#AI ChatGPT – OpenAI: Is clearing for perceived credit risk both in assets and in equity, excessive and dangerous?

I asked OpenAI:

"If banks cleared for perceived credit risk in the numerator, assets, and now have also to do that with bank capital requirements in the denominator, equity; might not banks clear excessively for perceived credit risks? Is that not dangerous?"

OpenAI answered:

"Clearing excessively for perceived credit risks, while ensuring bank capital requirements are met, can indeed have potential drawbacks and risks. Here are a few considerations:

1. Overly Restrictive Lending: If banks become overly cautious in their credit risk assessment, they may tighten lending standards too much, making it difficult for businesses and individuals to access credit. This can hinder economic growth and restrict capital flow, which is essential for investment and development.

2. Reduced Profitability: Excessive risk aversion can lead to conservative lending practices, resulting in lower loan volumes and potentially reduced profitability for banks. This can impact their ability to generate returns for shareholders and allocate capital efficiently, potentially hampering economic activity.

3. Inadequate Credit Provision: Clearing excessively for perceived credit risk may result in banks underestimating the actual risk inherent in their loan portfolios. If credit risks are not accurately assessed and provisions are insufficiently allocated, banks may face significant losses during economic downturns, which can weaken their financial stability.

4. Economic Impact: Banks play a crucial role in supporting economic growth by providing credit to businesses and households. If banks clear excessively for perceived credit risks, it can lead to a credit crunch, hampering investment, consumption, and overall economic activity.

To strike the right balance, regulators and policymakers need to establish prudent risk management guidelines and ensure that banks have effective risk assessment frameworks in place. This includes periodic stress testing, robust capital adequacy assessments, and ongoing monitoring of banks' credit portfolios. The aim is to encourage responsible lending and risk-taking while maintaining adequate safeguards to protect the stability of the banking system.

Regulators should also regularly review and update capital adequacy requirements to align them with the prevailing economic conditions and risk landscape, ensuring they strike the right balance between safety and promoting lending activities.

Overall, while it is important for banks to clear credit risks and meet capital requirements, finding the right equilibrium is essential to avoid excessive risk aversion that could stifle economic growth or inadequate risk management that could lead to instability in the banking system."

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

PS. "Free us from imprudent risk aversion and give us some prudent risk-taking"

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

How come XXX, who graduated as a financial expert from YYY, did not know this?

Anyone with some basic financial knowledge must know that banks allocate their portfolio to what produces them the highest risk-adjusted return on their equity; and that constitutes in its turn the best possible (or least bad) way of allocating bank resources to the real economy.

What I cannot for my life figure out is how come a financial professional does not understand that if bank regulators allow banks to hold much less shareholder’s capital against some assets, for instance those perceived as “safe”, than against other assets, for instance those perceived as “risky”, then the banks will earn higher risk adjusted returns on “safe” assets than on “risky” assets, which will distort the allocation of bank credit, and guarantee that the banks will hold too much “safe” assets and too little “risky” assets.

And of course when banks hold “too much” of a “safe” asset, then that asset could turn into a very risky asset for the banks. This is by the way something empirically well established. Never ever has a major bank crisis resulted from excessive exposures to what was perceived ex ante as “risky”, these have all, no exceptions, resulted from excessive exposures to what was ex ante, erroneously perceived as safe... like AAA-rated securities, Greece, etc.

And of course holding “too little” of the “risky” assets, like of loans to medium and small businesses, entrepreneurs and start ups, is very bad for the real economy which thrives on risk-taking, and is therefore, in the medium term, something also very risky for the banks.

How come all those reputable tenured finance professors in so reputable universities did not care one iota about the allocation of bank credit in the real economy was being so completely distorted by the risk-weighted capital requirements for banks?