest rate would depend on various factors, including the magnitude of the capital requirement changes, market conditions, and the overall economic environment. Additionally, regulatory changes like this can have unintended consequences, and policymakers must carefully consider the potential risks and benefits of such adjustments to capital requirements."

I asked OpenAI:

"Have regulators, since 1988, with the Basel Accord, not decreed lower bank capital/equity requirements against government debt, e.g., US government bonds- treasuries than against any other bank assets?"

OpenAI answered:

"Under the Basel Accords, which include Basel I (1988), Basel II (2004), and Basel III (2010), government debt, particularly that of financially stable governments like the U.S. Treasury bonds (Treasuries), has historically been assigned lower risk weights compared to many other bank assets. The rationale behind this treatment is that government bonds are generally considered to have lower credit risk.

Here's a simplified overview of how capital requirements for bank assets are typically determined under the Basel framework:

1. Risk-Weighted Assets: Basel regulations categorize bank assets into different risk classes, and each class is assigned a specific risk weight. These risk weights reflect the perceived riskiness of the asset.

2. Minimum Capital Requirements: Banks are required to hold a minimum amount of capital (expressed as a percentage of their risk-weighted assets) to cover potential losses. This minimum capital requirement is known as the Capital Adequacy Ratio (CAR).

3. Risk Weights for Government Debt: Historically, government debt, especially from financially stable governments, has been assigned a risk weight of 0% or a very low risk weight. This means that banks do not need to hold much regulatory capital against government debt because it is considered virtually risk-free.

4. Higher Risk Weights for Riskier Assets: In contrast, assets perceived as riskier, such as corporate loans or loans to small businesses, are assigned higher risk weights. Banks must hold more capital against these assets to cover potential losses.

So, to answer your question, yes, regulators, under the Basel Accords, have typically decreed lower capital requirements for government debt like U.S. Treasuries compared to many other bank assets. This is because government bonds are considered among the safest investments and are treated as such in regulatory capital calculations. However, the exact details of capital requirements, including risk weights, can vary under different iterations of the Basel framework and may be subject to updates and changes over time as regulators adapt to evolving market conditions and risks. It's important to refer to the specific regulations in effect at any given time for the most accurate information."

Thanks!

"You're welcome! If you have any more questions or need further information, feel free to ask. I'm here to help!"

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

Here's my 2013 “The subsidized risk-free rate.

Here is Paul Volcker on the 1988 Basel I: “Assets for which bank capital/equity requirements were nonexistent, were what had the most political support; sovereign credits. A ‘leverage ratio’ discouraged holdings of low-return government securities”

I have previously asked #AI: "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? 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?" Here's how #AI ChatGPT - OpenAI answered that then

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

#AI ChatGPT – OpenAI: If we compare the economy to a human body, do the current risk adverse bank capital requirements prescribe an adequate diet?

Me at the World Bank, 2003: “I put forward the possibility that the developed countries might not have developed as fast, or even at all, had they been regulated by a Basel Committee.”

Now, 2023, I asked OpenAI - ChatGPT:

"If for illustration purposes we compare the economy to a human body, could we argue that government loans and residential mortgages are somewhat akin to carbs, while loans to small businesses and entrepreneurs are more like proteins?"

OpenAI answered: 

"Comparing the economy to a human body and drawing parallels between different financial instruments and nutrients can be a useful way to illustrate economic concepts, but it's important to remember that such analogies are simplifications and may not capture the full complexity of the economic system. That said, let's explore your analogy:

1. Government Loans and Residential Mortgages as Carbs:

Carbohydrates are a primary source of energy in the human body. Similarly, government loans and residential mortgages can be seen as providing a foundational source of capital in the economy. Government loans, such as bonds, are often used to finance public projects and government operations. Residential mortgages provide individuals with the means to purchase homes, which are essential assets for many families.

2. Loans to Small Businesses and Entrepreneurs as Proteins:

Proteins are essential for growth and repair in the human body. Loans to small businesses and entrepreneurs can be likened to proteins because they support the growth and development of businesses, which are vital for economic progress. These loans often help businesses expand, create jobs, and innovate, contributing to economic development and stability.

While this analogy helps highlight the different roles that various types of loans play in the economy, it's important to note that the real-world economy is far more complex. Economic systems involve numerous interrelated factors and actors, including households, businesses, financial institutions, and governments. Loans and mortgages also vary widely in their characteristics, terms, and purposes.

Moreover, the analogy doesn't account for the risks and potential downsides associated with these financial instruments. For example, excessive government borrowing can lead to debt-related challenges, and the housing market can experience bubbles and crashes that impact the broader economy. Similarly, lending to small businesses carries risks related to business success and economic conditions.

In summary, while comparing the economy to a human body and using nutrient analogies can be a helpful way to explain economic concepts, it's essential to recognize the inherent simplifications and limitations of such analogies. The economy is a complex and dynamic system influenced by a multitude of factors, making it challenging to fully capture its intricacies through simple comparisons."

I asked OpenAI:

"In line with the previous question, the current risk weighted bank capital requirements incentivizes banks to hold much more “safer” carbs than “riskier” proteins. Does this not risk causing an obese economy, meaning too much fat and too little muscles?"

OpenAI answered: 

"Your analogy of "safer" carbs and "riskier" proteins in the context of risk-weighted bank capital requirements is an interesting way to frame the potential issue with these requirements. However, it's important to clarify a few points:

1. Risk-Weighted Bank Capital Requirements: Risk-weighted capital requirements are a regulatory framework that requires banks to hold a certain amount of capital as a cushion against potential losses on their assets. The idea is to ensure that banks have enough capital to absorb losses in case of economic downturns or adverse events. The level of capital required varies depending on the perceived riskiness of the assets on a bank's balance sheet. Safer assets, like government bonds, typically have lower risk weights, while riskier assets, like loans to small businesses or complex financial instruments, have higher risk weights.

2. Obese Economy vs. Muscular Economy: In your analogy, an "obese economy" could be interpreted as an economy with an overreliance on low-risk, low-return assets (the "safer" carbs). A "muscular economy," on the other hand, might imply an economy with a healthier mix of assets, including riskier but potentially more rewarding investments (the "riskier" proteins).

The concern you raise is valid. If banks are incentivized to hold predominantly low-risk assets to meet capital requirements, it can lead to an allocation of capital that favors safe but potentially lower-yielding investments. This could result in lower economic growth and innovation, as resources are not efficiently allocated to more productive uses. It may also hinder the growth of small businesses and entrepreneurship, which are often seen as the "muscles" of the economy.

Regulators and policymakers are aware of this issue, and there have been ongoing discussions and reforms aimed at addressing it. The challenge lies in striking a balance between financial stability (ensuring banks have sufficient capital to weather crises) and economic growth (encouraging investment in riskier but potentially more productive ventures). Reforms may include adjusting risk weights, enhancing transparency in risk assessment, and encouraging banks to diversify their portfolios.

In summary, your analogy highlights a genuine concern in the financial regulatory framework. Striking the right balance between safety and growth in the banking sector is a complex task, and policymakers continually strive to adapt regulations to ensure a healthy and balanced economy.

I asked OpenAI:

"Would not such an obese economy pose a serious danger to our bank systems? 

If, so does it illustrate an unexpected consequence of regulatory risk-aversion, or one that should have been expected?"

OpenAI answered: 

"An "obese" economy, as you described it, with an overemphasis on safer but lower-yielding assets, can pose risks to the banking system and the broader economy. This situation can be a consequence of regulatory risk-aversion, and it highlights some of the unintended consequences that can arise from well-intentioned regulations.

Here's how such an obese economy can pose dangers to the banking system:

1. Reduced Profitability: When banks are primarily incentivized to hold low-risk assets to meet capital requirements, their profitability may be constrained. Safer assets typically yield lower returns, which can reduce banks' ability to generate profits. Over time, this may limit their capacity to absorb losses and invest in other aspects of their operations.

2. Inefficiency: An economy overly reliant on low-risk assets may become less efficient. Capital that could be allocated to more productive, growth-oriented ventures, such as loans to small businesses or innovative startups, may instead be tied up in low-yield, low-risk assets like government bonds. This inefficiency can hinder overall economic growth.

3. Systemic Risk: Paradoxically, excessive risk-aversion by banks and regulators can lead to systemic risk. If banks collectively focus too much on the same safe assets, they may become highly correlated in their behavior. This means that when a downturn does occur (even if it's not directly related to the safe assets), the entire banking system could be vulnerable, potentially leading to a systemic crisis.

4. Dampened Innovation: An overly conservative approach to lending can stifle innovation and entrepreneurship, as it becomes more challenging for riskier ventures to secure funding. This can hinder long-term economic growth and job creation.

Should these dangers have been expected? To some extent, yes. Regulatory risk-aversion, while designed to enhance financial stability, has long been recognized as having the potential to create unintended consequences. Economists and policymakers are aware of the trade-offs involved in financial regulation. They understand that striking the right balance between risk mitigation and economic growth is challenging.

Over time, regulations have evolved in response to such concerns. Regulatory agencies have made efforts to fine-tune risk-weighted capital requirements, promote diversification of bank portfolios, and encourage lending to key sectors like small businesses.

In conclusion, the dangers posed by an obese economy, resulting from excessive risk-aversion in regulations, are recognized by experts in finance and economics. They illustrate the complexity of regulatory decision-making and the need for ongoing evaluation and adjustment of regulatory frameworks to achieve both financial stability and economic growth.

I asked OpenAI:

"One last question: Do you think these dietary instructions the regulators prescribed for our banks, show sufficient considerations to the economy our children and grandchildren will have to live with?"

OpenAI answered: 

"The regulatory decisions made by policymakers and regulators in the financial sector are intended to strike a balance between short-term financial stability and the long-term health of the economy. However, predicting the exact economic conditions that our children and grandchildren will face in the future is extremely challenging, and regulatory decisions are often made with the best information available at the time.

Here are some considerations regarding the regulatory framework and its implications for future generations:

1. Financial Stability: Ensuring the stability of the financial system is a primary concern for regulators. They aim to prevent the types of financial crises that can have severe and lasting effects on the economy. This focus on stability is intended to create a more secure foundation upon which future economic growth can be built.

2. Balancing Risk and Growth: As discussed earlier, regulators must strike a balance between risk mitigation and economic growth. The choices made today can influence the availability of credit, economic innovation, and entrepreneurial opportunities for future generations.

3. Adaptability: Regulatory frameworks should ideally be adaptable to changing economic conditions. Policymakers recognize that the economic landscape evolves, and regulations may need to be adjusted to meet new challenges and opportunities.

4. Long-Term Impact Assessment: Regulatory decisions should ideally consider their potential long-term effects on economic sustainability, job creation, and innovation. However, predicting the precise long-term consequences of regulatory actions can be difficult.

5. Interconnected Global Economy: Today's economy is highly interconnected on a global scale. Decisions made by one country's regulators can have ripple effects worldwide. Regulators often need to consider the global implications of their actions, as future generations will inherit an increasingly interconnected global economy.

In summary, regulatory decisions are typically made with the aim of balancing immediate financial stability with the long-term health of the economy. However, predicting the exact economic landscape that future generations will face is challenging. It's essential for policymakers and regulators to be mindful of the potential long-term consequences of their actions and to maintain a dynamic and adaptable approach to regulation to ensure the best outcomes for future generations. Additionally, policymakers often seek input from economists, experts, and the public to make informed decisions that consider the interests of current and future generations."

Thanks!

"You're welcome! If you have any more questions in the future or need further information, feel free to reach out. Have a great day!"

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

Me at the World Bank, 2003: “The financial sector’s role, the reason why it is granted a license to operate, is to assist society in promoting economic growth by stimulating savings, efficiently allocating financial resources satisfying credit needs and creating opportunities for wealth distribution.”

PS. “The sugar high is all fun until the resulting sugar crash affects the quality of your day. The term refers to the sudden drop in energy levels after consuming a large amount of carbohydrates. It causes symptoms that can disrupt productivity and energy levels.”

PS. In Martin Wolf’s Economic Forum in October 2009, I wrote: “Please free us from imprudent risk-aversion and give us some prudent risk-taking”

PS. My 2019 letter to the Financial Stability Board (FSB)

PS. Some of my many previous references to carbs v.s proteins in banking,

https://subprimeregulations.blogspot.com/2014/12/europe-america-use-average-risk.html

https://subprimeregulations.blogspot.com/2015/03/i-dont-know-whether-to-laugh-or-cry-but.html

https://teawithft.blogspot.com/2013/02/european-youth-is-still-unaware-of-how.html

https://teawithft.blogspot.com/2015/08/we-need-free-finance-sector-able-to.html

PS. Here on violations of that "Holy Intergenerational Social Contract" Edmund Burke spoke about. 

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

It takes two to tango, and it takes two to play the game of bank capital requirements

Sir, I refer to “On Wall Street Truth must be told about bank cap­ital rules plans” Sheila Bair, FT September 2, 2023.

Way back, before 1988, when there was one bank capital/equity requirement against all assets, a leverage ratio, the game bankers played was easier than Ludo. It was all about hiding some assets away from their balance sheet, and of finding more capital on it than what they really had.

After 1988, with the introduction of the Basel Committee’s risk weighted bank capital requirements, Basel I, and especially with Basel II which assigned so much importance to credit rating agencies, the game became dramatically more complicated. Out went the type of old time basically loan officer bankers, and in came the dangerously creative banking financial engineers. A game much more like chess has ensued. 

The steps in this Bank Capital Requirements are becoming ever more complicated. If you doubt it just consider that though Basel I had 30 pages, the recent Fed FDIC OCC July 2023 request for just comments on proposed rules to strengthen capital requirements for large banks has 1.087 pages.

Sheila Bair, expressing a con­cern about the complexity of current pro­pos­als ends with “Hopefully, reg­u­lat­ors will find ways to sim­plify the rules and make them more understandable to the pub­lic.”

Sir, from my thousands of letters to you over the last two decades, you know I would like the bank capital requirements to become a game of Ludo again. I might have given you hundred arguments for scrapping the risk weighted capital requirement, Please let me just list here the most fundamental ones.

Lower risk weights for government debt de facto imply that bureaucrats and politicians know better what to do with credit for which repayment they’re not personally responsible for than e.g., small businesses and entrepreneurs. (Long term US treasuries still have a 0% risk weight) I strongly object to that. Sir, don’t you?

Lower capital requirements against residential mortgages de facto imply that financing houses is more important for the economy than lending to small businesses and entrepreneurs. I object to that. Sir, don’t you?

Basing the risk weights on perceived risk and not conditioned to how bankers perceive risks; and on that what’s perceived as risky is more dangerous to bank systems than what’s perceived as safe is clear evidence that the regulators work from their desk and have never walked on main-street. Just think of Mark Twain supposedly saying: “A banker is a fellow who wants to lend you the umbrella when the sun shines and wants it back when it rains”, and then consider the risk weights of 20% for AAA to AA rated assets and 150% for the below BB- rated ones. It’s sheer hubristic lunacy. Sir, don’t you agree?

And honestly, in an uncertain world where so many unexpected events can become dangerous, how on earth, even with “a thoughtful multi year pro­cess” can regulators still base their capital requirements so much on the certainty of perceived risk? In “Against the Gods” Peter L. Bernstein writes that the boundary between the modern times and the past is the mastery of risk, since for those who believe that everything was in God’s hands, risk management, probability, and statistics, must have seemed quite irrelevant. Sir, today, I cannot but speculate on whether we, when managing risk, have not left out God’s hand just a little bit too much.

Finally, as I have tweeted or X-ed repeatedly: “When times are good, and bank capital buffers should be built-up, regulators allow banks to hold little equity, pay dividends and do buybacks so, when times turn bad, banks stand naked, when we need them the most, when the hardest to raise new bank equity.”

https://twitter.com/PerKurowski/status/1688901715989282816?s=20 

PS. Sheila Bair writes about “massive mort­gage defaults dur­ing the fin­an­cial crisis”. Let’s not ignore that crisis was caused not really by mortgages but by the AAA to AA rated securities backed with mortgages to the subprime sector and which therefore were assigned a mind-blowing low 20% risk weight.

@PerKurowski