#AI ChatGPT – OpenAI: What if roulette paid out more than what odds merited on “safe” bets and less so with “risky” bets?

I asked OpenAI:

"What would happen to a casino if their roulette game paid out more than what odds merited on “safe” bets, like colors, and paid out less than what odds merited on “risky” bets, like numbers?"

OpenAI answered: 

"If a casino intentionally set up their roulette game to pay out more than the odds merited on "safe" bets, such as colors, and paid out less than the odds merited on "risky" bets, like numbers, it would be a highly unusual and unsustainable practice. Let's explore the potential consequences:

1. Initial Attraction: Initially, such a casino might attract more players who are enticed by the higher payouts on the "safe" bets. This could result in increased footfall and activity, as people perceive it as an opportunity to earn more.

2. Imbalanced Payout Structure: However, the imbalanced payout structure would create a significant advantage for the players on "safe" bets. Over time, the casino would start losing money on these bets. The casino's profits would heavily depend on players consistently making "risky" bets, where the odds are unfairly skewed against them.

3. Unsustainability: The casino's profitability would likely suffer in the long run due to the imbalanced payout structure. Skilled or knowledgeable players would realize the advantageous odds on "safe" bets and exploit them, while the allure of the lower odds on "risky" bets would eventually wane.

4. Reputational Damage: Operating a casino with a flawed payout system could result in significant reputational damage. Players would quickly recognize the unfairness and feel cheated. Word would spread, and the casino's credibility and trustworthiness would be severely compromised, leading to a loss of customer loyalty.

5. Regulatory and Legal Consequences: Casinos are subject to strict regulations and oversight. Intentionally manipulating payout odds could be considered fraudulent or illegal, depending on the jurisdiction. The casino could face legal consequences, fines, or even lose its license to operate.

6. Competition and Market Impact: In a competitive gambling industry, other casinos would likely capitalize on the opportunity to criticize and attract players away from the casino with the imbalanced payout system. They could emphasize fair odds and better player experiences, further eroding the imbalanced casino's market share.

In conclusion, intentionally setting up a roulette game with imbalanced payouts would likely lead to short-term gains followed by long-term losses, reputational damage, and potential legal consequences. Casinos typically operate based on the principle of providing games with fair odds and a built-in house edge to ensure profitability over time.

I asked OpenAI:

"Is that situation not somewhat similar to when regulators, with risk weighted bank capital requirements, allow banks to leverage their equity more with bets on what’s perceived as safe and thereby easier obtain higher payouts on equity, than with bets on what’s perceived as risky?"

OpenAI answered:

"Yes, you are correct that there is a similarity between risk-weighted bank capital requirements and the potential for banks to leverage their equity more with perceived "safe" bets. Let's delve into this further:

1. Risk-Weighted Capital Requirements: Risk-weighted bank capital requirements are designed to incentivize banks to allocate more capital for riskier assets. This means that banks must hold a higher amount of capital relative to the risk associated with a particular asset or exposure. The risk weights are typically determined by regulatory authorities based on the perceived riskiness of different types of assets.

2. Leverage and Payouts: When banks hold more capital against riskier assets, it effectively limits their ability to leverage their equity and increases the amount of capital they need to set aside. Consequently, banks have less leverage available to amplify potential gains or payouts on those riskier assets.

3. Perceived Safety and Higher Payouts: On the other hand, if regulators deem certain assets or exposures as less risky, they assign lower risk weights. This allows banks to hold less capital against those assets, enabling them to have higher leverage and potentially obtain higher payouts on their equity. This can be seen as an incentive for banks to allocate more resources towards assets perceived as safer.

4. Risk-Return Tradeoff: The risk-weighted capital requirements acknowledge the risk-return tradeoff inherent in banking activities. By allowing banks to leverage more on perceived safer bets, regulators aim to create a balance that encourages prudent risk management. Banks have the potential to generate higher returns on their equity from these safer bets, but with relatively lower risk.

It is important to note that risk-weighted capital requirements are part of a broader regulatory framework aimed at maintaining financial stability and safeguarding the banking system. Regulators continuously evaluate and adjust these requirements based on evolving market conditions and risk assessments.

While there are similarities to the casino example in terms of leveraging equity differently based on perceived risk, the motivations and implications in the banking sector are fundamentally different due to the importance of financial stability, prudential risk management, and systemic considerations.

I asked OpenAI:

With respect to obtaining profits without compromising the security of their entity, how do the motivations between casino owner and bank owners differ?

OpenAI answered:

"The motivations of casino owners and bank owners differ significantly due to the nature of their respective industries and the role they play within the economy. When it comes to obtaining profits without compromising the security of their entities, the motivations can be understood as follows:

1. Casino Owners: Casino owners primarily operate within the entertainment and gambling industry. Their motivation is to generate profits by offering various games and attractions to customers. However, casinos operate under the understanding that the odds are in their favor in the long run. They design their games to have a built-in house edge, ensuring that they are statistically likely to make money over time. The profitability of a casino depends on a consistent flow of customers who participate in games and, on average, lose more money than they win. Casino owners strive to strike a balance between providing an enjoyable experience to customers and maintaining profitability.

2. Bank Owners: Bank owners operate within the financial sector and provide various banking services such as accepting deposits, making loans, facilitating transactions, and offering investment products. Their primary motivation is to generate profits while managing risk. Banks make money through the interest charged on loans, fees for services, and returns on investments. However, their profitability is not solely dependent on customer losses but rather on effective risk management, prudent lending practices, and diversification of their operations. Banks have a fiduciary responsibility to protect customer deposits and maintain the stability of the financial system. Their motivations are driven by long-term sustainability, maintaining regulatory compliance, and building trust and confidence among their customers and stakeholders.

In summary, while both casino owners and bank owners seek profitability, their motivations and the ways they achieve profits differ significantly. Casino owners rely on the inherent odds in their favor, whereas banks aim to generate profits through a range of financial services while managing risks and maintaining the security and stability of their entities."

My comment: Artificial Intelligence here seems with certainty opine casino owners love profits much more than what bankers do. I guess AI could be helped by relying a bit more on Human Intelligence / Intuition.

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

PS. Not the first time I have dwelt on this issue.

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

What if golf, roulette, horse-racing or tennis, had fallen into the hands of a Basel Committee?

What would have happened to golf, if its handicap system had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to casinos, if odds settings, like for roulette, had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to horse racing, if the handicapping of horses with weights had fallen into hands as those of the Basel Committee who designed the risk weighted bank capital requirements?

What would have happened to tennis, if the ranking of the players had fallen into hands of those of the Basel Committee who designed the risk weighted bank capital requirements?

My 2019 letter to the Financial Stability Board

My 2019 letter to the IMF

My current memo on the mistakes of the risk weighted bank capital requirements

I am not new to this

Did regulators, when developing the fundamentally wrong risk weighted capital requirements for banks, suffer some kind of “perception controlled hallucination” or any other psychological disorder?

In 1988, with the Basel Accord, Basel I, the Basel Committee for Banking Supervision introduced the use of risk-weighted capital requirements for banks. That scheme was further much expanded in 2004 with Basel II.

In essence that meant that banks had to hold more capital against what is (ex ante) perceived as risky than against what is perceived as safe. 

The stated goal of this regulation, was and is to avoid the failure of banks that can put the economy in jeopardy and that could cause big loses for depositors or big costs for tax payers derived from official rescue interventions.

Nothing wrong with that intention, except for what they did and what they ignored when developing these risk-weighted capital requirements.

What did they do? 

They looked at the risk of the assets just like bankers do, and not at the risk that bankers might be perceiving the risks wrong, or acting wrongly to risks well perceived. 

What’s the worst case scenario about risks perceived wrong? Clearly that something ex ante perceived as very safe turns out ex post as very risky. The opposite, something perceived as very risky turning out very safe should obviously not bother anyone… except of course the borrower who had to pay too high risk premiums.

What did they ignore? 

First that all major bank crises have resulted from, criminal behavior, unexpected events or excessive exposures to something ex ante perceived as safe but that ex post turned out to be very risky. “A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain.” Mark Twain. The mistake can perhaps be illustrated by the fact that regulators, in their standardized risk weights of 2004, assigned a 150% to the below BB- rated, that which bankers won’t touch with a teen feet pole, but a meager 20% to what is AAA to AA rated.

Second, that these risk weighted capital requirements, which allowed banks to leverage more with what was perceived safe, would have banks earning higher expected risk adjusted returns with what was perceived safe, which would naturally increase the risk of some perceived safe havens become dangerously overpopulated, against especially little capital. In a Roulette in a casino,  2 to 1 and 36 to 1 are equivalent winnings paid out to those playing it “safe” on color or those playing it “risky” on a number. If the winning for those same bets were for example 3 to 1 and 30 to 1, that would break the bank and sink the casino.

Third, that the real economy, in order to move forward depends much on risky entrepreneurs and small and medium enterprises (SMEs) having access to bank credit. “A ship in harbor is safe, but that is not what ships are for.” John A Shedd.

I do not think it is prudent to distort the allocation of bank credit to the real economy, so I would favor one single capital requirement against all assets, but if I absolutely had to distort in this way, then my risk weighting would have to be 180 degrees in the opposite direction, higher perceived risk-lower capital, lower perceived risk-higher capital. 

It was 30 years when this monumental mistake was initiated, and for all practical purposes it is not yet even discussed… so the stickiness of that mistake has proven to be equally monumental.

Friends, is it something in “Predictive Processing” that could explain this so fundamental mistake in our current bank regulation, and its stickiness?

And more importantly still, in what way can “Predictive Processing” help us to avoid this type of extremely costly mistakes.

Here a brief aide memoire on the major mistakes with the risk weighted capital requirements

@PerKurowski

All dollars (or Pounds, or Euros) should be equal!

The efficient market hypothesis, and the capacity of free markets to allocate efficiently financial resources have, as a consequence of the recent financial crisis, been seriously questioned. There is absolutely no cause for that.

In a free market all dollars pursuing assets are equal, and so the prices reflect the markets appreciations of returns, risks, and other factors… and so in essence, all assets will produce equivalent all included risk-adjusted returns. Like any bet on the roulette.

But then came bank regulators, with their risk-weighted capital requirements, more risk more capital, less risk less capital, and determined that some dollars, those being lent to what was perceived as “absolutely safe” were worth much more because these could be leveraged by banks much much more, than the dollars lent to what was perceived as “risky”. Like doubling the roulette payout when playing it safe, like betting on a color.

And of course that made it impossible for the markets to function. It would be like pricing assets in dollars Euros and Pounds, simultaneously without informing the markets of which currency was used. In fact, since bank capital when in “risk-free” land could sometimes be leveraged about 40 times more than when in “risky” land, the currencies used are perhaps more like dollars, pesos and yen. 

And so a dollar going to someone “risky” is for the banks worth de facto much much less than a dollar going to the AAAristocracy. Talk about financial exclusion! Talk about increasing inequality gaps!

Discriminating against risk-taking, in the "Home of the Brave"... you´ve got to be kidding!

Please regulators, allow a dollar to be a dollar for everyone! So that markets will work again!

PS. By the way who authorized all that?

The Basel II Roulette Manipulation

Because of what they perceive as reckless speculative risk-taking by banks, many refer to banking as a casino. So, let us think of the different loans and investments a bank can make, in other words of their allocation of bank credit to the economy, as their alternative bets on a roulette table.

On such table there are e.g., “Safe Bets”, black or red, with a payout of 1 plus the bet; “Intermediate bets”, columns, with a payout of 2 plus the bet; and “Risky Bets”, any single number, with a payout of 35 plus the bet. All bets have of course a similar expected value of return, the same risk-adjusted return. In the case of the roulette, a somewhat negative one, because the House always wins when the zero or double zero comes up, the House Edge. In banking, good credit and investment analysis, is expected to provide positive yields, even for the "zero" and "double zero".

Imagine then that a Basel Committee for Roulette Supervision suddenly got concerned with that some players were making too many risky plays; losing all their money, very fast, and that this was something for which they, as a regulatory authority, could be blamed for, and decided to do something about it.

And so, they decreed their Basel Roulette Regulations by which, in order to keep the players playing longer and not losing it all so fast, they allowed the payout for “Safe Bets” to be five times higher, 5 plus the bet; the payout for “Intermediate Bets” double the current, 4 plus the bet; while the payout for “Risky Bets” would remain the same, 35 plus the bet. 

What do you think would happen? Just what had to happen! Every player ran to make “Safe Bets”, and now and again, just for kicks, perhaps an “Intermediate Bet”, but they all stayed away from “Risky Bets”, since these just did not any longer make sense.

And the players got so excited with their profits, and bet more than ever, and so when suddenly the zero or double zero appeared, as had to happen, sooner or later, they lost fortunes and got wiped out, more than ever, often to such an extent that the casino even had to pay for their taxi ride home. Of course casinos, as we know them, could no longer exist.

Before current Basel bank regulations, all bank lending or investment alternatives produced basically the same expected risk and cost of transaction adjusted returns on equity; because that is what a free competitive market and banking mostly produces. This was precisely what The Basel Committee for Banking Supervision changed when, with Basel II, it imposed different risk-weights to determine the banks shareholder's capital/equity/skin-in-the-game requirements for different assets.

For instance, against any AAA to AA rated asset, “The Infallible”, banks had to hold only 1.6 percent in shareholders’ capital/equity/skin-in-the-game, and were therefore allowed to leverage their equity with the net risk adjusted interest rate 62.5 times to 1. Against “The Risky” assets, like loans to unrated small businesses and entrepreneurs, banks must hold 8 percent in capital meaning they then can “only” leverage their equity 12.5 times to 1. For “The Intermediate” assets, with a 4 percent capital requirement, in a similar way a 25 to 1 leverage is authorized.

The result? When compared to the allowed leverage on equity of the net risk adjusted interest rate, the payout/ROE for “The Risky”, translates into a FIVE times higher allowed payout/ROE for “The Infallible”, and TWO times higher for “The Intermediate”. 

This absolutely loony manipulation of the odds of banking; and which obviously not only guaranteed that when disaster struck the banks would be standing there naked without any capital; also made it impossible for the banks to perform with any sort of efficiency their vital role of allocating economic resources. 

And the craziest thing is that soon five years after the 2008 GFC disaster occurred, this manipulation of the odds of banking is not even being discussed. Not even against clear evidence that, as usual, as these always are, this crisis was the result of banks building up excessive exposures to what’s perceived or decreed as safe, in this case AAA to AA rated securities backed with mortgages to USA’s subprime sector.

Poor us! These banking regulations are castrating our banks, making them sing in falsetto accumulating more balance sheets exposure to the "safe-havens", which will become dangerously overpopulated; while avoiding like the plague exposures to the riskier but probably more productive bays where our young could find the next generation of jobs they so urgently need.

PS. The distortion had already begun in 1988 with Basel I: “The assets assigned the lowest risk, for which bank capital requirements were therefore low or nonexistent, were those that had the most political support: sovereign credits and home mortgages” Paul Volcker

PS. And it would be so comic, if not so tragic, that absolutely most experts, including Nobel Prize winners, keep on referring to the crisis as a result of excessive risk-taking by banks, and which is of little assistance when trying to explain that what all banks were doing, was betting excessively on boring safe bets, red or black, and this only because of bad regulations… rien ne va plus.

PS. What if golf, horse-racing and tennis had also fallen into the hands of a Basel Committee?