#AI ChatGPT – Grok: Can regulations make interests on bank loans to productive and innovative projects higher than need to be?

I asked ChatGPT: Briefly in 200 words:

"The interest rates for bank loans that funds innovative projects that result in productive economic growth and high future levels of prosperity; are these higher than need be because of the risk weighted bank capital/equity requirements?"

ChatGPT answered:

"Yes, they can be, although the extent depends on the regulatory framework, market conditions, and the borrower's characteristics.

Risk-weighted bank capital requirements generally assign higher capital charges to many loans made to innovative startups, entrepreneurs, and small businesses than to residential mortgages or highly rated sovereign debt. Because equity funding is typically more expensive than deposits or debt, requiring banks to finance these loans with more equity can increase their overall cost of making them.

Banks may respond by charging higher interest rates, tightening lending standards, or reducing the supply of such credit altogether. As a result, some innovative but productive projects may face financing costs above what they would under a neutral leverage ratio that required the same capital against all assets.

That said, not all of the interest-rate difference is attributable to regulation. Innovative projects are often genuinely riskier, less collateralized, and more information-intensive, so some premium would exist even without risk-weighted capital requirements.

Critics argue that risk-weighted requirements amplify this premium by adding a regulatory cost on top of the underlying credit risk, potentially discouraging investment in activities that drive long-term productivity and economic growth. Supporters counter that the additional capital reflects the greater likelihood of losses and helps maintain banking system resilience.

I said: Thanks!

It replied: "You're very welcome! I'm glad it was helpful.

Your question highlights an important distinction that is often overlooked: the market price of risk versus the regulatory price of risk. Even if innovative projects should naturally pay somewhat higher interest rates because they are riskier, a risk-weighted capital framework may add an additional regulatory cost. Whether that extra cost is justified remains a subject of debate, as it involves balancing financial stability against the efficient allocation of credit and long-term economic growth.

I look forward to your next question."

I asked Grok: Briefly in 200 words:

"The interest rates for bank loans that funds innovative projects that result in productive economic growth and high future levels of prosperity; are these higher than need be because of the risk weighted bank capital/equity requirements?"

Grok answered:

"Yes, to a meaningful degree.

Risk-weighted capital rules (Basel framework) require banks to hold more equity against loans judged riskier. Innovative projects—new technologies, startups, R&D-intensive firms—typically receive higher risk weights because of greater uncertainty, thinner collateral, and limited track records. Equity is costlier than deposits or wholesale debt, so the extra capital raises the bank’s funding cost. That cost is passed through as higher loan interest rates (or tighter credit rationing).

The resulting rates can exceed the pure economic cost of the risk. Innovation generates large positive externalities (knowledge spillovers, productivity growth, future prosperity) that private lenders do not capture. Conservative risk weights therefore amplify a private–social gap: society benefits more from these projects than the bank’s private risk–return calculation implies. Low-risk assets (mortgages, sovereign bonds) face lighter weights and cheaper funding, further tilting the relative price against growth-oriented lending.

The rules improve systemic resilience, but they do raise the price of financing high-upside innovation above the level warranted by social returns alone."

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 – Grok on bank regulations.

Do the risk weighted bank capital requirements make the risky more or less risky?

Basel III’s bank capital requirement’s risk weights (RW) for residential mortgages depending on Loan to Value (LTV); implied Allowed Leverage of capital/equity (AL) and expected Return On Equity (eROE), calculated with a Risk Adjusted 0.5% expected Return on Asset (eROE) 

LTV<50%: RW = 20%: AL = 62.5 to 1: eROE = 31%

50% < LTV ≤ 60%: RW = 25%: AL = 50 to 1: eROE = 25%

60% < LTV ≤ 80%: RW = 30%: AL = 41.7 to 1:  eROE = 21%

80% < LTV ≤ 90%: RW = 40%: AL 31.25 to 1: eROE = 16%

90% < LTV ≤ 100%: RW = 50%: AL 25 to 1: eROE = 12%

LTV > 100%: RW = 70%: AL 17.9 to 1: eROE = 9%

Those with higher LTV, because they are riskier, must naturally pay banks higher risk adjusted interest rates. But, since banks can hold less capital against lower LTVs, they must also compensate banks, so as to provide these with a competitive risk adjusted return on equity.

So, in order for those who have no money to put down (LTV) > 100%, and with which banks can leverage 17.9 times, in order to compete with those who put down LTV <50%, need to provide an expected Risk Adjusted Return on Asset of 1.73 (31%/17.9); meaning in this case a 1.23% higher interest rate than without this distortion.

And we ask: charging those who have no money to put down, and who should perhaps not even have access to a residential mortgage, a 1.23% higher interest rate than what their risk adjusted interest rate would otherwise be, does that make these more or less risky?

Conclusion: The risk weighted bank capital requirements have, de facto, 0% to do with credit risk reduction, and 100% to do with risk generating distortions.

If race can be correlated to higher LTV mortgages, does this not de facto imply regulators are engaged in discrimination based on race?

Basel Committee... Good Job!

In that real very real class war between those who have houses as investment assets and those who just want affordable homes, where do you stand?

Being more creditworthy should not mean being more worthy of credit

And we must also ask, are the risk weighted bank capital requirements really in accordance with the spirit of the Equal Credit Opportunity Act (ECOA) or the Community Reinvestment Act (CRA)?

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

Why has Academia for decades kept silence on Basel Committee’s loony and dangerous risk weighted bank capital requirements?

My 2019 letter to the Financial Stability Board (FSB)

Even perfectly perceived risks cause wrong decisions if excessively considered

Should banks consider risk factors, such as the probability of default (PD) and the expected loss given a default (LGD), when setting the interest rates it charges clients? Of course, higher perceived risk-higher interests, lower risks-lower interest rates. 

But regulators curiously decided that these risks should also be cleared for in the capital requirements for banks, and decreed: higher perceived risk-higher capital, lower risks-lower capital.

So now banks clear for these risks both with risk adjusted interest rates and risk adjusted capital. That’s a real serious problem because any risk excessively considered, will produce the wrong decision, even if the risk is perfectly perceived.

Now a higher interest rate perfectly set in accordance to a perfectly perceived higher risk translates, because of higher capital requirement, meaning a lower leverage, into a lower risk adjusted expected return on equity. 

Now a lower interest rate perfectly set in accordance to a perfectly perceived lower risk translates, because of a lower capital requirement, meaning a higher leverage, into a higher risk adjusted expected return on equity.

So now banks, even when the risks are perfectly perceived, lend too little to the risky, or in order to compensate for lower ROEs, at too high risk adjusted interest rates; and lend too much to the safe, or thanks to higher ROEs, at too low risk adjusted interest rates.

This is insane! It produces dangerous misallocation of bank credit to the real economy. Too little financing of the "riskier" future and too much refinancing of the "safer" present.

PS. There is still a possibility of credit being allocated efficiently to the real economy, but that requires that what's perceived as safe to be much safer and what’s perceived as risky to be much riskier. What credit rating agencies could guarantee us such mistakes?

Regulators and bankers looking out for the same risks 

IMF, where have you been since the financial crisis broke out in 2007?

In January 2003, while being an Executive Director at the World Bank, in a letter published by FT, I wrote: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds. Friend, please consider that the world is tough enough as it is.”

And as predicted, with the help of the capital requirements for banks much based on credit ratings concocted by the Basel Committee in Basel II, the rating error of the AAA rated securities backed with mortgages to the subprime sector in the US, was propagated into trillions of dollars in exposures, even in faraway Europe.

And now, soon seven years after the outbreak of the crisis, we read a compendium of articles published by the International Monetary Fund, under the not so humble title of “Financial Crises: Causes, Consequences, and Policy Responses”, and in which we do not find one single reference to the risk-weighted capital requirements.

There is one reference though to credit ratings: “Credit ratings also deteriorate notably before a default, and improve only slowly in the aftermath of debt restructuring”. But that reference, if anything, makes it even clearer why the IMF should be opposed to the risk weighted capital requirements.

Also, in the World Economic Outlook, April 2004, that has a chapter titled “Perspectives on Global Real Interests, we do not find one single reference, or adjustment to the fact that allowing banks to hold sovereign debt, at least that of “the infallible”, against no capital, translates effectively into a subsidy of public debt, and which makes historical comparisons of rates not longer really valid.

And the Global Financial Stability Report, April 2014, also clearly evidences IMF has still not understood how the risk-weighted capital requirements for banks not only distorts the allocation of bank credit but also, by amplifying the effect of any insufficient perception of risk, becomes one of the most important sources of instability in our financial system.

Run for your lives! A baby has peed in the pool!

I really do not care much about The Libor Affair, an interest rate manipulation scandal that has some winning and others losing, not really of much importance in the grand scheme of things.

And so, when compared to other official interest manipulations, like what happens when regulators dole out risk weights based on perceived risks to set the specific capital requirements for banks, The Libor Affair is basically the same as a little baby peeing in a big swimming pool. If chemical elements are used to detect it, and water turns blue, then everyone screams, though in fact no one really needs to care that much about it.

What really should upset us all is The Basel Affair, the greatest and most dangerous interest rate manipulation ever.