#AI #OpenAI #ChatGPT: Could current bank regulations imply that a successful leftist regulatory guerrilla war has been taking place?

I asked ChatGPT:

"Government debt, when expressed in the currency of the nation is, by bank regulators, considered to be much less risky than private sector debt. Could that be because they argue governments can always print more money in order to repay that debt?"

ChatGPT answered:

Yes, that is one of the primary reasons why government debt, when denominated in the nation’s own currency, is considered less risky than private sector debt. Governments that issue debt in their own currency have the ability to print more money to meet their obligations. This means that, in theory, they can always avoid defaulting on their debt, since they control the currency in which the debt is denominated.

However, while the ability to print money reduces the risk of outright default, it doesn't eliminate other risks, such as inflation. If a government resorts to printing large amounts of money to repay its debt, it could lead to inflation or even hyperinflation, which would erode the value of the currency and the real value of the debt being repaid.

In contrast, private sector entities, like corporations or individuals, do not have the ability to print money and are more dependent on their income, assets, and access to credit markets to meet their debt obligations. This makes private sector debt inherently riskier, as these entities can default if they are unable to generate sufficient cash flow or refinance their debt.

Bank regulators and financial institutions take these factors into account, which is why government debt is often given a lower risk weighting in regulatory frameworks, such as the Basel Accords, compared to private sector debt.

I asked ChatGPT:

"That, when compared to the private sector’s access to bank credit, does it not translate into an effective regulatory subsidy given to the government?"

ChatGPT answered:

Yes, you can interpret the lower risk weighting of government debt compared to private sector debt as an effective regulatory subsidy to the government. This occurs because financial institutions are required to hold less capital against government debt, which is considered safer, than they would for private sector debt.

Here's how this works:

1. Capital Requirements: Banks are required by regulators to hold a certain amount of capital against their assets to cover potential losses. Government debt, especially when issued in the country’s own currency, often has a lower risk weight (sometimes even zero) in these calculations. This means banks need to hold less capital against government debt than they would for other types of debt, such as corporate bonds or loans.

2. Cost of Financing: Because banks perceive government debt as safer due to the low or zero risk weight, they are more willing to lend to the government at lower interest rates compared to the private sector. This effectively reduces the cost of borrowing for the government.

3. Increased Demand for Government Debt: The regulatory framework incentivizes banks to hold government debt, given its lower capital requirement. This increased demand for government securities further lowers the interest rates at which governments can borrow, enhancing the "subsidy" effect.

4. Crowding Out: In some cases, this preferential treatment can crowd out private sector borrowers, as banks may prefer to invest in government debt rather than lending to businesses or individuals. This can lead to a situation where the private sector faces higher borrowing costs and limited access to credit, while the government enjoys easier access to funds.

So, in essence, the regulatory framework creates a favorable environment for government borrowing by treating government, debt as less risky, which can be seen as an implicit subsidy when compared to the private sector's cost of capital.

I asked ChatGPT:

"If so, would it be completely ludicrous, for someone defending the private sector and free markets, to argue that a leftist regulatory guerilla war has been taking place within the realm of bank regulation authorities?"

ChatGPT answered:

While it might be an exaggeration to frame the situation as a "leftist regulatory guerrilla war," the sentiment behind the argument could stem from legitimate concerns about the potential distortion of free markets due to regulatory policies that favor government debt over private sector debt. Here's how someone might approach this argument:

1. Market Distortion: From a free-market perspective, the preferential treatment of government debt could be seen as distorting capital allocation. In an ideal free market, capital would flow to the most productive and profitable opportunities, regardless of whether they are in the public or private sector. However, by incentivizing banks to hold government debt through lower capital requirements, regulators might be skewing the market in favor of government borrowing, potentially at the expense of private enterprise.

2. Moral Hazard: The argument could also touch on moral hazard. If governments know they can borrow at lower rates due to favorable regulations, they might be encouraged to take on more debt than is fiscally responsible, relying on the ability to print money to service it. This could lead to long-term economic instability, which free-market advocates might see as a direct consequence of regulatory interference.

3. Philosophical Opposition: Free-market advocates often oppose government intervention in markets, arguing that it leads to inefficiencies and stifles innovation. The perception that regulatory bodies are systematically favoring government debt could be seen as a form of intervention that benefits the public sector at the expense of the private sector.

4. Rhetorical Flourish: Referring to this as a "leftist regulatory guerrilla war" is likely more of a rhetorical flourish than a literal accusation. It could be used to emphasize the speaker's belief that the regulatory environment is biased in favor of government intervention and against the private sector, a stance often associated with left-leaning economic policies.

However, this argument would likely face pushback. Critics might argue that the preferential treatment of government debt is based on risk assessment rather than ideology. The reasoning behind lower risk weights for government debt is tied to its perceived stability and the government’s ability to service its debt, not necessarily to a political agenda.

In sum, while it might not be "ludicrous" to argue that regulatory policies have unintended consequences that favor government borrowing, framing it as a coordinated "leftist guerrilla war" is more likely to be seen as a provocative or hyperbolic statement rather than a balanced analysis.

I asked ChatGPT:

By the way, do you think it is completely impossible for a group with a clear leftist pro-government mentality, to be able to penetrate and strongly influence the decisions of global institutions. such as the Basel Committee for Banking Supervision?

ChatGPT answered:

It’s not impossible for a group with a pro-government or left-leaning ideology to influence global institutions like the Basel Committee for Banking Supervision (BCBS), though the process is more complex and multifaceted than a single ideological group's infiltration. Global financial regulatory bodies are influenced by a wide array of stakeholders, including national governments, central banks, and private sector financial institutions, each with its own interests and ideologies. Here's why it’s not impossible but also not simple:

1. Political and Economic Realities Influence Institutions: :Global institutions like the Basel Committee are shaped by the political and economic realities of the member countries that participate in these bodies. If a significant number of influential countries adopt more left-leaning, pro-government economic policies, it's conceivable that the decisions and policies of these global institutions could reflect those ideological shifts. For example, during times of financial crises or recessions, there is often a shift toward greater government intervention, regulation, and public sector support, which could influence global financial regulatory policies.

2. Diverse Membership of the Basel Committee: The BCBS is composed of central banks and supervisory authorities from numerous countries, each with differing political and economic ideologies. This diversity of membership can serve as a check against any one ideology dominating the process. However, if a coalition of influential members with similar left-leaning policies were to form, they could certainly sway the direction of discussions and decisions. Institutions like the BCBS operate through consensus-building, which means strong alliances within the group could have meaningful influence.

3. Public Sentiment and Crises as Catalysts: Major financial crises, such as the 2008 global financial crisis, often lead to public demand for more regulation and oversight, which is typically aligned with more interventionist, pro-government approaches. These crises create opportunities for more left-leaning or pro-government voices to push for reforms that prioritize stability and social outcomes over market liberalism. In these contexts, ideas favoring increased regulation, public ownership, or greater control over financial markets can gain traction, even in traditionally conservative financial bodies.

4. Influence of Academia and Think Tanks: Many of the ideas that influence global financial regulations originate in academia, think tanks, and policy research institutions, which can have ideological leanings. Over time, these ideas can filter into the policy-making processes of institutions like the BCBS. If left-leaning economic theories advocating for greater regulation, financial market controls, or public sector dominance gain intellectual legitimacy, they could impact the committee's decisions. For example, after the 2008 crisis, the ideas of economists who favored stricter financial regulation gained prominence.

5. Historical Precedent for Ideological Shifts: Global institutions have historically shifted in response to changing political climates. For instance, the rise of Keynesian economics after World War II led to a period of significant government intervention in markets globally. Similarly, the 1980s saw the rise of neoliberal economic policies that emphasized deregulation and free markets, influencing global institutions. Ideological shifts can occur over time, and left-leaning ideologies could shape the policies of global financial regulators if the political and economic context favors such a shift.

6. Checks and Balances: While it’s possible for a group with a left-leaning, pro-government mentality to influence global financial regulatory decisions, it's unlikely that they could do so unilaterally or without resistance. There are multiple layers of checks and balances within institutions like the BCBS, including input from a wide array of stakeholders, making it difficult for one group or ideology to dominate. Countries with more free-market or conservative approaches, for example, would push back against regulations they see as overreach.

Conclusion

It's not impossible for a left-leaning group to influence decisions at global institutions like the BCBS, but it would require a combination of broader ideological shifts among member states, alignment with academic and intellectual trends, and possibly catalytic events like financial crises. Such influence would likely emerge through consensus-building and a response to changing global conditions, rather than as a result of a single group "infiltrating" the system. Ultimately, global financial regulation tends to evolve in response to practical realities and the need for stability, rather than being driven purely by ideology.

I asked ChatGPT:

"But what if that leftist influence exploited the interest of banks of having to hold less capital/equity against government debt, as this would allow them to easier earn higher risk adjusted returns on their capital/equity on such asset?"

ChatGPT answered:

The scenario you’re describing—where a leftist influence exploits the interests of banks to hold less capital against government debt—could theoretically align different interests in a way that benefits both pro-government regulators and financial institutions. Here’s how this might work and why it’s a plausible, though complex, situation:

1. Mutual Interests Between Regulators and Banks:

Regulators’ Perspective: Regulators with a left-leaning or pro-government stance might prioritize financial stability and government funding over market freedom. By encouraging banks to hold more government debt through favorable capital requirements, they ensure that governments can borrow more easily and at lower costs. This supports government spending and interventionist policies, which might align with their ideological goals.

Banks’ Perspective: Banks, motivated by profit, might support lower capital requirements for government debt because it allows them to earn higher returns on their equity. Government bonds, especially those with low or zero risk weights, can provide a relatively safe way to generate returns without tying up large amounts of capital. This makes it attractive for banks to hold large amounts of government debt.

2. The Capital Requirement Loophole

Capital requirements are designed to ensure that banks have enough equity to absorb losses. If government debt is treated as low-risk, banks don’t have to hold much capital against it, freeing up capital for other investments or increasing their leverage. This can create a situation where banks willingly support or even lobby for regulations that favor government debt, because it allows them to maximize their risk-adjusted returns.

3. Potential Regulatory Capture

The concept of regulatory capture occurs when regulatory agencies are dominated or unduly influenced by the industries they are supposed to regulate. In this scenario, if leftist regulators and banks find common ground in promoting policies that favor government debt, there’s a risk of regulatory capture. This could lead to policies that disproportionately benefit the government and banks at the expense of broader financial stability or market efficiency.

4. Alignment of Ideological and Economic Interests

This situation is a convergence of interests rather than a straightforward leftist ideological push. Left-leaning regulators might advocate for policies that make it easier for governments to fund social programs or public investments through borrowing. Banks, in turn, support these policies because they can earn relatively safe returns on government bonds without having to hold significant capital against them. This alignment of interests could lead to policies that favor the accumulation of government debt in banks' portfolios.

5. Risks and Consequences

· Moral Hazard and Excessive Debt: If banks heavily invest in government debt due to favorable regulations, it could lead to excessive government borrowing, potentially increasing national debt to unsustainable levels. The assumption that government debt is always safe could be challenged if a country faces a fiscal crisis, leading to significant risks for both the banks and the broader economy.

· Reduced Private Sector Lending: If banks are incentivized to hold more government debt, this might come at the expense of lending to the private sector. This could stifle economic growth, particularly in sectors that rely on bank financing.

· Systemic Risk: Concentrating too much risk in government debt could create systemic vulnerabilities. If a fiscal crisis leads to a loss of confidence in government bonds, banks heavily exposed to this debt could face significant losses, potentially triggering a broader financial crisis.

6. Political Dynamics

This alignment of interests might be politically feasible and could occur within the broader context of regulatory negotiations and reforms. However, it would likely face opposition from more market-oriented regulators, policymakers, and economists who might argue that it distorts market incentives and increases long-term risks.

Conclusion

"While it might seem unusual for left-leaning regulators and profit-driven banks to find common ground, the scenario you describe is plausible. Both parties could benefit from a regulatory environment that favors government debt: regulators by facilitating government borrowing and banks by improving their risk-adjusted returns. However, this could lead to unintended consequences, including moral hazard, reduced private sector lending, and increased systemic risk. The challenge would be balancing these competing interests to maintain financial stability and market integrity."

I said: Thanks! 

ChatGPT said: You're very welcome! If you ever have more questions or just want to explore another topic, feel free to reach out. I'm here to help. 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

PS. The origins of my speculations on this theme go way back.

PS. And these arguments were greatly reinforced when Paul Volcker, in his autobiography, confessed: “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” 

Basel I, II, and III are all examples of pure unabridged regulatory statism

In July 1988 the G10 approved the Basel Accord. For its risk weighted bank capital requirements it assigned the following risk weights:

0% to claims on central governments and central banks denominated in national currency and funded in that currency. 

100% to claims on the private sector.

That means banks can leverage much more whatever net margin a sovereign borrower offers than what it can leverage loans like to entrepreneurs. That means banks will find it easier to earn high risk adjusted returns on their equity lending to the sovereign than for instance when lending to entrepreneurs. That means it will lend too much at too low rates to the sovereign and too little at too high rates to entrepreneurs.

In other words Basel I introduced pure and unabridged statism into our bank regulations. 

Basel II of June 2004 in its Standardized Risk Weight, for the same credit ratings, also set lower risk weights for claims on sovereigns than for claims on corporates.

In a letter published by FT November 2004 I asked: “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. In some developing countries, access to credit for the private sector is all but gone, and the banks are up to the hilt in public credits.”

And the European Commission, I do not know when, to top it up, assigned a Sovereign Debt Privilege of a 0% risk weight to all Eurozone sovereigns, even when these de facto do not take on debt in a national printable currency.

And, to top it up, the ECB launched its Quantitative Easing programs, QEs, purchasing European sovereign debts.

At the end of the day, the difference between the interest rates on sovereign debt that would exist in the absence of regulatory subsidies and central bank purchases, and the current ultra low or even negative rates, is just a non-transparent tax, paid by those who save. Financial communism

And all this began one year before the fall of the Berlin Wall

Risk weights are to access to credit what protectionist tariffs are to trade, only more pernicious.

A letter to the Executive Directors and Staff of the International Monetary Fund.

For decades now IMF has helped to spread around all developing countries the pillar of the Basel Committee’s bank regulations; the risk weighted capital requirements for banks.

Since risk taking is in essence the oxygen of any development, that piece of regulation is fundamentally flawed, especially for developing countries.

How do risk weighted capital requirements alter the incentives for banks? 

If banks hold the same capital against their whole portfolio, as they used do until some three decades ago, then with an eye on their overall portfolio and funding structure, banks lend in accordance to what produces them the highest risk adjusted interest rate; which would also provide them with the highest risk adjusted return on equity.

But, when different assets have different capital requirements, obtaining the highest risk adjusted return on equity will depend on how many times the risk adjusted interest rate for any specific loan or asset will depend on how many times it can be leveraged. The higher the allowed leverage is, the easier it is to obtain a high ROE; which means that “safe” highly leveregable loans could be competitive at lower risk adjusted interest rates than before, while “risky” lower leveregable loans would require paying higher risk adjusted interest rates. 

In essence the introduction of that regulation has caused banks to substitute savvy loan officers with equity minimizing engineers.

How do risk weighted capital requirements distort the allocation of bank credit?

The regulators based their decision on how much banks were allowed to leverage their capital with for the different assets, solely on the perceptions of credit risk. It never explicitly had one iota to do with banks fulfilling their obligation of allocating credit efficiently to the real economy.

So the introduction of that regulation simply distorts the allocation of bank credit; in favor of “the safer present” and against “the riskier future”. 

“A ship in harbor is safe, but that is not what ships are for”, John A Shedd.

Specifically, a credit that is perceived as risky but that is directly related to helping reach a Sustainable Development Goal is much less favored by bankers, and now by bank regulators too, than a credit, perceived as safe, but which purpose could in fact be harmful to any SDG.

Specifically, safe credits for the purchase of houses are much more favored over credits to risky entrepreneurs, those who could create the jobs that would allow the income needed to service the mortgages and pay the utilities. 

Specifically, assigning lower risk weights to the sovereign than to citizens de implies de facto a statist belief that bureaucrats know better what to do with bank credit, than entrepreneurs who put their name on the line.

In other words these risk weight are to access to credit what tariffs are to trade, only much more pernicious. 

Do risk weighted capital requirements make our banks system safer?

If that regulation made the financial system safer there would at least be a favorable tradeoff. But it doesn’t, much the contrary. Too much easy credit can turn what is safe into something risky, like for instance morphing houses from being affordable homes into investment assets. 

The 2007/2008-bank crisis would never have happened or, if so, remotely had been of the same scale had regulators, for their risk weights, instead of perceived credit risk risks, used the probabilities of banks investing conditioned on how credit risks were perceived.

Many Eurozone sovereigns would not face current high levels of indebtedness had not EU authorities decreed a Sovereign Debt Privilege and assigned it a 0% risk weight, this even though they take on debt denominated in a currency that de facto is not their domestic printable one.

And so, at the end of the day, this regulation only guarantees especially large bank crisis, caused by especially large exposures to what was perceived (or decreed) as especially safe, which end up being especially risky, and are held against especially little capital.

Risk weighted capital requirements and inequality.

John Kenneth Galbraith wrote: “The function of credit in a simple society is, in fact, remarkably egalitarian. It allows the man with energy and no money to participate in the economy more or less on a par with the man who has capital of his own. And the more casual the conditions under which credit is granted and hence the more impecunious those accommodated, the more egalitarian credit is… the poor risk… is another name for the poor man.” “Money: Whence it came where it went” 1975.

So I ask, how many millions of SMEs and entrepreneurs have not been given the opportunity to advance with credits over the last 25 years as a direct result of it?

IMF, please, wake up!

Should banks not be regulated? 

Of course these need to be regulated! I am only reminding everyone of the fact that the damage dumb bank regulators can cause when meddling without taking enough care, by far surpasses anything the free market can do. A free market would never have knowingly allowed banks to leverage 62.5 times their equity like regulators did, only because some very few human fallible credit rating agencies had assigned an AAA to AA rating to some securities backed with mortgages to the US subprime sector. 

A simple leverage ratio between 10 to 15% for all banks assets would be a much mote effective regulation than all those thousands of pages that currently exist.

And please, please, please, stop talking about "deregulation" in the presence of such an awful and intrusive mis-regulation. The regulators imposed the worst kind of capital controls.

Of course, just in case, all problems here referred to, are clearly applicable to developed economies too.

Sincerely,

Per Kurowski

@PerKurowski

PS. Basel Committee’s distortion of credit allocation explained to dummies, in just four tweets.

PS. “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”, “Keeping at it” 2018, Paul Volcker

PS. My 2019 letter to the Financial Stability Board

PS. An ever growing aide memoire on Basel Committee’s many mistakes.

PS. The risk weighted bank capital requirements utterly distorted central banks’ monetary policy by directing way too much credit to what’s decreed or perceived as “safe”, sovereign/ residential mortgages/ AAA rated; and way too little to “risky” SMEs and entrepreneurs.

PS. Because it would also create distortions I am not proposing it, but would not risk weighted bank capital requirements based on SDGs ratings at least show more purpose for our banks? And, in the case of sovereigns, besides credit ratings, do we citizens not also need ethic ratings?

PS. “Are Basel bank regulations good for development?” a document presented at the High-level Dialogue on Financing for Developing at the United Nations, New York, October 2007.

PS. GDP growth based on too much carbs and too little proteins? Muscular or obese?

PS. Being creditworthy and being worthy of credit, c'est pas la même chose :-(

PS. And I am no newcomer to this issue

PS. Here AI - ChatGPT opining on risk weights and tariffs

Reading, little by little, Adam Tooze’s “Crashed: How a Decade of Financial Crises Changed the World” 2018

Here a comment I made before beginning to read the book

Chapter 14 “Greece 2010: Extend and pretend”

I read: “As recently as 2007 Greece’s bonds had traded at virtually the same yield as Gemany’s”

The credit rating of Greece in 2007 was A, and that of Germany AAA. According to Basel II’s risk weighted capital requirements Greece should have a risk weight of 20% while Germany 0%.

But, European authorities extended Sovereign Debt Privileges to all Eurozone nations, and assigned Greece also risk weight of 0%. All this even though these nations are all taking on debt in a currency that de facto is not their own printable one. 

When Greece’s crisis breaks lose Greece has still a risk weight of 0%... meaning European banks could lend to Greece against no capital at all... and it is still 0% risk weighted. 

How is Greece going to extract itself from that corner into which it has been painted is anybody's guess. And extract itself it must, as  must all nations. A 0% risk weight for the sovereign and 100% for the citizens is an unsustainable statist proposition.

It all makes me wonder how Tooze would have written this chapter had he considered this. Perhaps he could have been closer to opine this?