#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.
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