#AI #ChatGPT #Grok: For more sturdy economic growth and less dangerous bank systems what’s better: risk weighted bank capital requirements or a leverage ratio?

I asked: 

In less than 300 words please opine on: Between the current risk weighted bank capital requirements and a simple leverage ratio, e.g., 10 percent against all assets, what helps to generate a higher and more sturdy general economic growth, without creating bigger dangers for bank systems at large?

ChatGPT answered:

A simple leverage ratio—e.g., requiring banks to hold 10% capital against all assets—would likely foster sturdier and more sustainable economic growth than the current risk-weighted capital requirements.

Risk-weighted frameworks, such as those under Basel accords, distort credit allocation by assigning very low capital requirements to assets deemed “safe” (e.g., government bonds, AAA securities, residential mortgages) and much higher requirements to loans to small businesses and entrepreneurs. This encourages banks to overinvest in assets with regulatory privileges, inflating sovereign debts and housing markets, while underfinancing productive sectors that drive real economic growth. The result is a misallocation of credit, weaker innovation, and more volatile growth cycles.

Moreover, risk weights are pro-cyclical: in good times, perceived risks fall, reducing required capital and fueling credit booms; in bad times, risks rise, forcing banks to deleverage when credit is most needed. This amplifies financial instability and recessions.

A flat leverage ratio, by contrast, treats all assets equally, pushing banks to assess risk and return based on market fundamentals rather than regulatory incentives. While critics argue it may discourage lending to low-risk borrowers, it would promote a healthier distribution of credit, more productive investment, and reduce systemic bubbles tied to regulatory favoritism.

In sum, a simple leverage ratio may modestly slow credit growth in the short term but supports steadier, more innovation-driven growth over time—without introducing the systemic fragilities risk-weighted rules have repeatedly failed to prevent.

Would you also like me to add a one-sentence conclusion explicitly stating which is safer for bank systems at large?

I said: Please do!

ChatGPT said:

In conclusion, a simple leverage ratio is safer for bank systems at large, as it limits overall leverage uniformly and avoids the concentration and systemic risks fostered by mispriced regulatory risk weights.

I said: Thanks!

It replied: You're welcome! 😊 Always glad to help—feel free to return anytime!

Grok answered: 

A simple leverage ratio, such as 10% against all assets, likely fosters higher and more robust economic growth compared to risk-weighted bank capital requirements, without significantly increasing systemic dangers. Risk-weighted frameworks, like Basel III, assign lower capital requirements to assets deemed "safe" (e.g., government bonds), incentivizing banks to overweight these assets. This can distort investment decisions, channeling funds away from riskier but potentially more productive ventures, like small business loans, stifling economic dynamism. Moreover, risk-weighting relies on subjective models that often fail to predict crises, as seen in 2008 when highly rated assets collapsed.

A uniform leverage ratio simplifies regulation, reduces gaming of risk models, and ensures banks hold sufficient capital against all assets, enhancing resilience. By not favoring specific asset classes, it promotes broader lending, supporting diverse economic activity and growth. For instance, a 10% ratio could encourage banks to finance innovative sectors without penalizing perceived risk, as risk-weighting does.

However, leverage ratios aren’t flawless. They might constrain lending during booms, potentially dampening growth, and could push risk-taking into unregulated sectors. Yet, their transparency and uniformity reduce complexity and regulatory arbitrage, which risk-weighted systems exacerbate, often masking vulnerabilities until crises hit.

Empirical data suggests economies with simpler capital rules recover faster from downturns. For example, post-2008, banks with higher leverage ratios weathered shocks better than those reliant on risk-weighted metrics. A 10% leverage ratio, while not perfect, balances growth and stability by enforcing discipline without distorting market signals. Risk-weighted systems, while sophisticated, often breed complacency and misallocation, undermining both economic vigor and systemic safety.

I said: Thanks

It replied: You’re welcome

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

Here my many other questions to ChatGPT and Grok on bank regulations

ChatGPT OpenAI: What’s more dangerous to bank systems assets perceived as risky turning out risky, or assets perceived as safe turning out risky?

I asked ChatGPT:

"What’s more dangerous to bank systems assets perceived ex ante as risky turning out risky ex post, or assets perceived ex ante as safe turning out risky ex post?"

ChatGPT answered:

"Both types of assets can be dangerous to bank systems, but assets that are perceived as safe but turn out to be risky ex post can be particularly dangerous.

When a bank invests in assets perceived as risky, it is aware of the potential risks and should be taking steps to manage and mitigate those risks. However, when a bank invests in assets perceived as safe but turns out to be risky ex post, it may not have taken sufficient precautions to manage those risks, and the losses can be unexpected and severe.

For example, during the 2008 financial crisis, many banks had invested in mortgage-backed securities that were perceived as safe because they were rated AAA by credit rating agencies. However, when the underlying mortgages began to default at higher rates than expected, the value of these securities plummeted, causing significant losses for banks that held them.

In contrast, when a bank invests in assets perceived as risky and they turn out to be risky ex post, the bank may have already factored in potential losses and taken steps to manage the risks. Of course, it is still important for banks to carefully manage their exposure to risky assets and have strong risk management practices in place to minimize potential losses."

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

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

Note: I fully agree!

ChatGPT - OpenAI: Are large bank exposures built up with assets perceived as risky or with what's perceived as safe?

I asked ChatGPT:

"Those large exposures that can become dangerous to our bank systems are built-up with assets perceived as risky or with assets perceived as safe?"

ChatGPT answered:

"Large exposures that can become dangerous to bank systems can be built-up with either risky assets or safe assets, depending on the circumstances.

If a bank has a large exposure to risky assets such as high-yield bonds or subprime mortgages, then a sudden drop in the value of these assets can lead to significant losses for the bank. This can be especially dangerous if the bank is highly leveraged, meaning it has borrowed a lot of money to invest in these assets.

On the other hand, large exposures to safe assets such as government bonds or highly rated corporate bonds may not seem risky on the surface. However, if a bank has a significant amount of its assets invested in these types of securities and there is a sudden rise in interest rates, the value of these bonds may fall, causing losses for the bank. In addition, if many banks are invested in the same types of safe assets, a sudden market shift could lead to widespread losses across the banking system.

In either case, it's important for banks to manage their exposures carefully and have robust risk management practices in place to identify and mitigate potential risks."

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

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

The almost 600 year long history of banks changed dramatically, for the worse, in 1988, with the Basel Accord.

If we use the Medici Bank as the first bank, it was established in 1397. From there on, until 1988, a bank’s capital (equity) followed the simple “one for all and all for one” principle. 

Then with the Basel Accord, Basel I, the regulators introduced risk weighted capital requirements for the banks. More ex ante perceived risk more capital – less risk less capital. That had serious and non-transparent consequences for the borrowers, for the economy, for bank stability and for the balance between the government and We the People.

It promoted inequality among the borrowers:

The ex ante perceived “risky” borrowers, those who precisely because of those perceptions, already got less credit and had to pay higher interest rates, now also had to face the costs of generating higher capital requirements for banks; while the ex ante perceived “sage” borrowers, those who precisely because of those perceptions, already got more credit and had to pay lower interest rates, now also received the subsidy of generating lower capital requirements for banks.

It stopped the economy to move forward, so it stalls and falls

Banks, because of the higher leverage allowed with assets perceived as safe, obtained higher expected risk adjusted returns on equity when financing, the “safe” than when financing the “risky”, like SMEs. The new regulations stopped banks from financing the riskier future and mostly dedicate themselves to refinance the safer past and present. They now finance safe basements where jobless kids can live with parents, but not the SMEs that could get the kids jobs.

It destabilized the bank system.

By assigning ultra low capital requirements for what was perceived as safe it caused the dangerous overpopulation of “safe havens”, like the AAA rated securities built-up with lousy mortgages to the subprime sector… and against very little capital.

It brought in statism thru the bathroom window.

Risk weights of 0% for the Sovereign and 100% for We the People, expresses unabridged statism in that it, de facto, implies regulators think government bureaucrats are able to use bank credit better than SMEs and entrepreneurs.

Just try to imagine what the Médicis would have said about assigning a 0% risk weight to the Sovereign?

PS. “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” Paul Volcker

PS. Here's a more extensive aide memoire on some of the monstrosities of such regulations

Evidence that demonstrates, without any reasonable doubt, we have landed us some very feeble-minded bank regulators

What are the chances banks build up huge exposures to those rated prime, AAA to AA, and which could be dangerous to the bank system, if these, ex post, turn out to have been worthy of a much lower rating? Big!

What are the chances banks build up dangerously large exposures to those rated “highly speculative “ and worse below BB-? None! 

And yet the regulators, for the purposes of determining the capital requirements for banks, in Basel II, assigned to the AAA to AA rated, a risk weight of 20%, and to the below BB- rated, a risk weight of 150%.

And to top it up, the risk weights are portfolio invariant.

Do we really need more evidence that the Basel Committee regulators and those affiliated to it are cuckoo?

They behave like nannies telling the children “Stay away from the ugly and foul smelling, and embrace the nice gents bringing you candy”, and so dangerously distort the allocation of bank credit to the real economy.

Voltaire to the Basel Committee: “May God defend me from my friends [AAA rated]: I can defend myself from my enemies [BB- rated]”

Here is a brief memo that further explains their idiocy.