Do current risk weighted bank capital/equity requirements promote or impede fiscal insolvency?

I asked: "Do current risk bank capital/equity requirements, which favor banks holding public debt over loans to e.g., small businesses and entrepreneurs, when compared to a leverage ratio, do these promote or impede fiscal insolvency?"

Grok answered: 

Current risk-based capital requirements, which give public debt a lighter touch (often zero or near-zero risk weights) compared to loans for small businesses and entrepreneurs (higher risk weights), tend to promote fiscal insolvency in the long run, though not directly or obviously. Here’s how it shakes out:

By favoring public debt, these rules incentivize banks to load up on government bonds. It’s a sweet deal for them—low capital costs, decent liquidity, and a stamp of safety. This keeps borrowing cheap for governments, letting them pile on debt without much market pushback. Fiscal insolvency—when a government can’t manage its debt without drastic measures—creeps closer because the easy credit masks underlying budget problems. Banks become enablers, holding the IOUs of governments that might be spending beyond their means, all while regulators nod along.

Contrast that with a leverage ratio, like Volcker hinted at. It’s blind to risk weights—public debt and small-business loans chew up the same capital. Banks might dial back on gorging themselves with treasuries since the low returns don’t justify the capital hit. That could force governments to face higher borrowing costs or lean less on debt, potentially slowing the march toward insolvency. Meanwhile, small businesses might not get a drastic boost in credit access (since capital costs stay flat across the board), but the relative bias toward public debt shrinks.

The kicker? Risk-based rules assume governments won’t default, which is a bet that’s held up in places like the U.S. or Germany but looks shakier elsewhere—think Greece or Argentina. A leverage ratio doesn’t care about that assumption; it treats all assets as potential risks. 

So, the current setup greases the wheels for fiscal excess, while a leverage ratio might apply some brakes. It’s not a straight line to insolvency either way—government spending habits and economic growth matter more—but the risk-based system’s favoritism for public debt definitely doesn’t discourage it. 

ChatGPT answered:

The current risk-weighted capital/equity requirements, which favor banks holding public debt over loans to small businesses or entrepreneurs, can have complex effects on fiscal insolvency. Here’s how these dynamics play out:

1. Promotion of Fiscal Insolvency (Indirectly):

Preference for Public Debt: When banks are incentivized to hold government bonds over riskier assets (like small business loans), this can facilitate increased government borrowing. Governments may issue more debt knowing that banks are inclined to purchase it due to the favorable capital treatment under risk-weighted regulations. Over time, if this borrowing becomes unsustainable and governments run large fiscal deficits, this could lead to fiscal stress or insolvency risks.

Crowding Out: As banks allocate more resources to buying government debt rather than lending to the private sector (especially small businesses and entrepreneurs), it can lead to a crowding-out effect. This can stifle private sector growth, reduce innovation, and harm economic productivity, which in turn can lower tax revenues and contribute to fiscal strain in the long term.

2. Impediment to Fiscal Insolvency:

Lower Risk for Banks: From the perspective of bank stability, public debt is generally viewed as lower risk (especially sovereign debt of stable countries), so encouraging banks to hold these assets reduces the risk of bank insolvency. Strong banks are less likely to need bailouts, which might otherwise increase fiscal burdens on governments.

Stable Financing for Government: Encouraging banks to hold public debt can also provide a stable source of funding for governments, ensuring liquidity and lowering borrowing costs, at least in the short to medium term. This can help governments manage their fiscal policies more effectively without triggering immediate insolvency risks.

Leverage Ratio vs. Risk-Weighted Capital Requirements:

Leverage Ratio: A leverage ratio (e.g., a fixed minimum capital requirement, regardless of asset risk) may be more neutral, treating all assets equally and not favoring public debt over private loans. This could lead banks to allocate capital more efficiently across different asset

Leverage Ratio vs. Risk-Weighted Capital Requirements

Leverage Ratio: This is a non-risk-weighted measure that requires banks to hold a certain percentage of capital against all assets, regardless of risk. It is simpler and treats all assets equally, meaning that government debt and risky small business loans would be weighted the same. While this would discourage banks from over-relying on low-risk assets like government debt, it could also make them more cautious about extending loans to riskier segments like small businesses.

Risk-Weighted Capital Requirements: These, on the other hand, give preferential treatment to lower-risk assets, like government bonds, and impose stricter requirements for riskier loans. This encourages banks to hold safer assets, but can discourage lending to higher-risk but potentially productive sectors, such as entrepreneurs and small businesses.

Overall Impact on Fiscal Insolvency

Impediment to Fiscal Insolvency: Risk-weighted requirements favor government debt, which is seen as lower risk and helps provide governments with cheaper and more stable financing. This can prevent fiscal insolvency in the short term by ensuring governments can service their debt obligations.

Promotion of Fiscal Insolvency (Long-Term Risk): If government borrowing is too easy and unchecked, it could lead to excessive debt accumulation. Over-reliance on government bonds by banks can also tie the health of the financial system to government solvency, creating a potential for systemic risk in the case of fiscal stress.

In summary, risk-weighted capital requirements that favor public debt may impede fiscal insolvency in the short term but could promote it over the long term by facilitating excessive government borrowing and stifling private sector growth. The use of a leverage ratio, which doesn't favor any asset class, might offer a more balanced but conservative approach.

Note: The answers are copied exactly from those given to me by ChatGPT and Grok

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

A 2004 letter in the Financial Times: "The Basel Committee is unwittingly controlling the capital flows in the world. How many Basel propositions will it take before they start realizing the damage they are doing by favoring so much bank lending to the public sector?"